Question 1c
Brace Co is split into two divisions, A and B, each with their own cost and revenue streams. Each of them is managed by a divisional manager who has the power to make all investment decisions within the division. The cost of capital for both divisions is 12%. Historically, investment decisions have been made by calculating the return on investment (ROI) of any opportunities and at present, the return on investment of each division is 16%.
A new manager who has recently been appointed in division A has argued that using residual income to make investment decisions would result in ‘better goal congruence’ throughout the company.
Each division is currently considering the following separate investments:
| Division A | Division B | |
|---|---|---|
| Capital required for investment | $82·8 million | $40·6 million |
| Sales generated by investment | $44·6 million | $21·8 million |
| Net profit margin | 28% | 33% |
Required:
(c) Comment on the results, taking into consideration the manager’s views about residual income. (4 marks)