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ACCA Applied Skills · Performance Management · Divisional performance and transfer pricing

Division Alpha has capital employed of $800,000 and annual controllable profit of $140,000. The group cost of capital is 15%. A new project requires $200,000 of extra capital and will earn annual profit of $34,000. Assuming the project is the only change, which statement is correct?

The project earns 17%, below the division's current 17.5% ROI, so a manager judged on ROI would reject it. But 17% exceeds the 15% cost of capital, giving positive residual income of $4,000, so it adds value and would be accepted under residual income.

  1. AThe manager would accept the project under ROI but it would reduce residual income
  2. BThe manager would reject the project under ROI but it would increase residual incomeCorrect
  3. CThe manager would accept the project under both ROI and residual income
  4. DThe manager would reject the project under both ROI and residual income

Explanation

Current ROI = 140/800 = 17.5%. Project ROI = 34/200 = 17%. New ROI = 174/1,000 = 17.4%, which is lower, so the manager rejects under ROI. Project RI = 34 - (15% x 200 = 30) = +$4,000, so RI increases and the project is worthwhile for the group. Option A has the effects the wrong way round.

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