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ACCA Applied Knowledge · Management Accounting · Monitoring performance and reporting

Division X has operating profit of $330,000 and capital employed of $2,200,000. The cost of capital is 13%. Management is considering a project requiring $400,000 of extra capital that will earn $56,000 a year. Which statement is correct?

The manager would reject it on ROI but it adds residual income. Division ROI is 15% and the project earns 14%, which dilutes ROI. However it earns $56,000 against a capital charge of $52,000, so residual income rises by $4,000.

  1. AThe manager would reject it using ROI but it adds residual incomeCorrect
  2. BThe manager would accept it using ROI and it adds residual income
  3. CThe manager would accept it using ROI but it reduces residual income
  4. DThe manager would reject it using ROI and it reduces residual income

Explanation

Current ROI = 330/2,200 = 15%. Project return = 56/400 = 14%, below 15%, so ROI falls and the manager would reject it. Capital charge on project = 13% x 400,000 = 52,000; RI change = 56,000 - 52,000 = +4,000, so RI rises and the project should be accepted for the company.

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