Under the present bonus system how would the acquisition of GGI affect Peach’s bonus expectations?


Question Description:

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(Performance and compensation) Family Fun Vehicle Co.(FFV), a subsidiary of Drummondville Automotive, manufactures go-carts and other recreational vehicles. Family recreational centers that feature go-cart tracks, miniature golf, batting cages, paint ball wars, and arcade games have increased in popularity. As a result, FFV has been receiving some pressure from Drummondville Automotive top management to diversify into some of these other recreational areas. Great Games Inc.(GGI), one of the largest firms that leases arcade games to family recreation centers, is looking for a friendly buyer. Drummondville Automotive management believes that GGI’s assets could be acquired for an investment of $6.4 million and has strongly urged Sam Peach, division manager of FFV, to consider acquiring GGI. Peach has reviewed GGI’s financial statements with his controller, Molly Howe, and they believe that the acquisition may not be in FFV’s best interests. “If we decide not to do this, the Drummondville Automotive people are not going to be happy,” said Peach. “If we could convince them to base our bonuses on something other than return on investment, maybe this acquisition would look more attractive. How would we do if the bonuses were based on residual income using the company’s 15 percent cost of capital?” Drummondville Automotive has traditionally evaluated all of its divisions on the basis of return on investment, which is defined as the ratio of operating income to total assets; the desired rate of return for each division is 20 percent. The management team of any division reporting an annual increase in the return on investment is automatically eligible for a bonus. The management of divisions reporting a decline in the return on investment must provide convincing explanations for the decline to be eligible for a bonus, and this bonus is limited to 50 percent of the bonus paid to divisions reporting an increase. Presented below are condensed financial statements for both FFV and GGI for the fiscal year ended May 31, 2010. FFV GGI Sales revenue $ 21,000,000 Leasing revenue $ 5,600,000 Variable expenses (14,000,000) (2,000,000) Fixed expenses (3,000,000) (2,400,000) Operating income $ 4,000,000 $ 1,200,000 Current assets $ 4,600,000 $ 3,800,000 Long-term assets 11,400,000 2,600,000 Total assets $ 16,000,000 $ 6,400,000 FFV GGI Current liabilities $ 2,800,000 $ 1,900,000 Long-term liabilities 7,600,000 2,600,000 Shareholders’ equity 5,600,000 1,900,000 Total liabilities and shareholders’ equity $ 16,000,000 $ 6,400,000 a. Under the present bonus system how would the acquisition of GGI affect Peach’s bonus expectations? b. If Peach’s suggestion to use residual income as the evaluation criterion is accepted, how would acquisition of GGI affect Peach’s bonus expectations? c. Given the present bonus arrangement, is it fair for Drummondville Automotive management to expect Peach to acquire GGI? d. Is the present bonus system consistent with Drummondville Automotive’s goal of expansion of FFV into new recreational products?

Answer

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