A multinational bank evaluates its regional division managers based on Return on Investment (ROI). The European division currently has an ROI of 18%. The bank's cost of capital is 12%.

The European manager is considering a new project that yields an ROI of 15%.

Which of the following statements is true regarding the manager's likely decision and the bank's preference?

Answer options:

The manager will likely accept the project, and the bank would want it accepted.

The manager will likely reject the project, and the bank would want it rejected.

The manager will likely reject the project, but the bank would want it accepted.

The manager will likely accept the project, but the bank would want it rejected.

How to approach this question

Compare the project ROI (15%) to the manager's current ROI (18%) to see what the manager will do. Compare the project ROI (15%) to the cost of capital (12%) to see what the company wants.

Full Answer

C.The manager will likely reject the project, but the bank would want it accepted.✓ Correct

The manager is evaluated on ROI. Adding a 15% project to an 18% division will drag the average ROI down, so the manager will likely reject it (dysfunctional behavior). However, the bank wants the project accepted because its return (15%) exceeds the cost of capital (12%), meaning it adds absolute value to the firm. This illustrates why Residual Income (RI) is often preferred over ROI.

Common mistakes

Assuming managers always accept projects above the cost of capital when evaluated on ROI.

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