Question

Axel Corporation (which has a weighted-average cost of capital of 12%) has two divisions with the following information:

Total Assets = $720,000 (Beta Division), $550,000 (Cal Division)
Current Liabilities = $220,000 (Beta Division), $110,000 (Cal Division)
After-Tax Operating Income = $105,000 (Beta Division), $110,000 (Cal Division)
ROI = 15% (Beta Division), 20% (Cal Division)
Each manager is offered an investment project opportunity that would increase each division's investment base by $10,000 and generate an additional profit for each division of $1,800. Which of the following is true?
Multiple Choice
A. If the managers are evaluated based on their divison's ROI, Beta would accept the project but Cal would reject it.
B. If the managers are evaluated based on their divison's ROI, Cal would accept the project but Beta would reject it.
C. If the company rewards managers for accepting any project with positive residual income, and the company's target return for projects is 20%, both division managers would accept the project.
D. If the compay rewards managers for accepting any project with positive residual income, and the company's target return for projects is 15%, both division managers would reject the project.

Answer 1

To determine which statement is true, we need to evaluate the impact of the investment project on the ROI and residual income for each division.

Statement A: If the managers are evaluated based on their division's ROI, Beta would accept the project but Cal would reject it.

To calculate the new ROI for each division, we add the additional profit ($1,800) to the after-tax operating income and divide it by the new total assets (existing total assets + $10,000).

Beta Division ROI: (105,000 + 1,800) / (720,000 + 10,000) ≈ 14.29%

Cal Division ROI: (110,000 + 1,800) / (550,000 + 10,000) ≈ 20.71%

Based on the new ROI calculations, Statement A is false. Both Beta and Cal divisions would reject the project if they are evaluated based on their division's ROI.

Statement B: If the managers are evaluated based on their division's ROI, Cal would accept the project but Beta would reject it.

Based on the calculations above, Statement B is also false. Cal Division would still reject the project based on ROI.

Statement C: If the company rewards managers for accepting any project with positive residual income, and the company's target return for projects is 20%, both division managers would accept the project.

To calculate the residual income, we subtract the target return from the after-tax operating income for each division.

Beta Division residual income: 105,000 - (720,000 * 0.20) = 105,000 - 144,000 = -39,000 (negative)

Cal Division residual income: 110,000 - (550,000 * 0.20) = 110,000 - 110,000 = 0

Based on the residual income calculations, Statement C is false. Both Beta and Cal divisions would reject the project if the company rewards managers for accepting any project with positive residual income and the target return for projects is 20%.

Statement D: If the company rewards managers for accepting any project with positive residual income, and the company's target return for projects is 15%, both division managers would reject the project.

Based on the residual income calculations, Statement D is true. Both Beta and Cal divisions would reject the project if the company rewards managers for accepting any project with positive residual income and the target return for projects is 15%.

Therefore, the correct answer is D. If the company rewards managers for accepting any project with positive residual income, and the company's target return for projects is 15%, both division managers would reject the project.