Question

1. ROI and Investment Decisions

   Jarriot, Inc., presented two years of data for its Furniture Division and its Houseware Division.

   Furniture Division:

   	Year 1	Year 2
   Sales	$35,000,000	$37,500,000
   Operating income	1,400,000	1,500,000
   Average operating assets	10,000,000	10,000,000

   Houseware Division:

   	Year 1	Year 2
   Sales	$12,000,000	$12,500,000
   Operating income	600,000	500,000
   Average operating assets	5,000,000	5,000,000

   At the end of Year 2, the manager of the Houseware Division is concerned about the division’s performance. As a result, he is considering the opportunity to invest in two independent projects. The first is called the Espresso-Pro; it is an in-home espresso maker that can brew regular coffee as well as make espresso and latte drinks. While the market for espresso drinkers is small initially, he believes this market can grow, especially around gift-giving occasions. The second is the Mini-Prep appliance that can be used to do small chopping and dicing chores that do not require a full-sized food processor. Without the investments, the division expects that Year 2 data will remain unchanged. The expected operating incomes and the outlay required for each investment are as follows:

   	Espresso-Pro	Mini-Prep
   Operating income	$ 27,500	$ 19,000
   Outlay	250,000	200,000

   Jarriot’s corporate headquarters has made available up to $500,000 of capital for this division. Any funds not invested by the division will be retained by headquarters and invested to earn the company’s minimum required rate of return, 9 percent.

   Required:

   Round your answers to four decimal places before converting to a percentage. For example, .06349 would be rounded to .0635 and entered as "6.35" percent.

   1. Compute the ROI for each investment.

   Espresso-Pro ROI	%
   Mini-Prep ROI	%

   2. Compute the divisional ROI for each of the following four alternatives:

   a. The Espresso-Pro is added.
   %

   b. The Mini-Prep is added.
   %

   c. Both investments are added.
   %

   d. Neither investment is made; the status quo is maintained.
   %

   Assuming that divisional managers are evaluated and rewarded on the basis of ROI performance, which alternative do you think the divisional manager will choose?

   1. Status Quo
   2. Both Projects
   3. Mini-Prep
   4. Espresso-Pro

Answer 1

Solution:

1) ROI = operating income / Total assets

Espress - Pro ROI = $27,500 / $250,000 = 11%

Mini prep ROI = $19,000 /$200,000 = 9.50%

2a) The Espress Pro is added:

New Divisional income = $500,000 + $27,500 = $527,500

New average operating assets = $5,000,000 + $250,000 =$5,250,000

New divisonal ROI =$527,500 / $5,250,000 = 10.05%

2b) The mini prep is added:

New Divisional income = $500,000 + $19,000 = $519,000

New average operating assets = $5,000,000 + $200,000 =$5,200,000

New divisonal ROI =$519,000 / $5,200,000 = 9.98%

2c) Both investments are added:

New Divisional income = $500,000 + $27,500 +$19,000 = $546,500

New average operating assets = $5,000,000 + $250,000 + $200,000 =$5,450,000

New divisonal ROI =$546,500 / $5,450,000 = 10.03%

2d) Neither investment is made the status quo is maintained:

Divisional income = $500,000

Average operating assets =$5,000,000

Divisional ROI =$500,000/ $5,000,000 = 10%

If divisional managers are evaluated and rewarded on the basis of ROI performance, therefore Espresso-Pro should be added to house ware division as it will result in highest ROI of division i.e. 10.05%