Question

Back Mountain Industries (BMI) has two divisions: East and West. BMI has a cost of capital of 25 percent. Selected financial information (in thousands of dollars) for the first year of business follows.
East West
Sales revenue $1,400 $5,400
Income 270 450
Investment (beginning of year) 1,900 2,400
Current liabilities (beginning of year) 220 220
R&D expenditures (note a) 500 400


A R&D is assumed to benefit two periods. All R&D is spent at the beginning of the year.

Required:
Evaluate the performance of the two divisions assuming BMI uses residual income.

Answer 1

Answer:

Both divisions have negative residual income,but the performance of West Division is preferred

Explanation:

Residual income is the word used in describing the remnant of profit after cost of doing business(cost of capital) has been deducted from net income.

The formula is stated thus:

residual income=net income-(cost of capital*investment)

For East Division,residual income is computed as follows:

Net income is $270,000

Investment is $1,900,000

cost of capital is 25%

residual income=$270,000-($1,900,000*25%)=-$205,000

For West Division,residual income is computed as follows:

Net income is $450,000

Investment is $2,400,000

cost of capital is 25%

residual income=$450,000-($2,400,000*25%)=-$150000