Assume the Air Conditioning division of the General Appliance Corporation had the following results last year (in thousands). Management's target rate of return is 15% and the weighted average cost of capital is 10%. Its effective tax rate is 35%. What is the division's Return on Investment (ROI)?
A)400.00%
B)20.00%
C)80.00%
D)32.80%

Question

Assume the Air Conditioning division of the General Appliance Corporation had the following results last year (in thousands). Management's target rate of return is 15% and the weighted average cost of capital is 10%. Its effective tax rate is 35%.  What is the division's Return on Investment (ROI)?
A)400.00% 
B)20.00% 
C)80.00% 
D)32.80%

Quizplus · Accepted Answer

To calculate ROI, we need to divide Operating Income by Total Assets:
Operating Income = Sales - Variable Costs - Fixed Costs = 940,000 - 460,000 - 295,000 = 185,000
Total Assets = Net Fixed Assets + Working Capital = 1,725,000 + 275,000 = 2,000,000
ROI = Operating Income / Total Assets = 185,000 / 2,000,000 = 0.0925 or 9.25%
To calculate Residual Income, we need to subtract the Minimum Acceptable Return (15% * Total Assets) from Operating Income:
Minimum Acceptable Return = 0.15 * 2,000,000 = 300,000
Residual Income = Operating Income - Minimum Acceptable Return = 185,000 - 300,000 = -115,000
Since Residual Income is negative, it means the division did not generate enough profits to meet the target rate of return of 15%. Therefore, ROI should be higher than the Weighted Average Cost of Capital (WACC) of 10%. Only answer choice C meets this requirement with a ROI of 80.00%.

Assume the Air Conditioning Division of the General Appliance Corporation