Question

Wolf Paints is a national paint manufacturer and retailer. The company is segmented into five divisions: Paint Stores (branded retail locations), Consumer (paint sold through home improvement stores), Automotive (sales to auto manufacturers), International, and Administration. The following is selected divisional information for its two largest divisions: Paint Stores and Consumer.

Net Sales Operating Average

Revenue Income Total Assets

Paint Stores \( 3,980,000 \) 476,000 $ 1,380,000

Consumer 1,315,000 195,000 1,600,000

Management has specified a 21% target rate of return.

Requirements

1. Calculate each division’s ROI. Round all of your answers to four decimal places.

2. Calculate each division’s profit margin ratio. Interpret your results.

3. Calculate each division’s asset turnover ratio. Interpret your results.

4. Use the expanded ROI formula to confirm your results from Requirement 1. Interpret your results.

5. Calculate each division’s RI. Interpret your results, and offer a recommendation for any division with negative RI.

6. Describe some of the factors that management considers when setting its minimum target rate of return.

Short answer

1. 34.49% for the paint store division and 12.19% for the consumer division

2. 11.96% for the paint store division and 14.89% for the consumer division

3. 2.9 times for the paint store division and 0.8 for the consumer division

4. Paint store division is much more efficient in terms of profit generation and asset turnover

5. $186,200 for the paint store division and -$141,000 for the consumer division

6.Asset to be considered, asset measurement and time period.

Step-by-step solution

Computation of ROI

$\begin{array}{c}\mathbf{R}\mathbf{O}\mathbf{I}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{P}\mathbf{a}\mathbf{i}\mathbf{n}\mathbf{t}\mathbf{}\mathbf{S}\mathbf{t}\mathbf{o}\mathbf{r}\mathbf{e}\mathbf{s}\mathbf{=}\frac{\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}}{\mathbf{A}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{g}\mathbf{e}\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{476}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{380}\mathbf{,}\mathbf{000}}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{3449}\mathbf{o}\mathbf{r}\mathbf{34}\mathbf{.}\mathbf{49}\mathbf{\%}\end{array}$

$\begin{array}{c}\mathbf{R}\mathbf{O}\mathbf{I}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{C}\mathbf{o}\mathbf{n}\mathbf{s}\mathbf{u}\mathbf{m}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{D}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{s}\mathbf{i}\mathbf{o}\mathbf{n}\mathbf{=}\frac{\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}}{\mathbf{A}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{g}\mathbf{e}\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{195}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{600}\mathbf{,}\mathbf{000}}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{1219}\mathbf{o}\mathbf{r}\mathbf{12}\mathbf{.}\mathbf{19}\mathbf{\%}\end{array}$

Computation of profit margin ratio

$\begin{array}{c}\mathbf{P}\mathbf{r}\mathbf{o}\mathbf{f}\mathbf{i}\mathbf{t}\mathbf{}\mathbf{M}\mathbf{a}\mathbf{r}\mathbf{g}\mathbf{i}\mathbf{n}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{p}\mathbf{a}\mathbf{i}\mathbf{n}\mathbf{t}\mathbf{}\mathbf{s}\mathbf{t}\mathbf{o}\mathbf{r}\mathbf{e}\mathbf{s}\mathbf{=}\frac{\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}}{\mathbf{N}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{S}\mathbf{a}\mathbf{l}\mathbf{e}\mathbf{s}\mathbf{}\mathbf{R}\mathbf{e}\mathbf{v}\mathbf{e}\mathbf{n}\mathbf{u}\mathbf{e}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{476}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{980}\mathbf{,}\mathbf{000}}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{1196}\mathbf{o}\mathbf{r}\mathbf{11}\mathbf{.}\mathbf{96}\mathbf{\%}\end{array}$

$\begin{array}{c}\mathbf{P}\mathbf{r}\mathbf{o}\mathbf{f}\mathbf{i}\mathbf{t}\mathbf{}\mathbf{M}\mathbf{a}\mathbf{r}\mathbf{g}\mathbf{i}\mathbf{n}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{c}\mathbf{o}\mathbf{n}\mathbf{s}\mathbf{u}\mathbf{m}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{d}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{s}\mathbf{i}\mathbf{o}\mathbf{n}\mathbf{=}\frac{\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}}{\mathbf{N}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{S}\mathbf{a}\mathbf{l}\mathbf{e}\mathbf{s}\mathbf{}\mathbf{R}\mathbf{e}\mathbf{v}\mathbf{e}\mathbf{n}\mathbf{u}\mathbf{e}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{195}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{315}\mathbf{,}\mathbf{000}}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{1489}\mathbf{o}\mathbf{r}\mathbf{14}\mathbf{.}\mathbf{89}\mathbf{\%}\end{array}$

Interpretation:-

The profit margin ratio shows the operating income earned against every amount of sales.

In the given case, the paint store division is able to generate $0.1196 of operating income from $1 of sales. On the other hand, the consumer division is able to generate $0.1489of operating income from $1 of sales.

Although each division has an almost equal profit margin, the consumer division is much more profitable than the paint store division.

Computation of asset turnover ratio

$\begin{array}{c}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{T}\mathbf{u}\mathbf{r}\mathbf{n}\mathbf{o}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{p}\mathbf{a}\mathbf{i}\mathbf{n}\mathbf{t}\mathbf{}\mathbf{s}\mathbf{t}\mathbf{o}\mathbf{r}\mathbf{e}\mathbf{=}\frac{\mathbf{N}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{S}\mathbf{a}\mathbf{l}\mathbf{e}\mathbf{s}\mathbf{}\mathbf{r}\mathbf{e}\mathbf{v}\mathbf{e}\mathbf{n}\mathbf{u}\mathbf{e}}{\mathbf{A}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{g}\mathbf{e}\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{980}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{380}\mathbf{,}\mathbf{000}}\\ \mathbf{=}\mathbf{2}\mathbf{.}\mathbf{8841}\mathbf{t}\mathbf{i}\mathbf{m}\mathbf{e}\mathbf{s}\end{array}$

$\begin{array}{c}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{T}\mathbf{u}\mathbf{r}\mathbf{n}\mathbf{o}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{c}\mathbf{o}\mathbf{n}\mathbf{s}\mathbf{u}\mathbf{m}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{d}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{s}\mathbf{i}\mathbf{o}\mathbf{n}\mathbf{=}\frac{\mathbf{N}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{S}\mathbf{a}\mathbf{l}\mathbf{e}\mathbf{s}\mathbf{}\mathbf{R}\mathbf{e}\mathbf{v}\mathbf{e}\mathbf{n}\mathbf{u}\mathbf{e}}{\mathbf{A}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{g}\mathbf{e}\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{315}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{600}\mathbf{,}\mathbf{000}}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{8219}\mathbf{t}\mathbf{i}\mathbf{m}\mathbf{e}\mathbf{s}\end{array}$

Interpretation:-

The asset turnover ratio shows every amount of net sales earned against every amount of average assets.

In the given case, the paint store division is able to generate almost 3 times of sales revenue from $1 of average assets. On the other hand, the consumer division is able to generate almost 1 timeof sales revenue $1 of average assets.

So, it is clearly evident that the paint store is much more efficient in generating sales from average assets.

Expanded ROI and its interpretation

The expanded ROI formula takes into consideration the profit margin ratio and asset turnover ratio to compute the ROI.

In the given case,

$\begin{array}{c}\mathbf{R}\mathbf{O}\mathbf{I}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{P}\mathbf{a}\mathbf{i}\mathbf{n}\mathbf{t}\mathbf{}\mathbf{s}\mathbf{t}\mathbf{o}\mathbf{r}\mathbf{e}\mathbf{=}\mathbf{P}\mathbf{r}\mathbf{o}\mathbf{f}\mathbf{i}\mathbf{t}\mathbf{}\mathbf{M}\mathbf{a}\mathbf{r}\mathbf{g}\mathbf{i}\mathbf{n}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{\times }\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{T}\mathbf{u}\mathbf{r}\mathbf{n}\mathbf{o}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{1196}\mathbf{\times }\mathbf{2}\mathbf{.}\mathbf{8841}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{3449}\mathbf{o}\mathbf{r}\mathbf{34}\mathbf{.}\mathbf{49}\mathbf{\%}\end{array}$

$\begin{array}{c}\mathbf{R}\mathbf{O}\mathbf{I}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{C}\mathbf{o}\mathbf{n}\mathbf{s}\mathbf{u}\mathbf{m}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{D}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{s}\mathbf{i}\mathbf{o}\mathbf{n}\mathbf{=}\mathbf{P}\mathbf{r}\mathbf{o}\mathbf{f}\mathbf{i}\mathbf{t}\mathbf{}\mathbf{M}\mathbf{a}\mathbf{r}\mathbf{g}\mathbf{i}\mathbf{n}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{\times }\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{T}\mathbf{u}\mathbf{r}\mathbf{n}\mathbf{o}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{1429}\mathbf{\times }\mathbf{0}\mathbf{.}\mathbf{8219}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{1174}\mathbf{o}\mathbf{r}\mathbf{11}\mathbf{.}\mathbf{74}\mathbf{\%}\end{array}$

Interpretation:-

In the given case, it can be seen that the paint store division is able to generate comparatively less profit margin but has been able to generate almost 3 times of asset turnover. This helped the paint store division to generate 35% of ROI.

On the other hand, the consumer division is able to generate a comparatively higher profit margin but fails to generate a higher asset turnover. Thus in turn it has earned only 12% of ROI.

So, it is clearly evident that the paint store is much more efficient in the overall generation of income computed in terms of ROI.

Computation of residual income

$\begin{array}{c}\mathbf{R}\mathbf{e}\mathbf{s}\mathbf{i}\mathbf{d}\mathbf{u}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{p}\mathbf{a}\mathbf{i}\mathbf{n}\mathbf{t}\mathbf{}\mathbf{s}\mathbf{t}\mathbf{o}\mathbf{r}\mathbf{e}\mathbf{=}\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{i}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}\mathbf{-}\left(Targetrateofretrun\times Averagetotalassets\right)\\ \mathbf{=}\mathbf{\$}\mathbf{476}\mathbf{,}\mathbf{000}\mathbf{-}\left(21\%\times \$1,380,000\right)\\ \mathbf{=}\mathbf{\$}\mathbf{476}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{289}\mathbf{,}\mathbf{800}\\ \mathbf{=}\mathbf{\$}\mathbf{186}\mathbf{,}\mathbf{200}\end{array}$

$\begin{array}{c}\mathbf{R}\mathbf{e}\mathbf{s}\mathbf{i}\mathbf{d}\mathbf{u}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}\mathbf{}\mathbf{f}\mathbf{o}\mathbf{r}\mathbf{}\mathbf{c}\mathbf{o}\mathbf{n}\mathbf{s}\mathbf{u}\mathbf{m}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{d}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{s}\mathbf{i}\mathbf{o}\mathbf{n}\mathbf{=}\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{i}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}\mathbf{-}\left(Targetrateofretrun\times Averagetotalassets\right)\\ \mathbf{=}\mathbf{\$}\mathbf{195}\mathbf{,}\mathbf{000}\mathbf{-}\left(21\%\times \$1,600,000\right)\\ \mathbf{=}\mathbf{\$}\mathbf{195}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{336}\mathbf{,}\mathbf{000}\\ \mathbf{=}\mathbf{-}\mathbf{\$}\mathbf{141}\mathbf{,}\mathbf{000}\end{array}$

Interpretation:-

The residual income is the measure of profitability that showing the income-earning efficiently against the minimum acceptable operating income.

In the given case, the residual income is positive in the case of the paint store and amounts to $186,200in figures. On the other hand, the residual income is negative for consumer division and amounts to -$141,000 in figures.

Thus it is clearly evident that the paint store is able t achieve the firm’s target operating income and the consumer division has failed to do so.

Recommendation:-

It is recommended to the consumer division to increase the efficiency of the assets to generate more sales and to have a higher asset turnover ratio.

Factors to consider while setting a minimum target rate of return

Following are the factors that must be given consideration while setting MTRR –

1. Assets to be considered: - The minimum target rate of return is used to determine the minimum income based on total or average assets. Sometimes, the firm is not able to utilize all of its assets. In such a case if the appropriate minimum rate is not determined then the minimum required income would be considerably low and the firm’s decisions would be affected.

2. Asset measurement: - Another factor that should be given due consideration is the measurement of assets on net book value or gross value. Generally, companies use net book value to determine residual income but if the company’s depreciation expense is increasing continuously in the long run the residual income would show an excessive amount due to the increased depreciation expense.

3. Time period: - generally residual income is calculated annually. But this annual figure may not be helpful in achieving the target. Thus the company should also focus on considering short-term residual income so that an immediate increase can be achieved in the residual income.