Comparing return on investment and residual income

Angelo Corporation operates three investment centers. The following financial statements apply to the investment center named Owen Division.

Income Statement

For the Year Ended December 31, 2008

Sales revenue

$113,385

Cost of goods sold

(60,420)

Gross margin

52,965

Operating expenses

Selling expenses

(1,345)

Depreciation expense

(1,300)

Operating income

52,320

Nonoperating income

Gain on sale of land

4,460

Net income

$ 54,780

OWEN DIVISION
Balance Sheet
As of December 31, 2008

Assets

Cash

$18,303

Accounts receivable

37,032

Merchandise inventory

37,455

Equipment less accum. dep.

90,000

Non operating assets

10,000

Total assets

$192,790

Liabilities

Accounts payable

$6,700

Notes payable

67,310

Stockholders’ equity

Common stock

64,000

Retained earnings

54,780

Total liab. and stk. equity

$192,790

Required

a. Should operating income or net income be used to determine the rate of return (ROI) for the Owen investment center? Explain your answer.

b. Should operating assets or total assets be used to determine the ROI for the Owen investment center? Explain your answer.

c. Calculate the ROI for Owen.

d. Angelo has a desired ROI of 10 percent. Headquarters has $91,000 of funds to assign its investment centers. The manager of the Owen division has an opportunity to invest the funds at an ROI of 13 percent. The other two divisions have investment opportunities that yield only 12 percent. Even so, the manager of Owen rejects the additional funding. Explain why the manager of Owen would reject the funds under these circumstances.

e. Explain how residual income could be used to encourage the manager to accept the additional funds.