'Many medium and large sized firms use Return on Investment (ROI) to measure the performance of their divisions. However, it can be argued that ROI can lead to dysfunctional decision making.'

Wilson Limited has two divisions, Division X and Division Y, whose performance are under review:

Division X currently earns a profit of $350,000 and has net assets of $1,500,000.

Division Y currently earns a profit of $500,000 and has net assets of $3,250,000.

Divisional Managers are paid performance bonuses on the basis of the division's Return on Investment (ROI).

Wilson Limited has a cost of capital of 18%.

Each of the divisions is considering an investment project that requires an initial outlay of $1million and has a useful life of 5 years. The project under consideration by Division X will make a ROI of 20% per annum. The project under consideration by Division Y will make a ROI of 16% per annum.

Required:

(a) Using the figures above, calculate the ROI and the Residual Income for each of the divisions of Wilson Limited.

(b) In your memo to your director, explain how ROI can lead to incorrect investment decisions being made and why Residual Income is considered to be a more reliable technique for decision making.

Use the information given above for both divisions of Wilson Limited to support your answer.