Average Operating Assets Calculation Question Accounting

Question

Last year, our return on investment equaled 20% ; our residual income equaled $50,000, and our minimum required rate of return (cost of capital) was 12%. What were our average operating assets (rounded to the nearest thousand ) ?

A) $625,000 B) $250,000 C) $417,000 D) $333,000 E) $575,000

 

 

I believe answer was A) but I need help with steps as to how.

 

Thanks.

Answer 1

The answer is A) 625,000

 

The assumption I made is that the 20% does not include the 12% cost of capital.  So if the 12% cost of capital to be considered then we need a larger pool of assets to give us the $50,000 return.  The way I arrived at the larger investment is by dividing 50,000 over .08 which will give you an investment pool equal to $625,000, and this is option A answer above. The 0.08 derived from 20%-12%.

To test our numbers 625,000 X.20 = 125,000

Less Cost of Capital  625,000 x .12=  75,000

the residual income                       = 50,000

Answer 2

Answer: calculate Average operating assets: add (sum) ending balances for total assets for each period on balance sheet financial statements; divide the sum total by the number of statement periods during the year to determine an Average..
 
assume: financial statements are reported quarterly, where

 

$625,000 = Average total assets

then,
find X (sum of Total assets for the year):
X = $625,000*4 
X = $2,500,000
$2,500,000 divided by 4 = $625,000 Average operating assets

(RI) formula:
Residual income = Net operating income minus (Rate of return on investment*Operating assets)
where,
Net operating income = $125,000
Residual income = $50,000
Rate of return = 12%
Operating assets = $625,000

find X (Net operating income),
$50,000 =  X minus (12%*$625,000)
$50,000 =  X minus $75,000
$50,000 + $75,000 = X
$125,000 = X
$125,000 = Net Operating Income

ROI (return on investment):

assume: net operating income is equal to net profit after taxes for this problem.. and, $125,000 = net profit after taxes, then

find:

ROI

formula =  Net profit after taxes divided by Total assets

20% (given) = ROI 
where,

Net profit after taxes = $125,000
Total assets = $625,000
$125,000 divided by $625,000 = 20%