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ACCA Strategic Professional · Advanced Performance Management · Financial performance measurement

Orion Co has a division with sales of $20m, operating profit of $3.0m and average capital employed of $10m. Its cost of capital is 12%. Management proposes a $4m investment earning $0.6m annual profit. Which statement about the proposal is correct?

ROI falls from 30% to about 25.7%, but residual income rises by $0.12m. The project earns 15%, above the 12% cost of capital, so it adds $0.6m profit less a $0.48m capital charge, although it dilutes the divisional average return.

  1. ADivisional ROI falls from 30% to about 25.7%, yet residual income rises by $0.12mCorrect
  2. BDivisional ROI rises, and residual income falls by $0.12m
  3. CDivisional ROI falls to 25.7% and residual income falls by $0.12m
  4. DDivisional ROI is unchanged and residual income rises by $0.6m

Explanation

Current ROI = 3.0/10 = 30%. New ROI = 3.6/14 = 25.7%. Project return is 0.6/4 = 15%, above the 12% cost of capital. The capital charge is 12% x 4m = $0.48m, so residual income rises by 0.6 - 0.48 = $0.12m. Hence ROI falls while RI rises.

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