Bombard Division has operating income of $200,000 for the year ending December 31,2011.Average invested capital is $1,000,000 and the weighted-average cost of capital is 10%.The division is considering a new investment that would cost $500,000 and earn 15% annually.If economic profit is the performance metric,should the manager of the Bombard Division accept the new investment?
A) No, because the return on investment of the division decreases with the new investment.
B) No, because the return on investment of the division increases with the new investment.
C) Yes, because the economic profit of the division increases with the new investment.
D) Yes, because the return on investment of the division increases with the new investment.

Question

Quizplus · Accepted Answer

To calculate economic profit, we subtract the cost of capital from the return on invested capital.

Return on invested capital = Operating income / Average invested capital = $200,000 / $1,000,000 = 20%

Cost of capital = Weighted-average cost of capital * Average invested capital = 10% * $1,000,000 = $100,000

Economic profit = Return on invested capital - Cost of capital = 20% - 10% = 10%

If the division were to invest in the new project, the return on invested capital would be 15%, which is higher than the current return on invested capital. Therefore, the economic profit would increase, and the manager should accept the new investment.

Bombard Division Has Operating Income of $200,000 for the Year