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Hello Tutor i hope you are doing well, i was going through one of ACCA’S technical article titled “Decentralisation and the need for Performance Measurement”.
In the article it has been mentioned
“Residual income also ties in with net present value, theoretically the best way to make investment decisions.The present value of a project’s residual income equals the project’s net present value.
In the long run, companies that maximise residual income will also maximise net present value and in turn shareholder wealth”.I’m a bit confused from the above statement, because during my time in F2. What i studied was that
ROI and RI are not the same as IRR and NPV. This is becausea) IRR and NPV work’s upon cash flow while ROI and RI focus upon Controllable (Traceable Profits).
b) The concept of IRR and NPV takes into consideration Time Value of Money, whereas ROI and RI just focuses upon profit generated in the current financial year only
Can you please help me out as to what Technical Article exactly mean to say.
Thankyou in Advance 🙂
To help you understand:
A feature of residual income valuation is that is does not matter how the accounting is done: the present value of a project’s RI will always be equal to its NPV.
In other words the NPV of a project is equal to the sum of its residuals incomes discounted by the required return on equity or cost of capital.
That is why it says ” The present value of a project’s residual income equals the project’s net present value ”
Hope it helps
Thankyou Tutor. I think i understood what you mean to say. As i have studied about N.P.V in detail during my graduation.
However, what i was thinking is that, NPV uses cash flow while RI used Accounting Profit. So won’t it might give slightly different figures.
For instance NPV ignores depreciation as it is non cash, while RI will consider depreciation as well and would then calculate the Residual Income. So i think it might give a slight different results/figures/ amount even if we are considering entire life of the project.
Sorry Tutor. You are right, i discounted the present value of Residual Income and what has been mentioned by the Article and you is true.
Though it’s a bit confusing for me, as I’m unable to understand how’s that happening.
The investment is 5m and the cashflow is 1.4 pa for 5 years at 10%
0.3M = -5+ (1.4*3.791)For RI
The profit is 0.4 pa (1st) step – as the cashflow is 1.4 – depreciation of 1m
Then you take away cost of capital * opening NBV
(2nd) step
So in yr 1 its 5 * 10% so its 0.5, in year 2 after depreciation its op nbv of 4 * 10% so its 0.4
in yr 3 its op nbv of 3 * 10% so its 0.3, in yr 4 its 2 *10% so 0.2 and in year 5 its 1 so 1 * 10% so its 0.1In year 1 the RI is therefore (0.1), year 2 its 0, year 3 its 0.1, in year 4 its 0.2
and in year 5 its 0.3M the same as NPVSo as long as your not myopic (short term) you will come to the same conclusion
Hope this helps!
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