Fun Time Company (FTC), a subsidiary of New Age Industries, manufactures go-carts, water skis and motorised scooters. With the increasing popularity of electronic arcade games, New Age has been encouraging FTC to diversify into some of these other recreational areas. Arcade Unlimited LTD (AUL) is a large manufacturer of arcade games and it is looking for a friendly buyer. New Age’s top management believes that AUL’s assets could be acquired for an investment of only $4.8 million and has strongly urgent Will Kelly, the divisional manager of FTC, to consider acquiring AIJL. Kelly has reviewed the financial statement of AUL and he believes that the acquisition may not be in the best interests of FTC, However, he knows that if he does riot acquire AUL, New Ages management is not going to be pleased! Kely exclaims to his divisional management team: ‘If only we could convince them to base our bonuses on something other than ROI, this acquisition would look more attractive. If only our bonuses were based on residual income, using the company’s weighted average cost of capital of 15 per cent!.
New Age has always evaluated the division on the basis of ROI, and the target ROI for each division is 20 per cent. The management team of any division that reports an annual increase in their ROI is given a bonus, but the managers of divisions where the ROI declines must provide a very convincing & explanation as to why they should get a bonus. Where ROI has declined, the bonus is limited to only 50 per cent of the bonus that is paid to the divisions that report an increase in ROI.
The following data relate to the most recent financial year:
1. Explain why FTC may be reluctant to acquire AUL. Provide calculations.
2. If New Age were to use residual income to measure divisional performance and evaluate managers, would FTC be more motivated to acquire AUL? Provide calculations.
3. Comment on the current bonus scheme and outline two other schemes that New Age could use to deliver bonuses to divisional managers.