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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 how the return on investment is decreasing since its pretty straight forward as the return on capital employed decreses so should the return on investment.
But can you please explain a bit how the residual income increases. It says that since the return on capital is higher than the cost of capital so the residual income will increase.The way i was calculating it is that residual income is equal to operating profit less the notional intrest on the capital employed. So as per question the way i understand it is that since the return on investment is now less then before so shouldnt the operating profit be less now?? Please if you could clear that.
ThanksImagine the investment is $100,000 (use any figure you want).
The profit will be 17% x 100,000 = 17,000
The interest will be 15% x 100,000 = 15,000
So the extra residual income is 2,000. (it is positive, so it is extra, so the existing RI will increase.)
It is only the new project that earns 17%. It won’t affect the return that existing projects are getting of 18%.
Great. That sure clears the concept. I was actually thinking in sense of comparing the two as if, by taking the new project the old will be abandoned. Thanks again
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