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CMA Intermediate · Management Accounting · Divisional Performance Measurement

Tara Industries' division currently earns ROI of 25% on capital employed of ₹40,00,000. The company's cost of capital is 15%. A new project requires an investment of ₹10,00,000 and yields annual profit of ₹1,80,000. Which statement is correct?

The manager will reject it under ROI but it adds value. The project yields 18 percent, lowering divisional ROI from 25 percent to 23.6 percent, yet it exceeds the 15 percent cost of capital and gives positive residual income of ₹30,000.

  1. AThe manager will accept it under ROI, and it adds value to the company
  2. BThe manager will reject it under ROI, though it adds value to the companyCorrect
  3. CThe manager will reject it under ROI, and it destroys value for the company
  4. DThe manager will accept it under ROI, though it destroys value

Explanation

Project ROI = 1,80,000/10,00,000 = 18%, below the division's 25%, so the new project would lower divisional ROI: new ROI = (10,00,000+1,80,000)/50,00,000 = 23.6%. Yet 18% exceeds the 15% cost of capital (RI = 1,80,000 − 1,50,000 = ₹30,000 positive), so it adds value. This is the goal-congruence problem of ROI.

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