Residual income and return on investment

Reference no: EM1310166

Grate Care Company specializes in producing products for personal grooming. The company operates six divisions, including the Hair Products Division. Each division is treated as an investment centre. Managers are evaluated and rewarded on the basis of ROT performance. Only those managers who produce the best ROIs are selected to receive bonuses and to fill higher-level managerial positions. Fred Olsen, manager of the Hair Products Division, has always been one of the top performers. For the past two years, Fred's division has produced the largest ROT; last year, the division earned an operating income of $2.56 million and employed average operating assets valued at $16 million. Fred is pleased with his division's performance and has been told that if the division does well this year, he will be in line for a headquarters position.

For the coming year, Fred's division has been promised new capital totalling $1.5 million. Any of the capital not invested by the division will be invested to earn the company's required rate of return (9 percent). After some careful investigation, the marketing and engineering staff recommended that the division invest in equipment that could be used to produce a crimping and waving iron, a product currently not produced by the division. The cost of the equipment was estimated at $1.2 million. The division's marketing manager estimated operating earnings from the new line to be $156,000 per year.

After receiving the proposal and reviewing the potential effects, Fred turned it down. He then wrote a memo to corporate headquarters, indicating that his division would not be able to employ the capital in any new projects within the next eight to 10 months. He did note, however, that he was confident that his marketing and engineering staff would have a project ready by the end of the year. At that time, he would like to have access to the capital.

Required:

1. Explain why Fred Olsen turned down the proposal to add the capability of producing a crimping and waving iron. Provide computations to support your reasoning.

2. Compute the effect that the new product line would have on the profitability of the firm as a whole. Should the division have produced the crimping and waving iron?

3. Suppose that the firm used residual income as a measure of divisional performance. Do you think Fred's decision might have been different? Why?

4. Explain why a firm like Grate Care might decide to use both residual income and return on investment as measures of performance.

5. Did Fred display ethical behaviour when he turned down the investment? In discussing this issue, consider why he refused to allow the investment.

Reference no: EM1310166

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