- 15 Marks
MA – L2 – Q62 – Divisional performance
Question
Kumasi Tech Ltd is organised into several investment centres. The annual performance of each investment centre is measured on the basis of ROI. ROI is measured each year as the profit before interest as a percentage of the average investment/average capital employed in the investment centre.
One of the investment centres has achieved a ROI in excess of 35% in each of the past four years. Its managers are considering a new investment project that will have the following cash flows:
| Year | Cash flow |
|---|---|
| Beginning of Year 1 | (42,000) |
| 1–3 | 19,000 each year |
The initial investment will be in an item of machinery that will have no residual value at the end of Year 3. Assume that depreciation is charged on a straight-line basis.
Required:
(a) Calculate the ROI for the project, each year and on average for the three-year period.
(b) Suggest whether the managers of the investment Centre are likely to invest in the project.
(c) Residual income
Answer
(a) ROI
Annual depreciation (straight-line) = GH₵42,000 / 3 = GH₵14,000.
Annual accounting profit = GH₵5,000
| Year | Profit | Average investment | ROI |
|---|---|---|---|
| 1 | 5,000 | 35,000 | 14.3% |
| 2 | 5,000 | 21,000 | 23.8% |
| 3 | 5,000 | 7,000 | 71.4% |
| Average | 5,000 | 21,000 | 23.8% |
Note: Average investment, measured as the net book value of the asset, is the mid-point between GH₵42,000 and GH₵28,000 in Year 1, the mid-point between GH₵28,000 and GH₵14,000 in Year 2, and the mid-point between GH₵14,000 and GH₵0 in Year 3.
(b) The investment Centre has been achieving a ROI in excess of 35% each year for several years. Investing in this project will therefore have the effect of bringing ROI down, although the investment is probably quite small in relation to the total size of the investment Centre and its assets. The managers of the investment center would therefore have no particular incentive to undertake the investment.
c) Residual income
For each year, Years 1–3, the residual income would be as follows:
| Year 1 | Year 2 | Year 3 | |
|---|---|---|---|
| Average investment | GH₵35,000 | GH₵21,000 | GH₵7,000 |
| GH₵ | GH₵ | GH₵ | |
| Profit after depreciation | 5,000 | 5,000 | 5,000 |
| Notional interest (12% of investment) | 4,200 | 2,520 | 840 |
| Residual income | 800 | 2,480 | 4,160 |
The residual income is positive in each of the three years, although it increases each year as the value of the investment declines.
If the performance of the investment center is measured by residual income, its managers would be willing to undertake the investment because it will improve the divisional performance by increasing the residual income.
- Tags: Depreciation, Divisional performance, Investment centre, Performance Measurement, ROI
- Level: Level 2
- Topic: Divisional performance
- Uploader: Salamat Hamid