Shikhar Mohan (PGDM-FS)

Roll no: 037

Case 13-50

Q.1 If New Age Industries continues to use ROI as the sole measure of divisional
performance, explain why FTEC would be reluctant to acquire Recreational Leasing,
Inc.

1. If New Age Industries continued to use return on investment (ROI) as the sole
measure of “division performance”, Fun Times Entertainment Corporation (FTEC)
would be reluctant to acquire Recreational Leasing Incorporation (RLI) because the
post-acquisition combined ROI would decrease.
Particulars Return on Investment
FTEC RLI Combined
Operating Income $10,00,000 $3,00,000 $13,00,000
Total Assets $40,00,000 %15,00,000 $55,00,000
ROI(Income/Assets) 25% 20% 23.6%

The result would be that FTEC’s management would either lose their bonuses or have their
bonuses limited to 50% of the eligible amounts. The assumption is that management could
provide convincing explanations for the decline in ROI.

Q.2 If New Age Industries could be persuaded to use residual income to measure the
performance of FTEC, explain why FTEC would be more willing to acquire RLI.

2. Residual income is the profit earned that exceeds an amount charged for funds
committed to a business unit. The amount charged for funds committed is equal to
an imputed interest rate multiplied by invested capital. If new age industries could
be persuaded to use residual income to measure performance, FTEC would be more
interested to acquire RLI, because residual income of the combined operations
would increase.

3. Discuss how the behavior of division managers is likely to be affected by the use of
the following performance measures: (a) return on investment and (b) residual
income.

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.