Sarah Jones the manager of the Teen division of Eve Clothing

Sarah Jones, the manager of the Teen division of Eve Clothing Company, was evaluating the acquisition of a new embroidery machine. The budgeted operating income of the Teen division was $4,950,000 with total assets of $32,400,000 and noninterest-bearing current liabilities of $1,500,000. The proposed investment would add $1,014,000 to operating income and would require an additional investment of $5,289,000. The targeted rate of return for the Teen division is 13.90 percent.

1. Compute the ROI of the Teen division if the embroidery machine is not purchased?

2. Compute the ROI of the Teen division if the embroidery machine is purchased?

3. Compute the residual income of the Teen division if the embroidery machine is not purchased?

4. Compute the residual income of the Teen division if the embroidery machine is purchased?

5. Will Sarah decide to invest in the embroidery machine if her performance is evaluated in terms of ROI?

Solution

Answer

Answer 1

Compute the ROI of the Teen division if the embroidery machine is not purchased?

ROI = budgeted operating income /( Total assets - noninterest-bearing current liabilities)

        = $4,950,000 / ($32,400,000 - $1,500,000)

        = 16.02%

Answer 2.

Compute the ROI of the Teen division if the embroidery machine is purchased?

ROI = budgeted operating income /( Total assets - noninterest-bearing current liabilities)

        = ($4,950,000 + $1,014,000) / ($32,400,000 - $1,500,000 + $5,289,000)

       = 16.48%

Answer 3.

Compute the residual income of the Teen division if the embroidery machine is not purchased?

Targeted return = targeted rate of return * (Total assets - noninterest-bearing current liabilities)

                              = 13.90 % * ($32,400,000 - $1,500,000)

                              =$ 4295100

Residual income = Budgeted operating income - Targeted return

                               = $4,950,000 - $ 4295100

                               = $ 654900.00

Answer 4.

Compute the residual income of the Teen division if the embroidery machine is purchased?

Targeted return = targeted rate of return * (Total assets - noninterest-bearing current liabilities)

                              = 13.90 % *($32,400,000 - $1,500,000 + $5,289,000)

                             = 5030271.00

Residual income = Budgeted operating income - Targeted return

                               = ($4,950,000 + $1,014,000) - 5030271.00

                               = 5964000.00 - 5030271.00

                               = 933729.00

Answer 5

Will Sarah decide to invest in the embroidery machine if her performance is evaluated in terms of ROI?

Answer : Yes, Sarah will invest in the embroidery machine if her performance is evaluated in terms of ROI because ROI is higher at 16.48% if the embroidery machine is purchased compared to 16.02% if machine is not purchased.