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- 12 Marks
Question
Ayittey Ltd is an organization with two divisions: A and B, each with its own cost and revenue streams. Each of the two divisions is classified as an Investment center. The company’s cost of capital is 12%. Historically, investment decisions have been made by calculating the return on investment (ROI). A new manager who has recently been appointed in Division A has argued that using residual income (RI) to make investment decisions would result in ‘better goal congruence’ throughout the company. The data below shows the current position of the division as at the end of 31 December, 2016:
| Details of Projects | Project A | Project B |
|---|---|---|
| Capital required | GH¢ 82.8 million | GH¢ 40.6 million |
| Sales generated | GH¢ 44.6 million | GH¢ 21.8 million |
| Net Profit margin | 28% | 33% |
The company is seeking to maximize shareholders’ wealth. Assuming that Division A acquires a more efficient asset at GH¢15 million and Division B sold one of its assets with a written down value of GH¢24 million, and profits are expected to increase and decrease by GH¢11 million and GH¢5 million for Division A and B respectively.
Required:
i) Calculate both the current Return on Investment (ROI) and Residual Income (RI) for each of the divisions. (5 marks)
ii) Calculate and comment on the effect of the decision to invest in the new asset and disposal of some assets on the current ROI and RI. (7 marks)
Answer
i) Divisional performance measurement using ROI
Division A:
ROI = Net Profit / investment x 100
= 12.49 / 82.8 x 100 = 15.085%
Division B:
ROI = Net Profit / investment x 100
= 7.194 / 40.6 x 100 = 17.72%
Divisional performance measurement using RI
Division A:
| GH¢ | |
|---|---|
| Net Profit | 12.49 |
| Less imputed interest charge (12% @ 82.8) | (9.936) |
| Residual Income (RI) | 2.554 |
Division B:
| GH¢ | |
|---|---|
| Net Profit | 7.194 |
| Less imputed interest charge (12% @ 40.6) | (4.872) |
| Residual Income (RI) | 2.322 |
(5 marks evenly spread using ticks)
ii) Divisional performance after the new investment
Division A:
ROI = Net Profit / investment x 100
= 23.49 / 97.8 x 100 = 24.02%
Division B:
ROI = Net Profit / investment x 100
= 2.194 / 16.6 x 100 = 13.21%
Residual Income after new investment.
| A | B | |
|---|---|---|
| Income | 23.49 | 2.194 |
| Cost of capital | 11.74 | 1.992 |
| RI | 11.75 | 0.202 |
(3 marks)
Comment
- If a decision about whether to proceed with the investments is made based on ROI, it is possible that the manager of Division A will accept the new proposal whereas the manager of Division B will reject the new proposal. Prior to the new investment Division A had 15.085%, though this is a bit lower than the target rate of return of 16% while Division B had 17.72%. With the new investment Division A’s manager has an ROI of 24.02%, which is above the target rate of return, representing a 37.21% increase in the ROI of division A. Division B has an ROI of 13.21%, which is lower than the target rate of return, representing a 25.45% reduction in the ROI of Division B.
- However, since Division B’s new ROI of 13.21% is higher than the firm’s cost of capital of 12%, accepting the new investment would encourage goal congruence and improve the firm’s overall performance. Behaviorally, Division B’s manager may not be motivated to venture into the new investment if his rewards are tied to the current level of performance. Accepting the new investment means a reduction in his incentives (bonuses).
- Tags: Divisional Performance, Goal Congruence, Investment Decision, Residual Income, ROI
- Level: Level 2
- Topic: Divisional Performance
- Series: MAY 2019
- Uploader: Joseph