Assume Stuart Modems Inc is a division of Gilmore Business P

Assume Stuart Modems, Inc., is a division of Gilmore Business Products (GBP). GBP uses ROI as the primary measure of managerial performance. GBP has a desired return on investment (ROI) of 6.10 percent. The company has $250,000 of investment funds to be assigned to its divisions. The president of Stuart is aware of an investment opportunity for these funds that is expected to yield an ROI of 7.50 percent. Income Statement Sales revenue Cost of goods sold Gross margin Sales commission Depreciation expense Administrative expense Net income 750,000 (530,000 S 220,000 (45,000) (10,000) (74,950) $ 90,050 Balance Sheet Assets: Cash Manufacturing equipment, net of accumulated depreciation Office equipment, net of accumulated depreciation Total assete Equity: Common stock Retained earnings Total equity $ 748,050 340,000 42,000 $1,130,050 $1,040,000 90,050 $1,130,050 Required a-1. Calculate the existing ROI for Stuart. a-2. Based on your computations will the President of Stuart accept or reject the $250,000 investment opportunity? c-1. Calculate the estimated residual income of the new investment opportunity. c-2. Based on the residual income would the President of Stuart accept or reject the $250,000 investment opportunity?

Solution

Solution a1:

ROI = Operating Income / Average invested assets

Average invested assets = Opening assets + (Net Income/2) = $1,040,000 + ($90,050/2) = $1,085,025

ROI = $90,050 / $1,085,025 = 8.30%

Solution a2:

As ROI offered by investment opportunity is 7.50% which is lesser than existing ROI for the division, therefore President of Staurt will reject $250,000 investment opportunity as it will result in decrease of overall ROI of the division.

Solution c-1:

Estimated residual income for new investment opportunity = Investment amount * (ROI offered - Minimum required return)

= $250,000 * (7.50% - 6.10%) = $3,500

Solution c-2:

On the basis of residula income, presiden of Stuart will accept the $250,000 investment opportunity.