[NinaSun]

I did a MC question talking about why Residual income is superior to return on investment

Residual income is a better measure for performance evaluation of an investment center manager than return on investment because:

a. Only the gross book value of asset needs to be calculated

b. The problems associated with measuring the asset base are eliminated

c. Desirable investment decisions will not be neglected by high-return divisions

d. Issues related to the implicit cost of interest are eliminated

The correct answer is C. My question is in a high-return division. ROI will be high. So the investment would not neglected under either measurement at high-return divisions. For d. Can any one explain what is implicit cost of interest in two cases? As the answer said both two case have implicit cost of interest.

AUD-74,75 11/2014
REG-80 04/2015
FAR-74, 91 11/2015
BEC-79 08/2015

[Anonymous]

If you use ROI, the managers might only focus on short-term benefits. Investing in new assets will lower ROI because it's not likely to benefit from your new assets immediately. While residual income eliminates this problem. The answer is C.

[spatel15]

Don't think its timing, its more about numbers alone. Small number in the denominator looks better than bigger numbers in both. 2/1 looks alooot better than 10/9.

think about it this way

your ROI = 100/20 = 5, pretty good right?

You have an opportunity an opportunity to make 2000, for only 1000 dollars investment! Your shareholders only require a 10% return, so this is perfect right? Well, if your bonus is based on ROI, lets do the math.]

You were getting bonus for a 5X ROI before.

Now…you're gonna get bonus based on 2100/1020 = 2.06

Org Goals don't congrue with yours, the manager. Goal Congruity, Controllable Incentives, and Ease of Measure are three KEY things when choosing how to compensate.

[spatel15]

Implicit costs are not eliminated, theyre actually added. ROI has no “hurdle rate” it's just what it is. What you made over what you invested.

Res.Inc. on the hand adds the implicit cost of equity to reduce net income…..or NOPAT less Total Costs(debt and equity)

[Author]

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