Use the information below to answer the following question(s).Thacker Company has two regional offices.The information for each is as follows:

-An automotive dealership, with a book value of $3,000,000, and total assets of $5,000,000, has a long history of earning 18%.Last year, the company earned $900,000.The owner is considering acquiring another dealership in a nearby town.If the expansion increases income by 50%, what is the maximum amount of investment the owner can make in the new dealership in order to maintain his desired 18% return?
A)$1,350,000
B)$9,000,000
C)$5,000,000
D)$3,000,000
E)$2,500,000

Question

Use the information below to answer the following question(s).Thacker Company has two regional offices.The information for each is as follows:
 
-An automotive dealership, with a book value of $3,000,000, and total assets of $5,000,000, has a long history of earning 18%.Last year, the company earned $900,000.The owner is considering acquiring another dealership in a nearby town.If the expansion increases income by 50%, what is the maximum amount of investment the owner can make in the new dealership in order to maintain his desired 18% return?
A)$1,350,000 
B)$9,000,000 
C)$5,000,000 
D)$3,000,000 
E)$2,500,000

Quizplus · Accepted Answer

First, we need to determine the current earnings of the dealership, given the book value and total assets. Since the book value is $3,000,000 and the total assets are $5,000,000, we know that $2,000,000 of the assets are not accounted for in the book value (i.e. they are likely financed by debt).

Therefore, we can estimate the current earnings as (18%)(3,000,000 + 2,000,000) = $900,000. This matches the earnings reported in the question.

If the owner wants to maintain his 18% return, he will need to earn $1,080,000 ($900,000 x 1.5) after the expansion. We can use the earnings formula to calculate the maximum amount of investment he can make in the new dealership:

(Earnings after expansion)/(Book value of new dealership) = 18%
($1,080,000)/(Book value of new dealership) = 18%
Book value of new dealership = $6,000,000
However, since the owner will only be investing a portion of the book value (i.e. he will likely finance the rest with debt), the maximum amount of investment he can make will be less than $6,000,000.

Therefore, the best choice is E) $2,500,000 as it is the closest amount to $6,000,000 that does not exceed the maximum investment.

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