Chapter 12 Notes

Chapter 12 Notes - Chapter12Notes RETURNONINVESTMENT

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Chapter 12 Notes RETURN ON INVESTMENT Investment centers are often evaluated based on their return on  investment (ROI), which is computed as follows: or ROI = Margin × Turnover where: EXAMPLE: Regal Company reports the following data for last year’s  operations: Net operating income. .......... $30,000 Sales. ................................... $500,000 Average operating assets. .... $200,000 To increase ROI, at least one of the following must occur: 1. Increase sales. 2. Reduce expenses. 3. Reduce operating assets.
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RETURN ON INVESTMENT (continued) Example 1—Increase sales: Assume that Regal Company is able to increase sales to $600,000 and  net operating income increases to $42,000. Also assume that operating  assets are not affected. (compared to 15% before) Example 2—Reduce expenses: Assume that Regal Company is able to reduce expenses by 10,000 per  year, so that net operating income increases from $30,000 to $40,000. Also  assume that sales and operating assets are not affected. (compared to 15% before) Example 3—Reduce assets: Assume that Regal Company is able to reduce its average operating  assets from $200,000 to $125,000. Also assume that sales and net  operating income are not affected. (compared to 15% before)
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RESIDUAL INCOME Residual income  is the net operating income that an investment center  earns above the minimum rate of return on its operating assets. EXAMPLE: Marsh Company has two divisions, A and B. Division A has  $1,000,000 and Division B has $3,000,000 in average operating assets.  Each division is required to earn a minimum return of 12% on its investment  in operating assets.  Division A Division B Average operating assets (given). .............. $1,000,000 $3,000,000 Net operating income (given). .................... $  200,000 $  450,000 Minimum required return:  12% × average operating assets. ............       120,000           360,000     Residual income. ........................................ $          80,000     $          90,000    
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RESIDUAL INCOME (continued) The residual income approach encourages managers to make profitable  investments that would be rejected under the ROI approach. EXAMPLE: Marsh Company’s Division A has an opportunity to make an 
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Chapter 12 Notes - Chapter12Notes RETURNONINVESTMENT

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