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Residual Income and Return of Investment

Forums › ACCA Forums › ACCA MA Management Accounting Forums › Residual Income and Return of Investment

  • This topic has 3 replies, 2 voices, and was last updated 10 years ago by John Moffat.
Viewing 4 posts - 1 through 4 (of 4 total)
  • Author
    Posts
  • October 18, 2014 at 1:54 pm #204842
    Mandip
    Member
    • Topics: 19
    • Replies: 15
    • ☆

    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

    October 18, 2014 at 7:44 pm #204874
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54699
    • ☆☆☆☆☆

    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.

    October 18, 2014 at 8:16 pm #204884
    Mandip
    Member
    • Topics: 19
    • Replies: 15
    • ☆

    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.

    October 19, 2014 at 9:23 am #204905
    John Moffat
    Keymaster
    • Topics: 57
    • Replies: 54699
    • ☆☆☆☆☆

    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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