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CMA Intermediate · Management Accounting · Responsibility Accounting

Division P of Himalaya Ltd has capital employed of Rs. 500 lakh and earns operating profit of Rs. 100 lakh, with a cost of capital of 14%. It can accept a new project needing Rs. 100 lakh, expected to yield Rs. 17 lakh a year. Which statement is correct?

An ROI-judged manager rejects the project but a residual income-judged manager accepts it. The project's 17% return is below the current 20% ROI, which would dilute it to 19.5%, but it exceeds the 14% cost of capital and adds Rs. 3 lakh of residual income.

  1. AUnder ROI the manager will reject it, but under residual income the manager will accept itCorrect
  2. BUnder ROI the manager will accept it, but under residual income the manager will reject it
  3. CBoth ROI and residual income lead the manager to accept it
  4. DBoth ROI and residual income lead the manager to reject it

Explanation

Current ROI = 100/500 = 20%. The project yields 17/100 = 17%, which is below 20%, so the divisional ROI falls (117/600 = 19.5%) and an ROI-judged manager rejects it. Residual income change = 17 - 14% x 100 = +3 lakh, so a residual income-judged manager accepts it. The project is above the 14% cost of capital, so it is desirable for the company.

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