Hi John sir, guide me about the following:
Q#1. Why Residual income is not more easily understandable by divisional managers than ROCE?
Q#2. How Residual income is directly related to NPV?
Q#3. How Residual income ensures that manager will select projects with positive NPV?
Q1 Most managers accountants and therefore are less likely to know what is mean by cost of capital. They are likely to be familiar with the idea of ROCE (and ROI is effectively the same. It is called ROI (not ROCE) when looking at divisions, because divisions do not have capital as such).
Q2 Because it uses the cost of capital
Q3 Because it checks that the return is more than the cost of capital.
(although still not 100% true because it looks at profits rather than cash flows)
Thanks John sir.
You are welcome 🙂
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