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Comparing return on investment and residual income

# Comparing return on investment and residual income

Question

Problem 15-22:

Comparing return on investment and residual income

Wells Corporation operates three investment centers. The following financial statements apply to the investment center named Huber Division.

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Required

a. Which should be used to determine the rate of return (ROI) for the Huber investment center, operating income or net income? Explain your answer.

b. Which should be used to determine the ROI for the Huber investment center, operating assets or total assets? Explain your answer.

c. Calculate the ROI for Huber.

d. Wells has a desired ROI of 15 percent. Headquarters has \$96,000 of funds to assign to its investment centers. The manager of the Huber Division has an opportunity to invest the funds at an ROI of 17 percent. The other two divisions have investment opportunities that yield only 16 percent. Even so, the manager of Huber rejects the additional funding. Explain why the manager of Huber would reject the funds under these circumstances.

e. Explain how residual income could be used to encourage the manager to accept the additional funds.

Problem 16-18:

Using net present value and internal rate of return to evaluate investment opportunities Veronica Tanner, the president of Tanner Enterprises, is considering two investment opportunities. Because of limited resources, she will be able to invest in only one of them. Project A is to purchase a machine that will enable factory automation; the machine is expected to have a useful life of four years and no salvage value. Project B supports a training program that will improve the skills of employees operating the current equipment. Initial cash expenditures for Project A are \$100,000 and for Project B are \$40,000. The annual expected cash inflows are \$31,487 for Project A and \$13,169 for Project B. Both investments are expected to provide cash flow benefits for the next four years. Tanner Enterprise’s cost of capital is 8 percent.

Required

a. Compute the net present value of each project. Which project should be adopted based on the net present value approach?

b. Compute the approximate internal rate of return of each project. Which one should be adopted based on the internal rate of return approach?

c. Compare the net present value approach with the internal rate of return approach. Which method is better in the given circumstances? Why?

d. The company pays 70 percent of accounts payable in the month of purchase and the remaining 30 percent in the following month. Prepare a cash payments budget for inventory purchases.
e. Budgeted selling and administrative expenses per month follow.

Salary expense (fixed) \$18,000
Sales commissions 5 percent of Sales
Supplies expense 2 percent of Sales
Utilities (fixed) \$1,400
Depreciation on store equipment (fixed)* \$4,000
Rent (fixed) \$4,800
Miscellaneous (fixed) \$1,200

*The capital expenditures budget indicates that Unici will spend
\$164,000 on October 1 for store fixtures, which are expected to have a
\$20,000 salvage value and a three-year (36-month) useful life.
f.Utilities and sales commissions are paid the month after they are incurred; all other expenses are paid in the month in which they are incurred. Prepare a cash payments budget for selling and administrative expenses.

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