Q17.4 (BPP Learning Media)

Question:

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?

Correct Answer :

Return on investment – Decrease
Residual Income – Increase

I fail to see why Residual Income increases.

Residual Income = Profit – Imputed Interest
Imputed Interest = Capital Employed × Cost of Capital
ROI = Profit/Capital Employed

Given Cost of Capital is the same in the new project (15%), and assuming Capital Employed is the same in the new project, Imputed Interest remains equal.

Given ROI decreases in the new project (from 18% to 17%), and assuming Capital Employed is the same in the new project, Profit decreases.

Therefore, we are subtracting the same Imputed Interest figure from a decreased Profit figure. Therefore, Residual Income decreases.

Thanks in advance!