SOLUTIONS TO CASES

CASE 13-50 (40 MINUTES)

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

Return on Investment
HEC RLI Combined
Operating income..........................................$2,000,000 $   600,000 $
2,600,000
Total assets................................................... 8,000,000 3,000,000 11,000,000
Return on investment (income/assets)............ 25% 20% 23.6%*

*Rounded.

The result would be that HEC'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, HEC would be more willing to acquire RLI, because the residual income
of the combined operations would increase.

Residual Income
HEC RLI Combined
Total assets............................................ $8,000,000 $3,200,000* $11,200,00
0
  
Income................................................... $2,000,000 $   600,000 $
2,600,000
Less: Imputed interest charge
(assets  15%)....................................  1,200,000    480,000      
1,680,000
Residual income..................................... $   800,000 $   120,000    $  
920,000
*Cost to acquire RLI.
CASE 13-50 (CONTINUED)

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.