The manager of the West Division of Beach Clothing Company is evaluating the acquisition of a new embroidery machine.The budgeted operating income of the West Division was $4,000,000 with total assets of $22,000,000 and noninterest-bearing current liabilities of $1,000,000.The proposed investment would add $750,000 to operating income and would require an additional investment of $3,500,000.The targeted rate of return for the West Division is 14 percent and the cost of capital is 9 percent.Ignoring taxes, how much is the residual income of the West division if the embroidery machine is not purchased?
A)$202,000
B)$1,930,000
C)$2,110,000
D)$1,060,000

Question

Quizplus · Accepted Answer

Residual income = Operating income - (Total assets x Cost of capital) 
Residual income without new investment = $4,000,000 - ($22,000,000 x 0.09) = $2,020,000 
Residual income with new investment = ($4,000,000 + $750,000) - ($22,000,000 + $3,500,000) x 0.09 = $2,110,000 
Therefore, the residual income would be $2,110,000 if the embroidery machine is not purchased. Based on this calculation, it would be best for the West Division to make the investment in the embroidery machine as it would increase the residual income.

The Manager of the West Division of Beach Clothing Company