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ACCA Strategic Professional · Advanced Financial Management · Strategic business and financial planning for multinational organisations

A multinational's subsidiary manager is assessed on return on investment (ROI). The division currently earns an ROI of 22% and the group cost of capital is 12%. A new project would earn 18% on its investment. What is the most likely outcome, and the best remedy?

The manager will probably reject the project because 18% dilutes the divisional ROI of 22%, even though it beats the 12% cost of capital and adds value. Measuring performance using residual income, which charges capital at the cost of capital, removes this dysfunctional incentive.

  1. AThe manager accepts the project; no remedy is needed
  2. BThe manager rejects the project because it lowers divisional ROI; residual income should be used to align decisions with shareholder wealthCorrect
  3. CThe manager rejects the project because its return is below the cost of capital; no remedy is needed
  4. DThe manager accepts the project; economic value added should be replaced by ROI

Explanation

At 18% the project exceeds the 12% cost of capital so it adds value, but it dilutes the divisional ROI of 22%, so the manager is likely to reject it. Residual income charges capital at the cost of capital, so any project returning more than 12% increases it, aligning the manager with shareholders. The third option is wrong because 18% exceeds 12%.

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