Section A

CityGrid, a public utility, evaluates its regional divisions using Return on Investment (ROI). The Northern Division currently has an ROI of 18%. The company's cost of capital is 12%.

The manager of the Northern Division is considering a new infrastructure project that will yield an ROI of 15%.

Which of the following statements correctly describes the likely behavior of the manager and the benefit of using Residual Income (RI) instead?

Answer options:

The manager will likely accept the project because 15% is higher than the cost of capital, and RI would lead to the same decision.

The manager will likely reject the project because it lowers their divisional ROI, but using RI would encourage them to accept it as it exceeds the cost of capital.

The manager will likely accept the project to increase the size of their division, but RI would discourage this.

Both ROI and RI will result in the manager rejecting the project.

How to approach this question

Compare the project's ROI (15%) to the current ROI (18%) and the cost of capital (12%). Determine how this affects the manager's metrics.

Full Answer

B.The manager will likely reject the project because it lowers their divisional ROI, but using RI would encourage them to accept it as it exceeds the cost of capital.✓ Correct

Because the project's ROI (15%) is lower than the division's current ROI (18%), accepting it will drag down the division's average ROI. A manager evaluated on ROI will likely reject it (dysfunctional behavior). However, because the project's return (15%) is greater than the company's cost of capital (12%), it adds value to the company. Residual Income (RI) charges a cost of capital on the investment; since 15% > 12%, the RI of the project is positive, encouraging the manager to accept it.

Common mistakes

Assuming managers always act in the best interest of the company (goal congruence) when evaluated on ROI.

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Practice the full ACCA PM — Performance Management Practice Exam 4

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