Under the current situation ROI exceeds the cost of capital and residual income is positive. The division is performing well.
In simple terms Proposal 1 is acceptable to the company. It offers a rate of return of 15% ($0.15m/$1m) which is greater than the cost of capital. However, divisional ROI falls and this could lead to the divisional manager rejecting Proposal 1. This would be a dysfunctional decision. Residual income increases if Proposal 1 is adopted and this performance measure should lead to goal congruent decisions.
In simple terms Proposal 2 is not acceptable to the company. The existing assets have a rate of return on 13% ($0.3m/$2.3m) which is greater than the cost of capital and hence should not be disposed of. However, divisional ROI rises and this could lead to the divisional manager accepting Proposal 2. This would be a dysfunctional decision. Residual income decreases if Proposal 2 is adopted and once again this performance measure should lead to goal congruent decisions.
Relative merits of ROI and residual income
Return on investment is a relative measure and hence suffers accordingly. For example, assume you could borrow unlimited amounts of money from the bank at a cost of 10% per annum. Would you rather borrow £100 and invest it at a 25% rate of return or borrow $1m and invest it at a rate of return of 15%?
Although the smaller investment has the higher percentage rate of return, it would only give you an absolute net return (residual income) of $15 per annum after borrowing costs. The bigger investment would give a net return of $50,000. Residual income, being an absolute measure, would lead you to select the project that maximises your wealth.
Residual income also ties in with net present value, theoretically the best way to make investment decisions. The present value of a project's residual income equals the project's net present value. In the long run, companies that maximise residual income will also maximise net present value and in turn shareholder wealth. Residual income does, however, experience problems in comparing managerial performance in divisions of different sizes. The manager of the larger division will generally show a higher residual income because of the size of the division rather than superior managerial performance.
In addition because RI uses the cost of capital to calculate an imputed interest this cost of capital can be adjusted to recognise the risk in different projects.
Problems common to both ROI and residual income
The following problems are common to both measures:
- Identifying controllable (traceable) profits and investment can be difficult.
- If used in a short-term way they can both overemphasise short-term performance at the expense of long-term performance. Investment projects with positive net present value can show poor ROI and residual income figures in early years leading to rejection of projects by managers (see Example 2).
- If assets are valued at net book value, ROI and residual income figures generally improve as assets get older. This can encourage managers to retain outdated plant and machinery (see Example 2).
- Both techniques attempt to measure divisional performance in a single figure. Given the complex nature of modern businesses, multi-faceted measures of performance are necessary.
- Both measures require an estimate of the cost of capital, a figure which can be difficult to calculate.
PQR plc is considering opening a new division to manage a new investment project. Forecast cash flows of the new project are as follows: