Textbook Problem

Jump Start Company (JSC), a subsidiary of Mason Industries, manufactures go-carts and other recreational vehicles. Family recreational centers that feature go-cart tracks along with miniature golf, batting cages, and arcade games have increased in popularity. As a result, JSC has been pressured by Mason management to diversify into some of these other recreational areas. Recreational Leasing, Inc. (RLI), one of the largest firms leasing arcade games to these family recreational centers, is looking for a friendly buyer. Mason’s top management believes that RLI’s assets could be acquired for an investment of $3.2 million and has strongly urged Bill Grieco, division manager of JSC, to consider acquiring RLI.

Bill has reviewed RLI’s financial statements with his controller, Marie Donnelly, and they believe that the acquisition may not be in the best interest of JSC.

“If we decide not to do this, the Mason people are not going to be happy,” said Bill. “If we could convince them to base our bonuses on something other than return on investment, maybe this acquisition would look more attractive. How would we do if the bonuses were based on residual income using the company’s 15 percent cost of capital?”

Mason has traditionally evaluated all of its divisions on the basis of return on investment, which is defined as the ratio of operating income to total assets. The desired rate of return for each division is 20 percent. The management team of any division reporting an annual increase in the return on investment is automatically eligible for a bonus. The management of divisions reporting a decline in the return on investment must provide convincing explanations for the decline to be eligible for a bonus, and this bonus is limited to 50 percent of the bonus paid to divisions reporting an increase.

The following condensed financial statements are for both JSC and RLI for the fiscal year ended May 31:

Required:

1. 1. If Mason Industries continues to use return on investment as the sole measure of division performance, explain why JSC would be reluctant to acquire RLI. Be sure to support your answer with appropriate calculations.
2. 2. If Mason Industries could be persuaded to use residual income to measure the performance of JSC, explain why JSC would be more willing to acquire RLI. Be sure to support your answer with appropriate calculations.
3. 3. Discuss how the behavior of division managers is likely to be affected by the use of:
   1. a. Return on investment as a performance measure
   2. b. Residual income as a performance measure (CMA adapted)