A division within a firm has an average return on assets employed of 12% and is considering purchasing a new asset.The new asset is expected to generate cash flows of $17,000 per year for the next seven years but these have a beta coefficient of 1.3 compared to the portfolio return on the other assets in the division.The risk free rate of return is 2%; the weighted average cost of capital is 9%; and, the cost of the new asset is $170,000.
-If the division manager's bonus depends on division ROI will she be likely to purchase the asset?
A)Yes, because ROI is greater than the division average return on assets employed.
B)No, because the ROI is less than the division average return on assets employed.
C)No, because the ROI is less than both the division average return on assets employed and the weighted average cost of capital.
D)Yes, because the ROI is greater than both the division average return on assets employed and the weighted average cost of capital.
E)Yes, because the net present value is positive when basing the discount rate on the weighted average cost of capital minus the risk free rate of return.

Question

Quizplus · Accepted Answer

The ROI for the new asset is calculated as the annual cash flow divided by the cost of the asset, which is $17,000 / $170,000 = 10%. This is less than the division's average return on assets employed of 12%, so the manager is unlikely to purchase the asset if her bonus depends on division ROI.

A Division Within a Firm Has an Average Return on Assets