Residual Income and Return of Investment

MMandip11y ago

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

John MoffatTutor11y ago#1

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.

MMandip11y ago#2

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.

John MoffatTutor11y ago#3

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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