A division has operating profit of £150,000 on capital employed of £1,000,000, and the group's cost of capital is 12%. It is offered a project needing £200,000 and earning £28,000 per year. Which statement is correct?
Answer and explanation
Correct answer: A. Divisional ROI would fall to 14.8% but residual income would rise by £4,000
- Step 1: Current ROI = £150,000 ÷ £1,000,000 = 15%. New ROI = £178,000 ÷ £1,200,000 = 14.8%, so ROI falls.
- Step 2: Project capital charge = 12% × £200,000 = £24,000; project profit £28,000.
- Step 3: RI changes by £28,000 − £24,000 = +£4,000, so a manager judged on ROI might reject a project that adds value.
Answer
Divisional ROI would fall to 14.8% but residual income would rise by £4,000.
Why not the others: ROI falls from 15% because the project earns 14%, and RI rises because the project earns more than 12%. Residual income rises, since the project's £28,000 exceeds the £24,000 capital charge. The extra profit of £28,000 exceeds the capital charge of £24,000, so RI rises.
Practise more Performance measurement.
Free questions with an explanation for every one, and full timed ACCA Applied Knowledge (BT, MA, FA) mock tests.
More Performance measurement questions
- 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…
- A division earns an ROI of 22% and the group requires 15%. A new project would earn 18% on its investment. Which statement is correct?
- Why is residual income often preferred to ROI for assessing the performance of divisional managers?
- Which of the four perspectives of the balanced scorecard is concerned with how well the organisation innovates and develops its people and s…
- In value for money (VFM) terms, which of the three Es refers to achieving the intended results and objectives?
- A hospital reduces the cost per patient by 10% but waiting times increase and patient satisfaction falls. Which of the three Es has it impro…