Residual Income and Investment Decisions

Jarriot, Inc., presented two years of data for its Furniture Division and its Houseware Division.

Furniture Division:

Year 1 Year 2
Sales $35,000,000 $37,500,000
Operating income 1,400,000 1,500,000
Average operating assets 10,000,000 10,000,000

Houseware Division:
Year 1 Year 2

Sales $12,000,000 $12,500,000
Operating income 600,000 500,000
Average operating assets 5,000,000 5,000,000

At the end of Year 2, the manager Of the Houseware Division is concerned about the division's performance. As a result, he is considering the opportunity to invest in two independent projects. The first is called the Espresso-pro; it is an in-home espresso maker that can brew regular coffee as well as make espresso and latte drinks. While the market for espresso drinkers is small initially, he believes this market can grow, especially around gift-giving occasions. The second is the Mini-prep appliance that can be used to do small chopping and dicing chores that do not require a full-sized food processor. Without the investments, the division expects that Year 2 data will remain unchanged. The expected operating incomes and the outlay required for each investment are as follows:

Espresso-Pro Mini-Pro
Operating income $ 27,500 $19,000
Outlay 250,000 200,000

Required:
a. Compute the residual income for each Of the opportunities. (Round to the nearest dollar.)
b. Compute the divisional residual income for each of the following four alternatives

2. Four alternatives: a. The Espresso-Pro is added. $ b. The Mini-Prep is added. $ c. Both investments are added. $ d. Neither investment is made; the status quo is maintained.

Answer:

Jarriot, Inc.

Household Division:

1. Residual income for each of the opportunities:

Espresso-Pro Mini-Pro Total

Residual income $2,500 ($1,000) $1,500

2. Residual income for the four alternatives:

a. The Espresso-Pro is added. $2,500

b. The Mini-Prep is added. ($1,000)

c. Both investments are added. $1,500

d. Neither investment is made; the status quo is maintained. $0.

Explanation:

a) Data and Calculations:

Residual income:

Furniture Division:

Year 1 Year 2

Sales $35,000,000 $37,500,000

Operating income 1,400,000 1,500,000

Average operating assets 10,000,000 10,000,000

Rate of return (10%) 1,000,000 1,000,000

Residual income $400,000 $500,000

Houseware Division:

Year 1 Year 2

Sales $12,000,000 $12,500,000

Operating income 600,000 500,000

Average operating assets 5,000,000 5,000,000

Rate of return (10%) 500,000 500,000

Residual income $100,000 $0

Residual income for each of the opportunities:

Espresso-Pro Mini-Pro

Operating income $ 27,500 $19,000

Outlay 250,000 200,000

Rate of return (10%) 25,000 20,000

Residual income $2,500 ($1,000)

Year 2 Espresso-Pro Total

Sales $12,500,000

Operating income 500,000 $27,500 $527,500

Average operating assets 5,000,000 250,000 5,250,000

Rate of return (10%) 500,000 25,000 525,000

Residual income $0 $2,500 $2,500

Year 2 Mini-Pro Total

Sales $12,500,000

Operating income 500,000 $19,000 $519,000

Average operating assets 5,000,000 200,000 5,200,000

Rate of return (10%) 500,000 20,000 520,000

Residual income $0 ($1,000) ($1,000)

b) Residual income is the difference between the operating income and the cost of capital (or the minimum required return). It is the income that is left after taking into consideration, the stockholders' opportunity cost of generating the income.