ExpertMedium2 marksMultiple Choice
ACCA · Question 30 · Syllabus F: Performance measurement
The manager of a renewable energy division is evaluated based on Return on Investment (ROI). The division's current ROI is 18%. The company's cost of capital is 12%.
The manager is considering a new wind farm project that will yield an ROI of 15%.
How will the manager react if evaluated on ROI, and how would they react if evaluated on Residual Income (RI)?
The manager of a renewable energy division is evaluated based on Return on Investment (ROI). The division's current ROI is 18%. The company's cost of capital is 12%.
The manager is considering a new wind farm project that will yield an ROI of 15%.
How will the manager react if evaluated on ROI, and how would they react if evaluated on Residual Income (RI)?
Answer options:
A.
Accept under ROI; Accept under RI.
B.
Reject under ROI; Reject under RI.
C.
Reject under ROI; Accept under RI.
D.
Accept under ROI; Reject under RI.
How to approach this question
Compare the project ROI (15%) to the current ROI (18%). If lower, ROI managers reject. Compare project ROI (15%) to Cost of Capital (12%). If higher, RI managers accept.
Full Answer
C.Reject under ROI; Accept under RI.✓ Correct
This highlights the classic dysfunctional behavior associated with ROI.
Under ROI: The manager's current ROI is 18%. The new project is 15%. Adding it will drag down their average ROI, so they will REJECT it, even though it's good for the company.
Under RI: Residual Income charges a cost of capital (12%). Since the project yields 15%, it will generate positive Residual Income, increasing the manager's total RI. Therefore, they will ACCEPT it. RI aligns managerial goals with corporate goals.
Common mistakes
Assuming managers will accept any project with an ROI higher than the cost of capital when evaluated on ROI.
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