Compuwork Corporation is organized in three separate divisions. The three divisional managers are evaluated at year-end, and bonuses are awarded based on ROI. Last year, the overall company produced a 12% return on its investment.Managers of Compuwork's Iowa Division recently studied an investment opportunity that would assist in the division's future growth. Relevant data follow.?Iowa DivisionInvestment OpportunityIncome$12,800,000$4,200,000Invested capital80,000,00030,000,000Required: A. Compute the current ROI of the Iowa Division and the division's ROI if the investment opportunity is pursued.B. What is the likely reaction of divisional management toward the acquisition? Why?C. What is the likely reaction of Compuwork's corporate management toward the investment? Why?D. Assume that
Compuwork uses residual income to evaluate performance and desires an 11% minimum return on invested capital. Compute the current residual income of the Iowa Division and the division's residual income if the investment is made. Will divisional management likely change its attitude toward the acquisition? Why?
What will be an ideal response?
A. ROI = Income ÷ invested capital
Current: $12,800,000 ÷ $80,000,000 = 16%
If investment is made: ($12,800,000 + $4,200,000) ÷ ($80,000,000 + $30,000,000) = 15.45%
B. Divisional management will likely be against the acquisition because ROI will be lowered from 16% to 15.45%. Since bonuses are awarded on the basis of ROI, the acquisition will result in less compensation. However, before a final decision is made, additional insights are needed concerning how the investment will assist in future growth and in what magnitude.
C. An examination of the investment reveals a 14% ROI ($4,200,000 ÷ $30,000,000). Corporate management would probably favor the acquisition. Compuwork has been earning a 12% return, and the investment will help the organization as a whole.
D.
| Current residual income of Iowa Division: | ? |
| Divisional income | $12,800,000 |
| Less: Imputed interest charge ($80,000,000 × 11%) | 8,800,000 |
| Residual income | $ 4,000,000 |
| Residual income if investment is made: | ? |
| Divisional income ($12,800,000 + $4,200,000) | $17,000,000 |
| Less: Imputed interest charge [($80,000,000 + $30,000,000 × 11%)] | 12,100,000 |
| Residual income | $ 4,900,000 |
Yes, divisional managers will likely change their attitude, particularly if they are team players. Residual income will increase by $900,000 ($4,900,000 - $4,000,000) from the acquisition. The RI measure focuses on the corporate perspective, not the divisional perspective, by integrating the firm's required return on invested capital.
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