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ACCA Strategic Professional · Advanced Performance Management · Financial performance measurement

Orion Foods uses residual income (RI) with a notional capital charge of 10% to assess divisions. Division Z has operating profit of $1.5m and capital employed of $12m. The division manager is considering a project requiring $4m that would earn $0.5m a year. The company's true risk-adjusted cost of capital for the project is 14%. What is Division Z's current RI, and what does the project analysis reveal as a limitation of RI with a single charge rate?

Current RI is $0.3m (1.5 less 10% of 12). The project adds $0.1m to RI at 10%, so it appears attractive, but at its true 14% cost of capital it loses $0.06m. A single charge rate ignores project risk and can drive wrong decisions.

  1. ARI of $0.3m; the project would reduce RI to $0.4m and so is rejected correctly
  2. BRI of $0.3m; the project adds $0.1m to RI at 10% and is accepted, although at the true 14% rate it would destroy value, so a single charge rate can misleadCorrect
  3. CRI of $1.5m; the project is irrelevant because RI ignores investment
  4. DRI of $0.3m; the project is rejected because it lowers RI by $0.1m

Explanation

Current RI = 1.5 − (12 × 10%) = 1.5 − 1.2 = $0.3m. The project adds 0.5 − (4 × 10%) = 0.5 − 0.4 = +$0.1m to RI, so the manager accepts. At 14% the charge is 0.56, giving 0.5 − 0.56 = −$0.06m, so the project destroys value. A single notional rate ignores differences in project risk.

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