Question

ABC inc. has 3 divisions which produced the following results last year:

Division A: Historical Cost of Investment = $750k / Operating Income $92250
Division B: Historical Cost of Investment = $720k / Operating Income $90k
Division C: Historical Cost of Investment = $200k / Operating income $26k

a) caclulate each divisions ROI and RI, assume 10% cost of capital
b) Assume that the carrying amonut of the investments is half the historical cost, calculate each divisions ROI and RI, assuming a 10% cost of capital, using the carrying amount.
c) Which measure, ROI or RI, is a better indicator of the performance of each division?

Please show work.

Answer 1

a. ROI = Operating Income / Carrying Amount * 100

RI = Operating Income - ( Carrying Amount x Cost of Capital)

	Division A	Division B	Division C
ROI	12.3%	12.5%	13 %
RI	$ 17,250	$ 18,000	$ 6,000

b. Using the carrying amount as half of the historical cost of the operating assets:

	Division A	Division B	Division C
ROI	24.6 %	25%	26%
RI	$ 54,750	$ 54,000	$ 16,000

c. Residual income, being expressed in absolute values is a better performance indicator, as it tells you by how much shareholder wealth increases or decreases in absolute dollar terms. ROI on the other hand is a percentage measure.

Also, if ROI is used as a performance indicator, divisional managers may not be too open to new investments, if that would result in a decrease in ROI. On the other hand, if RI is used as a performance indicator, in spite of a fresh investment, there could be increase in RI for the division. So the manager may not be averse to new investments.