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Hi! I have a problem with this question. I cannot understand how to solve it, because I have information about current ROI, but not about current RI. The question says that I should use RI as a base for the decision. I am a little confuse, can please explain me.
Alpha Co has two divisions, X and Y. Each division is considering the following separate projects:
Division X Division Y
Capital required $78.24 million $53.28 million
Sales to be generated $34.56 million $21.12 million
Operating profit margin 30% 24%
Cost of capital 12% 12%
Current return on investment
of division 16% 10%If residual income is used as the basis for the investment decision, which Division(s) would choose to invest in the project?
For division X, we know the profit (30% x 34.56M = 10.368M)
We know the capital required is $78.24M, and so the interest is 12% x $78.24 = 9.3888MTherefore the residual income is 10.368 – 9.3888 = $0.9792M.
Thank you very much for the quick response. But I still cannot understand how to decide which division would choose to invest in the project. I know I can calculate the residual income for both of the projects, but how to decide on that basis (RI basis) when I do not have anything to compare with. Or I just have to compare both residual incomes and to choose the better one on that basis and current ROI is given to make me confused? I know the current ROI, but not the current residual income.
I hope I made my question clearer.ROI us irrelevant for this question.
If the residual income is positive then the project is worth accepting, if the residual income is negative then it is not.
(It will help you to watch the free lectures on this)
Thank you! I watched all your lectures for all exams I have passed so far (with very good results, thanks to you and your wonderful site). I was a little confused because in the lectures we compared current ROI with the ROI of the new project, but now I fully understood the question. The project of division Y gave me negative RI, so the situation is clear, ROI is irrelevant. Thank you again! Have a nice day!
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