New Orleans, Inc., is a multidivision company. The current ROI for New Orleans, Inc. as a whole is 12 percent. New Orleans, Inc. has a minimum required rate of return on all investments of 10 percent. The most successful division within New Orleans, Inc. is the Shellfish Division. Currently the Shellfish Division has total assets of $4,000,000 with operating income of $800,000. The Manger of the Shellfish Division is considering the purchase of a small company called Shrimp, Inc. The purchase of Shrimp, Inc., will require an investment of $800,000 and with the synergy between the two companies will increase the Shellfish Division operating income by $80,000. Bonuses in all the New Orleans’s divisions are awarded to mangers with increasing ROIs.
a. What is the ROI for the Shellfish Division, before and after the proposed purchase of Shrimp, Inc.?
b. What is the residual income for the Shellfish Division, before and after the purchase of Shrimp, Inc.?
c. If the Shellfish Division purchases Shrimp, Inc., and income increases as expected, what will happen to the ROI of New Orleans, Inc.?
d. Given the current bonus structure within New Orleans, Inc., and assuming the manager of the Shellfish Division is a self-maximizing individual, what would you expect the manager of the Shellfish Division to do? Indicate all of the following that are correct.
(1) Purchase Shrimp, Inc., with the current bonus structure
(2) Not purchase Shrimp, Inc., with the current bonus structure
(3) Purchase Shrimp, Inc., if bonuses are based upon increasing residual income
(4) Not purchase Shrimp, Inc., if bonuses are based upon increasing residual income