Question

The Management of a large company is debating an investment. Management projects the investment will earn $100,000 annually. In addition, the investment will require the company to purchase $600,000 in assets. Management’s decision is summarized in the following chart:

	Before Investment	After Investment
Operating income	600,000	700,000
Average operating assets	3,000,000	3,600,000

Required:

1. Assume Management is evaluated based on growth in the company’s ROI. Compute the Return on Investment for the company before and after the investment. Would you recommend management make the investment?

2. Assume Management is evaluated based on growth in the company’s residual income. The company’s required rate of return is 15%. Compute the company’s residual income before and after the investment. Would you recommend Gentry make the investment?

3. Give at least one advantage and one disadvantage of using measures like ROI and residual income to evaluate company performance.

Answer 1

1. ROI is Retrun on Investment, which means, say for a particular project, the return generated over the assets invested. If project needs an invesment of 100,000 and gives the return of 10,000 the ROI is 10%.

It is pretty much clear that the project with the higher ROI shall be chosen as that will be the one giving the higher returns. In the given question, we need to compute the ROI generated before and after the extra investment. We simply need to divide the operating income by the average assets invested and choose that option which gives the highter ROI. Please see below;

After making an investment of 600,000 the ROI comes down from 20% to 19.44% which means that the project is not viable hence company should not make extra investment of 600,000.

2. On the basis of Residual Income - Residual income is that portion of the income which is over and above the Required income of the company. In the given case the required rate is 15% and if the new option gives the company more extra income over and above the 15% of required return then it should be selected and company should go ahead with ithe investment of 600,000. Plesae see the calculation below for the decision:

***15% is applied on Average assets.

hence the residual income comes more after the company makes the investment of 600,000 thus the new investment is worthy and should be made.

3. Residual Income -

Advantage - It encourages managers to accept any projects which is giving the return above the minimum required return.

Disadvantage - As we can see in the calculation in 2, it is only considering the return over and above the required return and that too the absolute figure only. i.e. we are directly comparing the 150,000 and 160,000 ignoring the base i.e. amount of investment made. hence this method ignores the base amount of investment made which is not good.

ROI method -

Advantage - it encourages managers to make new investment if they make an increase in the ROI. Making a new investment may increase the return but reduce the ROI as in the above case, then it shall be selcted basis on ROI i.e. percentage return.

disadvantage - It is based on the profit and asset invested which are subject to manipulation.