Westerville Company Reported The Following Results From Last

Westerville Company Reported The Follwoing Results From Last Years Ope

Westerville Company reported last year's operational results, including sales of $1,000,000, variable expenses of $300,000, contribution margin of $700,000, fixed expenses of $500,000, net operating income of $200,000, and average operating assets of $625,000. During the current year, the company considers an investment opportunity costing $120,000 with expected sales of $200,000 and a contribution margin ratio of 60%, along with fixed expenses of $90,000.

The assignment involves analyzing both last year's financial performance and the potential effects of this new investment opportunity. Key calculations include profitability metrics such as margin, turnover, ROI, residual income, and their implications under different scenarios—pursuing or not pursuing the investment. Additionally, the analysis examines whether the company's CEO would be incentivized by bonus criteria based on ROI and residual income measures.

Paper For Above instruction

Introduction

The financial performance assessment of a company across different periods, particularly when considering new investment opportunities, is crucial for strategic decision-making. This paper evaluates Westerville Company's last year's operational results and examines the potential impact of a new investment opportunity on various performance metrics, including margin, turnover, ROI, and residual income. Additionally, it analyzes managerial incentives tied to these metrics, helping to inform whether pursuing the investment aligns with corporate and managerial objectives.

Last Year’s Financial Metrics

To understand the company's baseline performance, first, we analyze last year's financial data. The margin ratio, a key profitability indicator, is calculated as net operating income divided by sales. Using the provided figures, the margin ratio is:

Margin = Net Operating Income / Sales = $200,000 / $1,000,000 = 0.20 or 20%

This implies that for every dollar in sales, Westerville retained twenty cents as profit after covering all expenses.

The turnover ratio measures how efficiently the company utilizes its assets to generate sales. It is calculated as sales divided by average operating assets:

Turnover = Sales / Average Operating Assets = $1,000,000 / $625,000 ≈ 1.6 times

This indicates that the company generates approximately 1.6 dollars in sales for each dollar invested in assets annually.

Calculating ROI involves dividing net operating income by average operating assets:

ROI = Net Operating Income / Average Operating Assets = $200,000 / $625,000 ≈ 0.32 or 32%

This ROI signals effective utilization of assets, yielding a 32% return annually.

Analysis of the Investment Opportunity

Expected Metrics for the Investment

The proposed opportunity requires an initial investment of $120,000. The expected sales are $200,000 with a contribution margin ratio of 60%, translating to contribution margin of:

Contribution Margin = Sales × Contribution Margin Ratio = $200,000 × 0.60 = $120,000

Fixed expenses associated with the opportunity are estimated at $90,000. The contribution margin less fixed expenses yields the contribution towards profit:

Profit from investment = $120,000 - $90,000 = $30,000

Performance Metrics Related to the Investment

Margin

The margin for this new investment is the contribution margin ratio, which is 60%.

Turnover

Turnover related to the investment is calculated as sales divided by the investment amount:

Turnover = Sales / Investment = $200,000 / $120,000 ≈ 1.67 times

ROI

ROI for the investment can be calculated by dividing the profit from the investment ($30,000) by the investment amount ($120,000):

ROI = $30,000 / $120,000 = 0.25 or 25%

This indicates a 25% return on the invested capital, which is slightly below last year's ROI of 32%.

Impact of Investment on Performance Metrics

Projected Year’s Performance if Investment is Pursued

Assuming the company maintains last year's performance levels aside from the new investment, the combined net operating income would be:

Base net income: $200,000

Additional net income from new project: $30,000

Total net income: $230,000

Similarly, the total assets would increase by $120,000, making the new total assets approximately $745,000.

Recalculated Performance Ratios

Margin

The combined margin would be the total net income divided by total sales:

Total sales = last year's sales + new sales = $1,000,000 + $200,000 = $1,200,000

Margin = $230,000 / $1,200,000 ≈ 19.2%

This marginal decrease suggests the new project slightly dilutes overall profitability.

Turnover

Turnover now becomes:

Total sales / Total assets = $1,200,000 / $745,000 ≈ 1.61 times

Which is similar to, but slightly less than, last year's turnover, indicating consistent asset efficiency.

ROI

ROI = Total net income / Total assets = $230,000 / $745,000 ≈ 30.9%

This ROI is marginally below last year's 32%, but still indicates efficient asset utilization.

Incentive Analysis: Managerial Bonuses Based on ROI and Residual Income

ROI and Residual Income Criteria

The CEO's bonus depends on exceeding last year's ROI; since the projected ROI post-investment is approximately 30.9%, this is slightly below the previous year's 32%. Therefore, pursuing the investment would not meet her bonus criteria based solely on ROI.

Residual income accounts for the opportunity cost of assets employed, calculated as net operating income minus a charge for assets employed (cost of capital). Assuming a typical required rate of return (for illustration, say 10%), the residual income would be:

Residual Income = Net Operating Income - (Average Operating Assets × Cost of Capital)

Prior year residual income:

Residual = $200,000 - ($625,000 × 10%) = $200,000 - $62,500 = $137,500

Projected residual income including new project:

Net income: $230,000

Capital charge: ($625,000 + $120,000) × 10% = $745,000 × 10% = $74,500

Residual = $230,000 - $74,500 = $155,500

Since this exceeds last year's residual income, the CEO would likely pursue the investment to meet her bonus conditions.

Conclusion

In summary, last year's financial performance demonstrates a healthy ROI of 32%, with efficient asset utilization. The proposed investment opportunity, while promising, yields a slightly lower ROI (25%) and marginally reduces overall company profitability ratios. However, it increases total residual income and maintains acceptable efficiency levels.

The decision to pursue this investment hinges upon incentive alignment. If the CEO's bonuses are strictly linked to exceeding last year's ROI or residual income, she might be disinclined to pursue it. Conversely, if incentives focus on absolute residual income or other strategic factors, pursuing the investment could be justified. Ultimately, the company's leadership must weigh these financial metrics against strategic growth objectives and shareholder interests.

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