Residual Income

ROI has the disadvantage of encouraging managers to sacrifice long-term benefits to increase short-term gain. In particular, a manager with a high ROI may turn down profitable opportunities with somewhat lower ROIs to maintain the current ROI. A measure has been developed to circumvent this, residual income.

Residual Income = Operating Income (Average Total Assets Hurdle Rate)

If residual income is positive, ROI is - Select your answer -lower thanhigher thanequal toItem 1 the hurdle rate. If residual income is negative, ROI is - Select your answer -lower thanhigher thanequal toItem 2 the hurdle rate. If residual income is zero, ROI is - Select your answer -lower thanhigher thanequal toItem 3 the hurdle rate.

Example: Jesper, Inc. provided the following data on its East and West Divisions for last year:

	East Division	West Division
Operating income	$95,200	$216,100
Average operating assets	920,500	2,455,000
ROI	10.34%	8.80%

Jesper requires a 6% rate of return.

Round your answers to the nearest cent.

The residual income for the East Division is	$
The residual income for the West Division is	$

Notice that while the East Division has a higher ROI than the West Division; the West Division has a higher residual income than the East Division. While this need not always be the case, it is true that larger divisions generally have a more difficult time increasing ROI because they have - Select your answer -small asset baseslarge asset basessmall operating incomelarge revenueItem 6 . However, it is relatively easier for larger divisions to generate larger residual income because they have - Select your answer -small asset baseslarge asset baseslarger operating incomelarge revenueItem 7 .

Both the East and the West Divisions have access to an additional $162,000 of investment. Each of the divisions could invest that amount in a new project with projected operating income of $12,960. First, assume that the divisions are evaluated on the basis of ROI. What decision will the East Division manager make with respect to the additional investment? - Select your answer -acceptdeclineItem 8 What decision will the West Division manager make with respect to the additional investment? - Select your answer -acceptdeclineItem 9

Now assume that the divisions are evaluated on the basis of residual income with a 6% hurdle rate. What decision will the East Division manager make with respect to the additional investment? - Select your answer -acceptdeclineItem 10 What decision will the West Division manager make with respect to the additional investment? - Select your answer -acceptdecline