[timmyj]

Question # 2538 | Blueprint Area: 5 D i : Budgeting and Analysis

An investment center has the following information (in thousands):

Revenue Liabilities Fixed Assets Equity
$25,000 $3,000 $7,000 $5,500
The Cost of Capital determined by the organization is 12%. If management required a residual income target of $1,500,000, what would the cost need to be in order to reach the target?

A. $8,400,000
B. $23,000,000
C. $22,840,000
D. $22,660,000
The correct answer is (D).

Residual income is calculated by deducting the cost of capital from net income, where the cost of capital is the required return on invested capital.

The required return on invested capital should be the percentage of the cost of capital applied to total assets, i.e., $7,000,000 x 12% = $840,000.

Residual income is the result of the investment’s operating income less the cost of capital. In this case, the cost of capital is $840,000, when that is added to the $1,500,000 of residual income target, you get $2,340,000 in operating income.

If the investment’s center revenue is $25,000,000, then the corresponding cost is $22,660,000 ($25,000,000 – $2,340,000).

——-

This question appears to be wrong. It is using fixed assets as invested capital instead of total assets (liabilities + equity). The answer explanation even address total assets, but then uses fixed asset for the calculation.