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An investment center earns a return on investment of 18% and a residual income of $300000. The cost of capital is 15%. A new project offers a return on capital employed of 17%.
If the new project were adopted, what would happen to the investment center’s return on investment and residual income?Return on investment Residual Income
A. Increase Decrease
B. Increase Increase
C. Decrease Decrease
D. Decrease IncreaseAnswer is D.
I get that the R.O.I will decrease straight away but to my understanding the residual income should decrease too…It is written in the answer that, “Since the project offers a return higher than the cost of capital it will increase the investment center’s residual income!” but how can it get the R.I more than $300000 that we already have? I even went on calculating the residual income if the return on investment decreases by 1% making an imaginary sum where the R.O.I decreases by 1% after calculation and those figures give less R.I too! So…please, explain briefly if possible and show me where I am getting it all wrong… thank you!!
The residual income is the profit less the notional interest.
The return on the new project (and therefore the profit on the new project) is 17% of the amount invested in the project. The notional interest is 15% of the amount invested in the new project.
Since 17% is more than 15%, the residual income must increase because the extra profit is more than the extra interest.I do suggest that you watch our free lectures on this where similar examples are considered.
(Our free lectures are a complete course for Paper F2 and cover everything needed to pass the exam well)
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