Question

All other things equal, which of the following would increase a division's residual income?

1) Increase in expenses
2) Decrease in average operating assets
3) Increase in minimum required return
4) Decrease in net operating income

Answer 1

A decrease in average operating assets would increase a division's residual income by lowering the capital cost charge. Increases in expenses, minimum required return, or decreases in net operating income would have the opposite effect.

Step-by-step explanation:

The question pertains to what would increase a division's residual income. Residual income is calculated as net operating income minus a charge for the cost of capital invested in the division's operating assets. Given this, an increase in expenses would decrease residual income, as it reduces net operating income. A decrease in average operating assets would likely increase residual income if it leads to lower capital cost charges. An increase in the minimum required return would increase the capital cost charge, therefore reducing residual income. Moreover, a decrease in net operating income would reduce residual income. Thus, the factor that would increase a division's residual income among the options provided is a decrease in average operating assets.

Answer 2

A decrease in average operating assets would increase a division's residual income, provided that net operating income does not change, as it lowers the capital charge component of the residual income calculation.

Step-by-step explanation:

The question concerns the concept of residual income, which is a measure used in corporate finance to assess a division's profitability. Residual income is defined as the net operating income a division earns above the minimum required return on its average operating assets. Based on the information provided, the options that could potentially increase a division's residual income are not directly stated; however, one can deduce that reducing expenses or reducing the minimum required return would be beneficial towards increasing residual income. The increase in expenses, increase in minimum required return, and decrease in net operating income would all decrease residual income. On the other hand, a decrease in average operating assets would increase residual income if the net operating income remains unchanged because the charge for the use of capital (minimum required return times average operating assets) would be lower.

Increase in minimum required return would increase a division's residual income. Residual income is calculated as net operating income minus the minimum required return multiplied by the average operating assets. By increasing the minimum required return, the division would need to generate a higher level of income to meet the return requirement, resulting in a higher residual income.