The performance of the division manager of Rarewood Furniture is measured by the ROI, defined as divisional segment income divided by the gross book value of total divisional assets. For existing operations, the division's projections for the coming year are as follows:
Sales.................................$ 25,000,000
Expenses............................(22,500,000)
Segment income.....................$ 2,500,000
The gross book value of the total assets now used in operations is $15 million. Currently, the manager is evaluating an investment in a new product line that would, according to her projections, increase 2012 segment income by $250,000. She has not determined the cost of the investment. The company's cost of capital is 12%.
Instructions
(a) Calculate the ROI for 2012 without the new investment.
(b) Assuming the new product line would require an investment of $1.2 million, calculate the revised projected ROI for the division in 2012 with the new investment. Would the manager likely accept or reject the investment? Explain.
(c) How much would the investment have to cost for the manager to be indifferent about making it?
(d) Create a brief example with numbers to explain and illustrate how the use of residual income as a performance measure may encourage a manager to accept a project that is good for the company, but that he or she might otherwise reject.