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Durham, Arkham: residual income vs. ROI

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Durham Division of ABC Corporation has average operating assets of $12,000,000. It expects to earn $1,800,000 for the coming year. The manager has the opportunity to acquire a successful existing business at the start of the year for $3,000,000. The new business is expected to earn $330,000. The earnings of both divisions are expected to be typical of future years.

a. If the manager of Durham is evaluated on the basis of ROI, will she make the acquisition? Explain.
b. If the manager is evaluated based on residual income, will she make the acquisition? Explain. Assume the "hurdle rate" for residual income is 9%.

For the current year, Arkham Corp. expects to sell one million units of product at a price of $15/unit. Cost of goods sold is expected to be $12,000,000, of which 60% is fixed cost and 40% is variable. Fixed selling and administrative costs are $1,200,000.

a. What is Arkham's breakeven point, to the nearest whole unit?
b. To the nearest whole unit, how many units would Arkham have to sell to make a profit of $1,000,000?
c. The marketing director believes that unit sales could increase by 1% with an advertising campaign costing $80,000. Is this plan advisable? Explain.

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Solution Summary

Your tutorial is attached and gives you the formulas for residual income, breakeven in units, target profit and computes the needed amounts. Short discussion guides the thinking process for evaluating these situations.