Return on investment and Residual Income

It is well known that there are numerous acceptable methods to calculate ROI for a company. The formula should be ROI = controllable profit / capital employed As you've found out - there are many ways to obtain a suitable capital employed figure depending on preference. Capital Employed may be obtained through calculation of Debt + Equity or through Total assets less current liabilities. It is also acceptable to use average assets ( Non current assets + current assets / 2) as the CE figure in ROI, In addition to this some calculations will use opening book values of non-current assets (so before depreciation) but more frequently seen is the capital employed figure being based on Net book values so depreciation is deducted from asset values. Because this variation in formula is well known - CIMA questions should either specify which version of the formula they wish you to use - e.g. 'using NBV, calculate ROI' or The information in the scenario will be limited so only one of the above methods will be possible. Eg if there is no means to calculate depreciation then assume that the ROI version will not require this adjustment to find the answer. Alternatively , there are many other ways for CIMA to test your knowledge of divisional performance and ROI - e.g. advantages, uses, its relationship with profit margin and asset turnover ratios. Residual income has the same problem - in this case the question should make it clear which capital employed figure to use. However, in the absence of any guidance it is perfectly acceptable to use net assets or total assets depending which is given in the scenario. Hope this helps....

Thankyou so much for the clarification.

You're welcome

I had the same issue/ confusion too. Great detailed explanation Cath

Thank you Abz12- great to have your feedback. Kindest Regards, Cath

Hello John, Could you possibly shed some light on this please? A division is considering investing in capital equipment costing $2·7m. The useful life is 50 years, with no resale value. The forecast return on the initial investment is 15% per annum before depreciation. The division’s cost of capital is 7% Answer : Divisional profit before depreciation = $2·7m x 15% = $405,000 per annum. (Less) depreciation = $2·7m x 1/50 = $54,000 per annum. Divisional profit after depreciation = $351,000 Imputed interest = $2·7m x 7% = $189,000 Residual income = $162,000. I don't quite understand as to why the depreciation of $54,000 is only deducted to arrive the net profit but not Imputed interest? I thought it should be ($2.7 - $54,000) x 7% = $185,220 ? Also if this was to calculate ROI, do we need to deduct depreciation to arrive the net capital employed? Many thanks in advance

Hi Navinda, It's Cath here, hopefully I can help you further. They have provided the profit figure in an unusual way here ( a bit like you sometimes see for ARR and payback and target costing also) First you find the gross annual profit ( ie $405,000) then we take off depreciation so we have net annual profit. ($351,000) So now we have a figure approximately equal to annual net profits. The imputed interest bit of the calculation for residual income needs to be: (notional interest * capital employed) Which is why we use the full 2.7m figure without depreciation its because this represents capital employed. It was also the basis of the calculation of net profit which is admittedly a bit confusing. In full the residual income calculation will look like: Residual Income = Net annual profit - ( imputed * capital employed) RI = 351,000 - (7% * 2.7m) RI = 162, 000 Hope that helps.

Thank you ever so much Cath for taking time explaining it. Sorry but I am just so confused because on the BPP revision kits says that "Residual income is calculated after deducting both depreciation on non-current assets and notional interest on the division's capital employed." From the above am I wrong in thinking that the capital employed of $2.7 m then needs to be deducted by depreciation to arrive the net capital employed? Many thanks for your time. Navinda

Hi Navinda, Its because its based on initial investment that we don't deduct the depreciation from capital employed. The same question is discussed in this forum - this explains it very well (please paste the link in below). https://opentuition.com/topic/residual-income-16/ Hope that's ok? Many Thanks Cath