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If the performance of the investment centre is being appraised, head office assets, or investment centre assets controlled by head office should not be included in the calculation of ROI.
(sir why is this statement wrong? as we always only use controllable assets)Residual income is more flexible, since a different cost of capital can be applied to investments with different risk characteristics.
(isnt this statement wrong?)if no whyWillow CO
Two of the divisional managers in WILLOW CO disagree on the performance measures which should be used to determine their bonus for the year. Manager 1 is the manager of a large division, while manager 2 is manager of a small division . Manager 1 prefers to use residual income and has given the following examples of limitations of ROI to support this decision.
Which of the following is a valid reason for Willow Co choosing to use RI and not ROI?
1) if assets are valued at NBV, ROI figures generally improve as assets get older. This can encourage managers to retain outdated plant and machinery.2) ROI is a relative measure, therefore small investments with a high rate of return may appear preferable to larger investment with lower ROI. However the larger investment may be worth more in absolute terms
(Sir in this question i think 1 is more relevant to the requirement but in exam kit 2 is the correct answer. Can you please explain why?)
Thanks,First question:
If we are measuring the performance of the manager, then we only include assets that are controlled by the manager. However, if we are measuring the performance of the division, we include all assets of the division.
Second question:
The statement is correct. The notional interest rate applied to a division’s assets can be changed depending on the level of risk in the division.
Third question:
ROI will improve as assets get older, but so too will the RI improve – so it is not a reason for choosing one measure over the other measure.
Right sir
Also sir i have to ask you that while i was calculating shadow price of an equation, two different shadow prices were calculated from the same equation if add 1 extra unit to either one of the equation why is that so?
like if the equation at optimal point is 0.16x + 0.5y=5000 and x=1200, if i add extra unit to first equation shadow price is different and if i add extra unit to second equation shadow price differs.
will it not lead to false answer in the exam? as both answers differsOf course they would give different answers!!
We only ever calculate the shadow price for one constraint at a time. So if (for example) it is materials that are limited, then we add 1 to the material constraint. If on the other hand (for example) it is about that is limited, then we add one to the labour constraint.
I really do suggest that you watch my free lectures on linear programming 🙂
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