MBA 701 Inclass-week7

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North Dakota State University *

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701

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Business

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Apr 3, 2024

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MBA 701 Strategic Cost Management In-Class Problem – Week 7 ABC Division currently has an operating profit of $3.75 million on average operating assets of $21 million. ABC is considering investing in two projects: Project #1 Project #2 Required Investment $1,250,000 $ 750,000 Annual Revenue or Cost Savings $ 200,000 $175,000 ABC’s division manager receives a bonus each year which is tied to the ROI of ABC. Corporate headquarters has made $2.5 million in capital available to ABC. Any unused funds would be invested at the corporate level at an expected rate of 10%. 1. Compute the current division ROI and the ROI of each project. Division ROI = Division operating profit / Division Average operating assets = 3.75 million / 21 million = 17.86% Project ROI = Annual Revenue or Cost Savings / Required Investment Project #1 ROI = 200,000 / 1,250,000 = 16% Project #2 ROI = 175,000 / 750,000 = 23.33% 2. Calculate the new ROI for ABC Division based on: a) adding Project #1; b) adding Project #2; and c) adding Project #1 and Project #2. A) $3,750,000 + $200,000 / $21,000,000 + $1,250,000 = 17.75% B) $3,750,000 + $175,000 / $21,000,000 + $750,000 = 18.05% C) $3,750,000 + $200,000 +$175,000 / $21,000,000 + $1,250,000 + $750,000 = 17.93% 3. What investment option is ABC’s manager likely to choose? What are you assuming is motivating the manager?

The manager would be most likely to choose option B, as this option gives the highest overall ROI percentage which is what the manager's incentives are tied to. 4. Which investment alternative is in the best interest of the overall company? Why? (Calculations not needed.) The best option for the company would be option C. Option C provides a return over 10%, while investing the most funds overall. 5. Calculate the residual income of each project (use 10% as the minimum return). Also calculate the new Residual income for ABC Division based on all possible investment alternatives. Residual income = Revenue – Return* *(Investment * 10%) Project #1 = $200,000 – (.1*1,250,000) = $200,000 - $125,000 = $75,000 Project #2 = $175,000 – (.1* 750,000) = $175,000 - $75,000 = $100,000 ABC Division + Project 1 = 200,000 + 3,750,000 = 3,950,000 = 21,000,000 + 1,250,000 = 22,250,000 = 3,950,000 – (22,250,000 * .1) = $3,950,000 – $2,225,000 = $1,725,000 ABC Division + Project 2 = 3,750,000 + 175,000 = 3,925,000 = 21,000,000 + 750,000 = 21,750,000 = 3,925,000 – (21,750,000 * .1) = $3,925,000 - $2,175,000 = $1,750,000 6. What investment option would ABC choose if the division manager were evaluated based on RI? If the manager was evaluated based on RI, they would choose to add project 2 to the normal division. This would lead to the largest RI out of all the possible options.

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