ROI and RI (chapter 11)

Annuity depreciation has the result that the depreciation plus the notional charge for interest are constant. This gives a constant ROI (if earnings before depreciation are constant).With ordinary straight-line depreciation, the annual depreciation is constant but the notional interest is very high in year 1 because the capital employed is high (assets not much depreciated). ROI then rises each year because the notional interest falls. However, the low (or even negative) ROI in Year 1 can be a disincentive to taking on the new investment. ONly in later years will the investment be seen to be worthwhile. Not all managers will want to hurt their performance by undertaking an investment that looks poor in year 1. Annuity depreciation smooths things out. The answer to Example 4 is on P142.