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Dear Sir,
Appreciate if you could help me understand the answer for the following question.
37. An investment division earns a return on investment of 15% and a residual income of $200,000. The cost of capital is 18%. A new project gives a return on capital employed of 16%.
If the new project is accepted, what will happen to the investment division’s return on investment and residual income?
Best Regards,
ShafiqThe company is current earning an ROI of 15%. If they take on a new project giving a return of 16%, then the overall ROI must increase (because 16% is more than 15%).
With regard to the RI, let me make up a few figures to try and make it clear.
Just suppose that the new investment meant spending 10,000. Since it gives a return of 16%, this would mean extra profit of 1,600 a year.
However, there would be extra notional interest of 18% (cost of capital) of 1,800.So…the total RI would fall by 200 (1,600 – 1,800).
I invented the amount of the investment, but however much we are investing the RI must fall because the return of 16% is less than the cost of capital of 18%.
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