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Hi, I need some help with the below question which was in the June 2012 exam paper.
“An investment centre earns a ROI of 18% and a residual income (RI) of £300,000. The cost of capital is 15%. A new project offers a return on capital employed 17%.
If the new project were adopted, what would happen to the investment centre’s return on investment and RI?
Return on Investment: Increase or Decrease?
Residual Income: Increase or Decrease?”The answer is ROI Decreases and RI increases but i am having trouble understanding how.
It is my knowledge that Return of Capital Employed is the same as Return of Investment so 17%-18% = -1% so ROI decreases.
But having great difficulty understanding how RI increases.
Thanks
The residual income is the profit less the (cost of capital x the amount invested).
If the project is earning 17% on the investment, and the cost of capital is only 15%, then the profit will be higher than the notional interest charge and therefore the residual income will increase.
Sorry John for posting on the other “Ask Tutor Section”. It is my first time posting but that is no excuse.
I am also sorry but i still do not understand. I understand the investment is earning 2% more than the cost of capital so it will make a profit. But how can you say it will earn more of a profit than the original ROI of 18%. Cost of capital remains the same at 15% and i’m assuming the amount invested will be the same.
I have tried with numbers and i get RI to decrease not increase.
Suppose the cost of the investment is 100,000.
ROI is profit/investment, so profit is 17,000.
Residual income is profit less (cost of capital x investment).
Cost of capital x investment is 15% x 100,000 = 15,000
So RI from the investment is 17,000 – 15,000, which is positive. RI will increase.
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