- 7 Marks
Question
The Bottle Labelling Division of Crush Drink Ltd currently has capital employed of GH¢100,000 and earns an annual profit after depreciation of GH¢18,000. The divisional manager is considering an investment of GH¢10,000 in an asset which will have a ten-year life with no residual value and will earn a constant annual profit after depreciation of GH¢1,600. The cost of capital is 15%.
Required:
Calculate the following and comment on the results.
i) The return on divisional investment, before and after the new investment
ii) The divisional residual income before and after the new investment
Answer
i) Return on Divisional Investments
= Divisional Profit / Divisional Investments * 100
| Before Investment | After Investment |
|---|---|
| Divisional profit | GH¢18,000 |
| Divisional investment | GH¢100,000 |
| Divisional ROI | 18% |
Comment:
The ROI will fall in the short term if the new investment is undertaken. This is a problem which often arises with ROI, as noted in part (b) of this solution.
ii) Divisional Residual Income
= Divisional Profit – (Cost of Capital (15%) * Divisional Investment)
| Before Investment | After Investment |
|---|---|
| Divisional profit | GH¢18,000 |
| Imputed cost of capital | (0.15 * GH¢100,000) GH¢15,000 |
| Divisional RI | GH¢3,000 |
Comment:
The Residual Income will increase in the short term if the new investment is undertaken.
- Tags: Divisional Profit, Investment Analysis, Residual Income, Return on investment
- Level: Level 2
- Topic: Divisional Performance
- Series: MAY 2018
- Uploader: Joseph