![]() Let’s take another look at the division that rejected an investment yielding an ROI higher than the company’s minimum required rate of return of 10 percent but lower than the division’s current ROI of 20 percent. Stern School of Business at New York University ( ). Note that several sources provide cost of capital information by industry. We will always provide the percent cost of capital in this chapter, leaving detailed discussions of its calculation to more advanced courses. For example, a company that raises funds by issuing bonds would use the interest rate associated with the bonds in establishing its percent cost of capital. The one new item, percent cost of capital, is the company’s percentage cost to obtain investment funds (often called capital). Notice that operating income and average operating assets used here to calculate RI are the same measures used in the ROI calculation presented earlier. The manager’s goal is to increase RI from one period to the next. As long as an investment yields operating profit higher than the division’s cost of acquiring capital, managers evaluated with RI have an incentive to accept the investment. Rather than using a ratio to evaluate performance, RI uses a dollar amount. An alternative measure to ROI, called residual income (RI), helps to mitigate this apparent conflict. In fact, the division manager has an incentive to shed all investments yielding less than 20 percent, even if the investments are producing a return above the company’s minimum requirement of 10 percent. If evaluated solely based on ROI, the division manager would prefer to invest only in projects that increase the division’s ROI above 20 percent. Although this investment is well above the company’s minimum required rate of return, the division manager will likely not make the investment since the division’s overall ROI will decline from 20 percent to 17.9 percent: The company’s minimum required rate of return is 10 percent, and the division manager is presented with an investment opportunity expected to yield an ROI of 15 percent. For example, assume the manager of a division is evaluated based on ROI, and the division currently has an ROI of 20 percent: Division managers have an incentive to turn down investments that exceed the company’s minimum required rate of return but are below the division’s current ROI, mainly because ROI trends are often used to evaluate managers. Some managers dislike ROI because it can lead to decisions that benefit the division but hurt the organization as a whole. ![]() Why do some division managers prefer not to use ROI as a performance measure? Answer Question: Although ROI is commonly used as a divisional performance measure, some division managers dislike this measure. Calculate and interpret residual income (RI) to evaluate performance.
0 Comments
Leave a Reply. |