SOLUTION: 13-50

1. If New Age Industries continues to use return on investment as the sole measure of
division performance, Fun Times Entertainment Corporation (FTEC) would be reluctant
to acquire Recreational Leasing, Inc. (RLI), because the post-acquisition combined ROI
would decrease.

Return on Investment
FTEC RLI Combined
Operating income ............................................. $1,000,000 $ 300,000 $ 1,300,000
Total assets ...................................................... 4,000,000 1,500,000 5,500,000
Return on investment (income/assets)........... 25% 20% 23.6%*

*Rounded.

The result would be that FTEC's management would either lose their bonuses or have
their bonuses limited to 50 percent of the eligible amounts. The assumption is that
management could provide convincing explanations for the decline in return on
investment.

2. Residual income is the profit earned that exceeds an amount charged for funds committed
to a business unit. The amount charged for funds is equal to an imputed interest rate
multiplied by the business unit's invested capital.

If New Age Industries could be persuaded to use residual income to measure

performance, FTEC would be more willing to acquire RLI, because the residual income of
the combined operations would increase.

Residual Income
FTEC RLI Combined
Total assets ................................................... $4,000,000 $1,600,000* $5,600,000
Income ........................................................... $1,000,000 $ 300,000 $1,300,000
Less: Imputed interest charge
(assets  15%) ........................................... 600,000 240,000 840,000
Residual income ............................................ $ 400,000 $ 60,000 $ 460,000

*Cost to acquire RLI.

3. a. The likely effect on the behavior of division managers whose performance is
measured by return on investment includes incentives to do the following:

• Put off capital improvements or modernization to avoid capital expenditures.

• Shy away from profitable opportunities or investments that would yield more
than the company's cost of capital but that could lower ROI.

b. The likely effect on the behavior of division managers whose performance is

measured by residual income includes incentives to do the following:

• Seek any opportunity or investment that will increase overall residual income.

• Seek to reduce the level of assets employed in the business.