Question

Megamart, a retailer of consumer goods, provides the following information on two of its departments (each considered an investment center).

Investment Center	Sales	Income	Average Invested Assets
Electronic goods	\(40,000,000	\)2,880,000	16,000,000
Sporting goods	20,000,000	2,040,000	12,000,000

1. Compute return on investment for each department. Using return on investment, which department is most efficient at using assets to generate returns for the company?

2. Assume a target income level of 12% of average invested assets. Compute residual income for each department. Which department generated the most residual income for the company?

3. Assume the electronics department is presented with a new investment opportunity that will yield a 15% return on investment. Should the new investment opportunity be accepted? Explain.

Short answer

Particular	Electronic goods	Sporting goods
Return on investment	0.18	0.17034
Residual income	$960,000	$600,000

The electronic department mustnot accept the investment offer.

Step-by-step solution

Step-by-Step SolutionStep 1: Definition of Residual Income

Return on invested capital is the formula used to determine the money generated by the business entity over the cost incurred in debt and equity capital.

Return on investment for each department

Investment Center	Profit margin	X	Investment Turnover	=	Return on investment
Electronic goods	0.072	X	2.5	=	0.18
Sporting goods	0.102	X	1.67	=	0.17034

Working note:

Calculation of profit margin

Investment Center	Net income	/	Sales	=	Profit margin
Electronic goods	$2,880,000	/	$40,000,000	=	0.072
Sporting goods	$2,040,000	/	$20,000,000	=	0.102

Calculation of investment turnover

Investment Center	Sales	/	Average Assets	=	Investment Turnover
Electronic goods	$40,000,000	/	$16,000,000	=	2.5
Sporting goods	$20,000,000	/	$12,000,000	=	1.67

Residual income of each department

Particular	Electronic goods	Sporting goods
Net income	$2,880,000	$2,040,000
Less: Targeted income	($1,920,000)	($1,440,000)
Residual income	$960,000	$600,000

Acceptance of investment opportunity

No, the electronic department must not accept new investment opportunities generating a 15% return on investment because the existing rate of the electronic department is 18%. This is 3% more than the expected rate of return from new investment.