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Is it true that residual income takes profit before interest and tax because we are measuring the performance of the divisions using RI which do not pay taxes rather it is the company that pays corporation tax so the interest and tax are irrelevant BUT sometimes profit before tax is used instead of profit before interest and tax in RI calculations? (why is that?)
Secondly, why do we take the notional/imputed interest on capital investment? What does it tell us and why interest is actually there?
Any costs that are controlled by the head office should not be included in either ROI or RI calculations because the manager cannot be penalized for the costs that are out of his control.
Thanks for your time.
Divisions of a company do not pay interest or pay tax – it is the company as a whole that has to pay interest on borrowing and has to pay tax.
The notional interest is there as a way of checking that the profits earned by the division are sufficient to cover the required return of the company.
And yes, it is only the profits that are controllable by the division that are used.
We compare the new investment whether it is attractive to the company as a whole we always take additional profit and additional capital investment to compare with target ROI. correct?
Please explain why do we take additional profit and additional capital investment?
And we compare the new investment whether it is attractive to the manager we always compare ROI without new investment with ROI with new investment. correct?
We take the addition profit and the addition investment in order to see if the return on the new investment is more or less than the target return.
Comparing the ROI with the new investment to the ROI without the new investment is the most likely requirement, but it depends what the exam question asks you to do.
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