Divergent LTD is an investment company which owns a number of subsidiary companies. Each subsidiary produces a particular product or service. The subsidiary companies are grouped into three divisions for performance evaluation purposes. Mechanical comprising two subsidiary companies which produce a range of mechanical and electrical components. Consumer; comprising five subsidiary companies that manufacture a variety of home appliances. Advertising and marketing; comprising a subsidiary company that provides advice on product marketing, electronic,magazine and newspaper advertising. Salaries comprise about 90% of the subsidiary costs. Divergent LTD is looking to expand its operations. The directors have calculated the following

Extract from statement of financial position information as at 31 October 20X8

MechanicalConsumerAdvertising

Land and building1200--

Plant and equipment3050103050

Other non-current assets68036070

Total non-current assets49301390120

Current assets760210140

Total assets56901600260

Current Liabilities2509060

Statement of divisional performance for year ended 31 Oct 20X8

MechanicalConsumerAdvertising

Sales 713026808420

Operating expenses404018427880

Depreciation108031860

Trading profit2010520480

Cost of capital charge at 16%87024232

Residual income1140278448

Return on investment36.9%34.43%240%

The plant and equipment in both the Mechanical and consumer divisions is depreciated over 10 years. The plant and equipment of the mechanical division is 7 years old and the current replacement cost is 18,2 million. Plant and equipment in the consumer division is 6 years old and has a current replacement cost of 3,6 million. Other fixed assets have a replacement cost close to the net carrying values, except for the assets of the advertising division. Changing technology has made the existing computer system part of the advertising division PPE obsolete and will be scrapped in 2019. A new system will cost 600000 and a life of 3 years. The existing computer system is one year old and originally costs 100000 and now carrying value of 50000.

Divergents Ltds cost of capital is 16% nd is used as a discount rate for project evaluation. They use total assets minus current liabilities as their investment. After revising the above figures, some directors were in favour of expanding the advertising because of high return on investment. Other directors suggested that the mechanical division should be expanded because of its high residual income. The managing director has suggested that expansion should be undertaken in a different sector altogether in order to lower the overall risk exposure.

A)Using the given replacement cost re-calculate ROI and RI on a more appropriate basis and comment on the results reflected.

Answer rating: 100% (QA)

To recalculate the Return on Investment ROI and Residual Income RI on a more appropriate basis we need to consider the revised replacement costs of the plant and equipment in the Mechanical and Consum... View the full answer