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    Residual Income

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    Wyalusing Industries has manufactured prefabricated houses for over 20 years. The houses are constructed in sections to be assembled on customer' lots. Wyalusing expanded into the precut housing market when it acquired Fairmont Company, one of its suppliers. In this market, various types of lumber are precut into the appropriate lengths, banded into packages, and shipped to customers' lots for assembly. Wyalusing designated the Fairmont Division as an investment center. Wyalusing uses return on investment (ROI) as a performance measure with investment defined as average productive assets. management bonuses are based in part on ROI. All investments are expected to earn a minimum return of 15 percent before income taxes. Fairmont's ROI has ranged from 19.3 to 22.1 percent since it was acquired. Fairmont has an investment opportunity in 20x1 that had an estimated ROI of 18 percent. Fairmont's management decided against the investment because it believed the investment would decrease the division's overall ROI. The 20x1 income statement for Fairmont Division follows. The division's productive assets were $12,600,000 at the end of 20x1, a 5 percent increase over the balance at the beginning of the year.

    Fairmont division
    Income Statement
    For the year Ended December 31, 20x1
    (In thousands)

    Sales revenue ...............$24,000
    Cost of goods sold.......... ..15,800
    Gross margin..................$8,200
    Operating expenses:
    Selling.................3,600 5,740
    Income from operations before income taxes 2640

    1. Calculate the following:
    a. Return on investment (ROI)
    b. Residual income.

    2. Would the management of Fairmont Division have been more likely to accept the investment opportunity it had in 20x1 if residual income were used as a performance measure instead of ROI? Explain your answer.

    3. Construct a Excel spreadsheet to solve requirement (1) above. Show how the solution will change if income from operations was $2,700,000

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    Solution Preview

    ROI= Income from operations 20.95%
    Divison's Productive Assets

    Residual Income= 750000 Income from Operations- ( Cost of Captial *Invested Capital)

    2. Would the management of Fairmont Division have been more likely to accept the investment opportunity it had in 20x1 if ...

    Solution Summary

    This provides the steps to calculate the Residual Income