Question

No hand writing and pictures please.

1. Illustrate the concept of ROI with suitable numerical example. How ROI is different from Residual Income? Explain in your own words.

Answer 1

Return on Investment (ROI):

Every person or an organization makes an investment with an idea to make some kind of return on such investment made. For E.g: A person makes a purchase of Land worth of $ 600,000 with a hope that the value of the Land increases in future, so that he can sell at a higher price than he purchased and make a gain.

The money earned on such investment is known as ‘Return’. Return on investment is a financial ratio, which expresses such return earned as a percentage of the investment made.

Consider the above example, the land is purchased at $ 600,000. After 3 years, he sold the land for an amount of $ 850,000. Here, the person made a gain of $ 250,000 (i.e., $ 850,000 - $ 600,000). Therefore, the return on the investment made is $ 250,000 in money value. The same can be expressed as a percentage on investment made by using the below mentioned formula.

Return on Investment (ROI) = [Return (i.e., Cost of Sale – Cost of Investment) / Cost of Investment] multiplied by 100.

ROI in the above example = $ 250,000 / $ 600,000 * 100

                                      = 41.667%

Therefore, the person has earned a ROI of 41.67 % (approx.) though the purchase and sale of Land.

Residual Income:

Residual Income is defined as the income earned in excess of the minimum required level of return on investment. That is, in simpler words, the residue income left after meeting the minimum level of return of investment.

For E.g: A company earned an amount of $ 100,000 of net income for the current accounting year. It has a cost of capital of 10% on capital of $ 500,000. That means, at least 10% of $ 500,000 must be earned to survive in the business, which equals to the $ 50,000. The company has earned a total income of $100,000 and out of which $ 50,000 is the min. amount of return it must be earned. Therefore, the balance of $ 50,000 is the residual income.

Difference: The ROI measures the total return on the investment and whereas residual income refers only to the net income earned after meeting the minimum required return (i.e., the residue left).

ROI is expressed in percentage. Residual Income can be expressed in both in monetary terms and in percentage.