Chapter 10, Problem 10.23AE

Comparison of ROI and residual income (Learning Objective 3)

Montgomery Ceramics, a division of Watson Corporation, has an operating income of $77,000 and total assets of $440,000. The required rate of return for the company is 14%. The company is evaluating whether it should use return on investment (ROI) or residual income (RI) as a measurement of performance for its division managers.

The manager of Montgomery Ceramics has the opportunity to undertake a new project that will require an investment of $110,000. This investment would earn $13,200 for the company.

Requirements

1. 1. What is the original return on investment (ROI) for Montgomery Ceramics (before making any additional investment)?
2. 2. What would the ROI be for Montgomery Ceramics if this investment opportunity were undertaken? Would the manager of the Montgomery Ceramics division want to make this investment if she were evaluated based on ROI? Why or why not?
3. 3. What is the ROI of the investment opportunity? Would the investment be desirable from the standpoint of Watson Corporation? Why or why not?
4. 4. What would the residual income (RI) be for Montgomery Ceramics if this investment opportunity were to be undertaken? Would the manager of the Montgomery Ceramics division want to make this investment if she were evaluated based on RI? Why or why not?
5. 5. What is the RI of the investment opportunity? Would the investment be desirable from the standpoint of Watson Corporation? Why or why not?
6. 6. Which performance measurement method, ROI or RI, promotes goal congruence? Why?