Question

The Clipper Corporation had net operating income of $380,000 and average operating assets of $2,000,000. The corporation requires a return on investment of 18%.
Required ( support your answers with explanations):
a.Calculate the company's return on investment (ROI) and residual income (RI).
b.Clipper Corporation is considering an investment of $70,000 in a project that will generate annual net operating income of $12,950. If the division planning to make the investment currently has a return on investment of 20% and its manager is evaluated based on the division's ROI, will the division manager be inclined to request funds to make this investment?(Note: the decision model for the division manager is self-interested i.e. centers on the decision's effect on his evaluation criteria)
c.Clipper Corporation is considering an investment of $70,000 in a project that will generate annual net operating income of $12,950. If the division planning to make the investment currently has a residual income of $50,000 and its manager is evaluated based on the division's residual income, will the division manager be inclined to request funds to make this investment?(Note: the decision model for the division manager is self-interested i.e. centers on the effect on his evaluation criteria)

Answer 1

Answer:

The Clipper Corporation

a. The company's return on investment (ROI) and residual income (RI):

ROI = $380,000/$2,000,000 x 100

= 19%

RI = $380,000 - (18% of $2,000,000)

= 380,000 - $360,000

= $20,000

b. Investment = $70,000

Annual operating income = $12,950

Department's current return on investment = 20%

Actual return on investment for this project = $12,950/$70,000 x 100

= 18.5%

The manager of the division will not be inclined to request funds to make this investment that will yield an ROI of 18.5% when the department is already making 20%.  This new investment will dilute his current ROI and adversely affect his performance evaluation.

c. Investment = $70,000

Annual operating income = $12,950

Current divisional residual income = $50,000

Actual residual income from this project,

= $12,950 - (18% of $70,000)

= $12,950 - $12,600

= $350

The division manager will be inclined to request funds for this investment that will increase her Residual Income marginally from $50,000 to $50,350, because her evaluation depends on an absolute figure and not a relative one (ROI).

Explanation:

1. The Clipper Corporation's Residual Income is equal to its operating income minus (minimum required return x operating assets).

2. The Clipper Corporation's Return on Investment is a derivative obtained from dividing the returns of its investment by the cost of the investment.