Solved Question: Al Huma Construction Company has three divisions that operate autonomously

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Question:

Al Huma Construction Company has three divisions that operate autonomously. Their results for 2015 are as follows:

A B C
Sales $8,000,000 $10,000,000 $6,000,000
Contribution margin 3,000,000 6,000,000 2,500,000
Operating income 2,200,000 7,200,000 3,500,000
Investment base 10,000,000 12,000,000 14,000,000

The company’s desired rate of return is 20%. The company is planning an expansion, which will require each division to increase its investments   by $3,000,000 and its income by $1,000,000.

Required:

Compute the current return on Investment (ROI) and Residual Income (RI) for each division

Compute the Return on Investment (ROI) and Residual Income for each division after expansion

Answer:

a)

ROI = operating income/investment base

ROI for A = 2,200,000/10,000,000 = 0.22

ROI of B = 7,200,000/12,000,000 = 0.6

ROI of C = 3,500,000/14,000,000 = 0.25

Residual Income:

= Operating Income – (investment * desired rate)

Residual Income of A = 2,200,000 – 10,000,000 * 0.2 = 200000

Residual Income of B = 7,200,000 – 12,000,000 * 0.2 = 4800000

Residual Income of C = 3,500,000 – 14,000,000 * 0.2 = 700000

b)

After expansion the investment and income increases (investments by $3,000,000 and its income by $1,000,000), below are the new investments and incomes for all the divisions

Investments:

A = 13000000

B = 15000000

C = 17000000

Operating Income:

A = 3200000

B = 8200000

C = 4500000

ROI of A = 3200000/13000000 = 0.25

ROI of B = 8200000/15000000 = 0.55

ROI of C = 4500000/17000000 = 0.26

residual income of A = 3200000 – 13000000 * 0.2 = 600000

residual income of B = 8200000 – 15000000 * 0.2 = 5200000

residual income of C = 4500000 – 17000000 * 0.2 = 1100000

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