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ACCA Strategic Professional · Advanced Performance Management · Financial performance measurement

Kestrel Components plc evaluates its divisional managers solely on annual return on investment (ROI). The Fabrication division currently earns an ROI of 22%, while the company's cost of capital is 12%. A new project would earn 16% on the investment required. Which limitation of ROI is most clearly shown if the divisional manager rejects the project?

ROI can cause dysfunctional decisions. A manager measured on a 22% ROI may reject a 16% project even though it beats the 12% cost of capital and would create value, because accepting it would lower the divisional ROI. This is a goal congruence failure.

  1. AROI ignores the time value of money in all cases, so projects cannot be compared
  2. BROI can encourage dysfunctional behaviour by leading managers to reject projects that earn above the cost of capital but below the current divisional ROICorrect
  3. CROI is based on cash flows, which are easily manipulated by managers
  4. DROI cannot be calculated for divisions with positive profits

Explanation

The project return of 16% exceeds the 12% cost of capital, so it would add value to the company. It would however dilute the division's 22% ROI, so a manager judged on ROI may reject it. This is a goal congruence problem. ROI is based on accounting profit, not cash flows, so option C is wrong.

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