Question:
Calculation of ROI and RI
Division M is a division of MR Co. The following data relate to Division M.
Capital employed (net assets) $20m
Annual profit $5m
Cost of capital 15% per annum
MR Co is considering two proposals.
Proposal 1
Invest a further $2m in fixed assets to earn an annual profit of $0.30m.
Proposal 2
Dispose of fixed assets at their net book value of $5.5m. This would lead to profits falling by $0.8m per annum. Proceeds from the disposal of these fixed assets would not be credited to Division M (but to the Holding Company of MR Co instead).
Required
(a) Calculate the current return on investment and residual income for Division M.
(b) Consider each of the two proposals and show how the return on investment and residual income would change if these proposals were adopted.