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ACCA Applied Knowledge · Management Accounting · Performance measurement - application

Division X of Brae Co has ROI of 20% and is considering a project costing $500,000 that would earn an annual profit of $90,000. The company's cost of capital is 14%. If managers are assessed on ROI, what is the likely decision, and would the project be acceptable to the company under residual income?

The manager would reject it, but it is acceptable under residual income. The project earns 18%, below the division's 20% ROI, so it would dilute ROI. However, it exceeds the 14% cost of capital and adds $20,000 of residual income, benefiting the company.

  1. AReject the project; accept under residual income, since the project return of 18% exceeds 14%Correct
  2. BAccept the project; accept under residual income, since 18% exceeds 14%
  3. CReject the project; reject under residual income, since 18% is below 20%
  4. DAccept the project; reject under residual income, since 18% exceeds 14%

Explanation

Project return = 90,000/500,000 = 18%. This is below the division's 20% ROI, so it would lower divisional ROI and be rejected by an ROI-assessed manager. Residual income rises by 90,000 - 14% x 500,000 = 20,000, so the project is acceptable to the company. This is the dysfunctional behaviour ROI can cause.

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