A division has operating profit of £240,000 and capital employed of £1,200,000. The group's cost of capital is 15%. What are the division's return on investment (ROI) and residual income (RI)?
Answer and explanation
Correct answer: D. ROI 20% and RI £60,000
- Step 1: ROI = £240,000 ÷ £1,200,000 = 20%.
- Step 2: Capital charge = 15% × £1,200,000 = £180,000.
- Step 3: RI = £240,000 − £180,000 = £60,000.
Answer
ROI 20% and RI £60,000.
Why not the others: ROI 20% and RI £240,000: The RI deducts a capital charge of 15% × £1,200,000 = £180,000 from the profit. ROI 20% and RI £420,000: This adds the capital charge of £180,000 to profit instead of deducting it. ROI 15% and RI nil: This confuses the cost of capital with the division's return.
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