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Chocolate Enterprise is a multi-division company. The current ROI for Chocolate Enterprise as a whole is 11%, and Chocolate Enterprise has a minimum required rate of return on all investments of 10%. The most successful division within Chocolate Enterprise is the Boxed Candy division. Currently the boxed candy division has total assets of $2,000,000 with operating income of $400,000. The manger of the Boxed Candy division is considering the purchase of a small company called Truffles Inc. The purchase of Truffles Inc. will require an investment of $800,000 and with the synergy between the two companies will increase the Boxed Candy Division operating income by $76,000. Bonuses in all the Chocolate Enterprise Divisions are awarded to mangers with increasing ROI's.
-Given the current bonus structure within Chocolate Enterprise and assuming the managing of the Boxed Candy Division is a self maximizing individual, you would expect the Boxed Candy Division to:
A) Purchase Truffles, Inc. with the current bonus structure
B) Not purchase Truffles, Inc. with the current bonus structure
C) Purchase Truffles, Inc. if bonuses are based upon increasing Residual Income
D) Not purchase Truffles Inc. if bonuses are based upon increasing EVA

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Quizplus · Accepted Answer

CThe Boxed Candy Division currently has an ROI of 20% ($400,000 operating income / $2,000,000 total assets). Purchasing Truffles Inc. would increase assets to $2,800,000 and operating income to $476,000, resulting in a new ROI of approximately 17% ($476,000 / $2,800,000). Since this is a decrease from the current 20% ROI, under the current bonus structure that rewards increasing ROI, the manager would likely not purchase Truffles Inc. However, if bonuses were based on increasing Residual Income, which is operating income minus a charge for the cost of capital (and given that the company's minimum required rate of return is 10%, the investment would still be profitable), the manager might be incentivized to make the purchase.

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