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CMA Final · Strategic Performance Management and Business Valuation · Performance Measurement, Evaluation and Improvement Tools

Case: Tara Auto Ltd's division earns an operating profit of ₹36 lakh on capital employed of ₹200 lakh. A new project needs ₹50 lakh and will earn ₹7.5 lakh. The company's cost of capital is 13%. The divisional manager is rewarded on ROCE (operating profit / capital employed). Which statement is correct?

Accepting the project lowers divisional ROCE from 18% to 17.4%, yet the project earns 15% against a 13% cost of capital, adding ₹1 lakh of residual income. So ROCE-based rewards may make the manager reject a project that adds value.

  1. AAccepting the project lowers ROCE to 17.4% and adds residual income, so ROCE-based rewards may cause the manager to reject a value-adding projectCorrect
  2. BAccepting the project raises ROCE and lowers residual income
  3. CAccepting the project lowers both ROCE and residual income, so rejection is right
  4. DAccepting the project leaves ROCE unchanged at 18% and adds residual income of ₹1 lakh

Explanation

Current ROCE = 36/200 = 18%. With the project: 43.5/250 = 17.4%, so ROCE falls. Project return = 7.5/50 = 15%, above 13%, so residual income rises by 7.5 − 6.5 = ₹1 lakh. Thus ROCE discourages a value-adding project, which is a goal-congruence problem.

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