Why is residual income often preferred to ROI for assessing the performance of divisional managers?
Answer and explanation
Correct answer: D. It encourages acceptance of any investment that earns more than the cost of capital
- Step 1: ROI can lead managers to reject projects which earn less than their division's average but more than the cost of capital.
- Step 2: RI rewards any project earning above the cost of capital because it increases RI.
- Step 3: RI is an absolute figure, so it does not allow comparison between different sizes.
Answer
It encourages acceptance of any investment that earns more than the cost of capital.
Why not the others: RI uses a capital charge based on the cost of capital. This is a feature of ROI, not RI, which is an absolute amount. RI deducts a charge based on capital employed.
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