Question

Residual Income and Investment Decisions Jarriot, Inc., presented two years of data for its Furniture Division and its Houseware Division Furniture Division: Sales Operating income Average operating assets Year 1 $35,800,000 1,430,000 2,480,000 Year 2 $38,000,000 1,590,000 2,480,000 Houseware Division: Year 1 Year 2 Sales $11,800,000 $12,600,000 Operating income 630,000 590,000 Average operating assets 5,550,000 5,550,000 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 $28,000 515,100 Outlay 160,000 110,000 Jarrot's corporate headquarters has made available up to $550,000 of capital for this division Any funds not invested by the division will be retained by headauarters and invested to earn the company's minimum required rate of return, 7 percent. Required: 1. Compute the residual income for each of the opportunities (Round to the nearest dollar) Espresso-Pro residual income $ 16,800 V Mini-Prep residual come 57,400 2 Carnitine

Answer 1

Solution

Jarriot Inc

Q2. Computation of the divisional residual income for each of the following four alternatives:

1. 1^st Alternative – The Espresso-Pro is added
   residual income = operating income – minimum expected return on invested assets

Minimum expected return on invested assets = minimum rate of return x invested assets

Company’s rate of return = 7%

Operating income whne espresso-pro is added –

Houseware Division’s Year 2 Operating Income = $590,000

Operating income – Espresso-pro = $28,000

Total = 618,000

Houseware division’s average operating assets = $5,550,000

Espresso-pro’s outlay = $160,000

Total = 5,710,000

Minimum rate of return = 7%

Minimum return = 5,710,000 x 7% = $399,700

Residual Income = 618,000 – 399,700 = $218,300

Hence, residual income when Espresso-pro is added = $218,300

2. 2^nd Alternative - The Mini -Prep is added

residual income = operating income – minimum expected return on invested assets

Minimum expected return on invested assets = minimum rate of return x invested assets

Company’s rate of return = 7%

Operating income when Mini-prep is added –

Houseware Division’s Year 2 Operating Income = $590,000

Operating income – Mini-prep = $15,100

Total = 605,100

Houseware division’s average operating assets = $5,550,000

Mini-prep’s outlay = $110,000

Total = 5,660,000

Minimum rate of return = 7%

Minimum return = 5,660,000 x 7% = $396,200

Residual Income = 605,100 – 396,200 = $208,900

Hence, Residual Income when Mini -Prep is added = $208,900

3. Both investments are added:

residual income = operating income – minimum expected return on invested assets

Minimum expected return on invested assets = minimum rate of return x invested assets

Company’s rate of return = 7%

Operating income whne espresso-pro is added –

Houseware Division’s Year 2 Operating Income = $590,000

Operating income – Espresso-pro = $28,000

Operating income – Mini -Prep = $15,100

Total = 633,100

Houseware division’s average operating assets = $5,550,000

Espresso-pro’s outlay = $160,000

Mini-Prep’s outlay = $110,000

Total = 5,820,000

Minimum rate of return = 7%

Minimum return = 5,820,000 x 7% = $407,400

Residual Income = 633,100 – 407,400 = $225,700

Hence, the residual income when both investments are made = $225,700

4. Neither investment is made –

residual income = operating income – minimum expected return on invested assets

Minimum expected return on invested assets = minimum rate of return x invested assets

Company’s rate of return = 7%

Houseware Division’s Year 2 Operating Income = $590,000

Houseware division’s average operating assets = $5,550,000

Minimum rate of return = 7%

Minimum return = 5,550,000 x 7% = $388,500

Residual Income = 590,000 – 388,500 = $201,500

Hence, the residual income when neither investments are made = $201,500

The divisional manager would opt Alternative C, Both investments are made, as this alternative results in highest residual income of $225,700.

Q3. Computation of change in profit or loss from the divisional manager’s investment decision:

Profit of Houseware Division increases by $43,100 (28,000 + 15,100)

The residual income increase is as follows,

$225,700 - $201,500 = $24,200

The investment decision results in $43,100 increase in profit and $24,200 increase in residual income for Houseware Division.