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An investment centre earns a return on investment of 18% and a residual income of $300,000. 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 centre’s return on investment
and residual income?
Return on investment Residual income
A Increase Decrease
B Increase Increase
C Decrease Decrease
D Decrease IncreaseI can understand the ROI part, I’m assuming that the ROCE of the project is the new ROI, and we compare the two to find the better option. Although please just confirm if mu assumption is accurate.
The residual income part, I cannot understand how will it increase. If I use any amount as an example and find the RI, i still dont get how will it get “increased”. How can we compare the RI before and after the project. Please help me.
With the new project there will be an increase in the profit of 17% of the extra investment.
When calculating the RI, the notional interest will increase by 15% of the extra investment.
Given that the extra profit is therefore higher than the extra interest, the residual income must be higher than without the new investment.
Have you watched my free lectures on this?
But the ROI before the new investment (18%) is greater than the ROI of the new investment (17%). Doesnt that mean the profit is decreased, resulting in decrease in Residual Income too?
I am calculating the residual income before new investment as = ROI (18%) giving the profit and from this subtract the 15% of notional interest.
And after new investment as = ROCE (17%) providing a profit and from this profit subtracting (15%) of notional interest.And according to this, The residual income before interest should be greater right? so it is getting decreased not increased.
Please help me understand this part Sir 🙂Just because the ROI of the new investment is lower than the current ROI certainly does not mean that the total profit will be lower!! Any profit at all from the new investment will mean that the overall profit will increase.
Provided that the total profit increases by more than the extra interest, then the RI will increase.
Please read my previous reply again (and please do watch my lectures on this).
OH okay I got what you were trying to say, you’re a lifesaver! thank you so much Sir for your help! 😀
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