John Ltd is an organization with two divisions: A and B, each with its own cost and revenue streams. Each of the two divisions is classified as Investment center. The company’s cost of capital is 9%. Historically, investment decisions have been made by calculating the return on investment (ROI). A new manager who has recently been appointed in division A has argued that using residual income (RI) to make investment decisions would result in ‘better goal congruence’ throughout the company. The data below shows the current position of the division as at the end of 31 December, 2019: Details of Projects Project A Project B Capital required GH¢ 82.8 million GH¢ 40.6 million Sales generated GH¢44.6 million GH¢ 21.8 million Net Profit margin 18% 25% The company is seeking to maximize shareholders wealth. Assuming that, Division A acquires a more efficient asset at GH¢17 million and Division B sold one of its assets with written down value of GH¢21 million, and profits are expected to increase and decrease by GH ¢10 million and GH¢7 million for division A and B respectively. Required: a) Calculate both the current Return on Investment (ROI) and Residual Income (RI) for each of the divisions. b) Calculate and comment on the effect of the decision to invest in the new asset and disposal of some assets will have on the current ROI and RI.
John Ltd is an organization with two divisions: A and B, each with its own cost and revenue streams. Each of the two divisions is classified as Investment center. The company’s cost of capital is 9%. Historically, investment decisions have been made by calculating the return on investment (ROI). A new manager who has recently been appointed in division A has argued that using residual income (RI) to make investment decisions would result in ‘better goal congruence’ throughout the company.
The data below shows the current position of the division as at the end of 31 December, 2019:
Details of Projects Project A Project B
Capital required GH¢ 82.8 million GH¢ 40.6 million
Sales generated GH¢44.6 million GH¢ 21.8 million
Net Profit margin 18% 25%
The company is seeking to maximize shareholders wealth. Assuming that, Division A acquires a more efficient asset at GH¢17 million and Division B sold one of its assets with written down value of GH¢21 million, and profits are expected to increase and decrease by GH ¢10 million and GH¢7 million for division A and B respectively.
Required:
a) Calculate both the current Return on Investment (ROI) and Residual Income (RI) for each of the divisions.
b) Calculate and comment on the effect of the decision to invest in the new asset and disposal of some assets will have on the current ROI and RI.
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