# Return on investment measurement issues

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12-44 Return on investment measurement issues

Green Company has prepared the following information for three of its divisions:

a. Compute each division's return on investment and residual income, assuming a 10% cost of capital.

b. Suppose the net book value of each division's investments is half of the historical cost. Using net book value as the measure of investment, compute each division's return on investment and residual income, assuming a 10% cost of capital.

c. Comment on the division rankings in (a) and (b).

d. If the division managers are rewarded on the basis of return on investment or residual income, will they find it attractive to invest in new, more costly equipment?

12-45 Return on investment components

Alpha Company would like to examine the sales margin and asset turnover components of return on investment for three of its divisions and has accordingly prepared the following information:

a. Compute each division's return on investment, sales margin, and asset turnover.

b. Comment on the divisions' relative rankings on the ratios computed in (a).

12-48 Computing residual income

A business whose investors required a return on investment of 8% reports an income of $1 million on an investment of $20 million. What is the residual income for this business?

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#### Solution Preview

12-44 Return on investment measurement issues

Green Company has prepared the following information for three of its divisions:

a. Compute each division's return on investment and residual income, assuming a 10% cost of capital.

Division X

Return on investment = Operating income/Investment

= 66,500/560,000 = 11.88%

RI = Net Operating Income - (Minimum Rate of Return on Investment x Operating Assets)

RI = $66,500 - (10% x $560,000)

RI = $10,500

Division Y

Return on investment = Operating income/Investment

= 64,400/532,000 = 12.11%

RI = Net Operating Income - (Minimum Rate of Return on Investment x Operating Assets)

RI = $64,400 - (10% x $532,000)

RI = $11,200

Division Z

Return on investment = Operating income/Investment

= 43,120/350,000 = 12.32%

RI = Net Operating Income - (Minimum Rate of Return on Investment x Operating Assets)

RI = $43,120 - (10% x $350,000)

RI = $8,120

b. Suppose the net book value of each division's investments is half of the historical cost. Using net book value as the measure of investment, compute each division's return on ...

#### Solution Summary

This solution is comprised of a detailed explanation to compute each division's return on investment and residual income, assuming a 10% cost of capital.