Question

Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divisions. The four divisional managers are evaluated at year-end, and bonuses are awarded based on ROI. Last year, the company as a whole produced a 14 percent return on its investment.

During the past week, management of the company’s Northeast Division was approached about the possibility of buying a competitor that had decided to redirect its retail activities. (If the competitor is acquired, it will be acquired at its book value.) The data that follow relate to recent performance of the Northeast Division and the competitor:

	Northeast Division					Competitor
Sales		$	4,330,000				$	2,730,000
Variable costs			70	% of sales				60	% of sales
Fixed costs		$	1,101,000				$	996,000
Invested capital		$	990,000				$	400,000

Management has determined that in order to upgrade the competitor to Megatronics’ standards, an additional $240,000 of invested capital would be needed.

Required:

1. Compute the current ROI of the Northeast Division and the division’s ROI if the competitor is acquired.

2. If divisional management is being evaluated on the basis of ROI, will the Northeast Division likely pursue acquisition of the competitor?

3-a. Compute the ROI of the competitor as it is now and after the intended upgrade.

3-b. If ROI is used as the basis for evaluation, would Megatronics Corporation likely be in favor of the acquisition of the competitor?

4. Calculate the Northeast Division's ROI after acquisition of competitor but before upgrading.

5-a. Assume that Megatronics uses residual income to evaluate performance and desires a 10 percent minimum return on invested capital. Compute the current residual income of the Northeast Division and the division’s residual income if the competitor is acquired.

5-b. If divisional management is being evaluated on the basis of residual income, will the Northeast Division likely pursue acquisition of the competitor?

Answer 1

Megatronics Corporation

1. Computation of the current ROI of the Northeast Division and the division’s ROI if the competitor is acquired:

Current ROI	20%
ROI if competitor is acquired	18.04%

Northeast Division’s ROI –

Sales Revenue	$	$4,330,000
less: variable costs	$3031000
Fixed costs	$1,101,000
Total costs		$41,32,000
Net Income		$198,000
ROI = net income/invested capital
ROI = $198,000/$990,000 = 20%

Northeast Division’s ROI = 20%

Northeast Division’s ROI if Competitor is acquired –

Sales Revenue		$70,60,000	(4,330,000 + 2,730,000)
less: variable costs	$4,669,000		(3031000 + 1,638,000)
Fixed costs	$2097,000		(1101000 + 996,000)
Total costs		$6,766,000
Net Income		$294,000
ROI = net income/invested capital
ROI = $294,000/$1,630,000 = 18.04%

Northeast Division’s ROI if Competitor is acquired = 18.04%

Note: invested capital = $990,000 + $400,000 + 240,000 = $1630,000

1. No

The Northeast Division is not likely to pursue the acquisition of the competitor as the acquisition would result in lower ROI (18.04%) from an existing 20%. Since, the evaluation of divisional management is based on ROI, the division is not likely to pursue the acquisition in view of lower ROI.

1. A. Computation of ROI of competitor as it is now and after the intended upgrade:

ROI before upgrading	24%
ROI after upgrading	15.00%

ROI of competitor as it is now –

Sales Revenue	$	$2,730,000
less: variable costs	$1,638,000
Fixed costs	$996,000
Total costs		$2,634,000
Net Income		$96,000
ROI = net income/invested capital
ROI = $96,000/$400,000 = 24%

ROI of competitor after intended upgrade –

Sales Revenue	$	$2,730,000
less: variable costs	$1,638,000
Fixed costs	$996,000
Total costs		$2,634,000
Net Income		$96,000
ROI = net income/invested capital
ROI = $96,000/$540,000 = 17.78%

3B. Yes, even with upgrading

The overall ROI for the company is 14% and the competitor’s ROI of 24% would increase the company’s profitability. Even the upgrade of $240,000 would make the competitor’s ROI at 17.78%, which is higher than the current ROI of 14% to the company. Assuming the past trend continues, the company might earn ROI of 18.04%.

1. Northeast Division’s ROI after acquisition but before upgrading:

ROI

20.95%

Sales Revenue	$	$7060,000	(4,330,000 + 2,730,000)
less: variable costs	$4,669,000		(3031000 + 1,638,000)
Fixed costs	$2097,000		(1091000 + 866,000)
Total costs		$6,766,000
Net Income		$294,000
ROI = net income/invested capital
ROI = $294,000/$1,390,000 = 21.15%

1. A. Northeast division’s residual income at minimum rate of return of 10% for existing and after the acquisition of the competitor:

Current Residual Income	$96,500
Residual Income if Competitor is Acquired	$120,500

Existing –

Minimum return = 10%

= 10% of 990,000 = $99,000

Net income of division = $198,000

Residual income = 198,000 – 99,000 = $99,000

After acquisition –

Minimum return = 10%

= 10% x (990,000 + 400,000 + 240,000) = $163,000

Net income = $294,000

Residual income = 294,000 – 163,000 = $131,000

5B. Yes

Since the acquisition of competitor would increase the residual income by $32,000 (131,000 – 99,000), the Northeast Division would favour the acquisition.