Return On Investment Question Managerial Accounting Need Help

Question

The Clipper Corporation had net operating income of $380,000 and average operating assets of $2,000,000. The corporation's minimum required return on new projects is 18%. The U.S. division of the corporation is considering an investment of $70,000 in a project that will generate net income of $13,000. The U.S. Division currently earns a return on investment rate of 20%. The U.S. division manager can be evaluated on either the Division's return on investment or the division's residual income. Which of the following is true?

A) The U.S. Division Manager would only invest in the new project only if the division's return on investment is used for evaluating division manager

B) The U.S. Division Manager would only invest in project if division's residual income is used for evaluating manager

C) The U.S. Division Manager would always invest in the new project whether the division's return on investment or residual income is used in evaluating the division manager

D) he U.S. Division Manager would never invest in the new project whether the division's return on investment or residual income is used in evaluating the division manager
E) None

 

Answer was B) I believe But I need help as to how with steps, and why it is.

Answer 1

The answer is option A) as stated above. To understand why we selected the A) answer we have to keep in mind that the Clipper Corp as a whole has a required minimum return of 18% on new projects.

The division currently earn 20% return on investment and the new project it is considering is estimated to yield 18.6%, this is derived from dividing 13,000 by 70,000. So if this investment is considered the division's current return will be lower than 20% (20,000/100000+13,000/70,000= 19.4%. The new rate 19.4% in this case is higher than the required return called for by the corporation which is 18%,  therefore the division manager ought to accept the new investment.

The difference between between ROI and Residual Income is the cost of capital. The cost of capital under  RI is deducted from Operating income. In the above problem no cost of capital was given and therefore assuming zero cost of capital (interest) will yield the same result as ROI which is stated above.