4/16/2023 0 Comments Residual income formulaThe one new item, percent cost of capital The company’s percentage cost to obtain investment funds., is the company’s percentage cost to obtain investment funds (often called capital). Notice that operating income and average operating assets used here to calculate RI are the same measures used in the ROI calculation presented earlier. The manager’s goal is to increase RI from one period to the next. As long as an investment yields operating profit higher than the division’s cost of acquiring capital, managers evaluated with RI have an incentive to accept the investment. Rather than using a ratio to evaluate performance, RI uses a dollar amount. Key Equation Residual income = Operating income − ( Percent cost of capital × Average operating assets ) An alternative measure to ROI, called residual income (RI), helps to mitigate this apparent conflict. In fact, the division manager has an incentive to shed all investments yielding less than 20 percent, even if the investments are producing a return above the company’s minimum requirement of 10 percent. If evaluated solely based on ROI, the division manager would prefer to invest only in projects that increase the division’s ROI above 20 percent. Although this investment is well above the company’s minimum required rate of return, the division manager will likely not make the investment since the division’s overall ROI will decline from 20 percent to 17.9 percent: ROI a f t e r new investment = $20,000 + $10,500 $100,000 + $70,000 = $30,500 $170,000 = 17.9% The company’s minimum required rate of return is 10 percent, and the division manager is presented with an investment opportunity expected to yield an ROI of 15 percent. For example, assume the manager of a division is evaluated based on ROI, and the division currently has an ROI of 20 percent: ROI before new investment = Operating income Average operating assets = $20,000 $100,000 = 20% Division managers have an incentive to turn down investments that exceed the company’s minimum required rate of return but are below the division’s current ROI, mainly because ROI trends are often used to evaluate managers. Why do some division managers prefer not to use ROI as a performance measure?Īnswer: Some managers dislike ROI because it can lead to decisions that benefit the division but hurt the organization as a whole. Question: Although ROI is commonly used as a divisional performance measure, some division managers dislike this measure.
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