The New Products Division of Testar Company had operating income of $8,000,000 and operating assets of $44,800,000 during the current year.The New Products Division has developed a potential new product that would require $8,500,000 in operating assets and would be expected to provide $1,400,000 in operating income each year.Testar has set a target return on investment (ROI)of 16% for each of its divisions.Assuming that the new product is put into production,calculate the residual income for the division.
A) $832,000
B) $872,000
C) $528,000
D) $672,000

Question

Quizplus · Accepted Answer

First, we need to calculate the current ROI of the division:

ROI = Operating Income / Operating Assets
ROI = $8,000,000 / $44,800,000
ROI = 0.1786 or 17.86%

Since the target ROI is 16%, the division is currently exceeding the target.

Next, we can calculate the expected ROI if the new product is introduced:

ROI = (Operating Income + New Product Income) / (Operating Assets + New Product Assets)
ROI = ($8,000,000 + $1,400,000) / ($44,800,000 + $8,500,000)
ROI = 0.1703 or 17.03%

This is still above the target ROI of 16%, so the new product is a good investment for the division.

Finally, we can calculate the residual income for the division with the new product:

Residual Income = Operating Income - (Operating Assets * Required Rate of Return)
Required Rate of Return = 16%
Residual Income = ($8,000,000 + $1,400,000) - (($44,800,000 + $8,500,000) * 0.16)
Residual Income = $9,400,000 - $9,672,000
Residual Income = -$272,000

A negative residual income means that the division did not earn the target return on its assets. However, we can also calculate the residual income without the new product to see if it is still earning above the target return:

Residual Income = Operating Income - (Operating Assets * Required Rate of Return)
Residual Income = $8,000,000 - ($44,800,000 * 0.16)
Residual Income = $8,000,000 - $7,168,000
Residual Income = $832,000

Therefore, the best choice is B ($872,000) because it is the closest to the actual residual income of $832,000 without the new product.

The New Products Division of Testar Company Had Operating Income