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 is an absolute dollar amount that compares operating income with the return - calculated as some preset hurdle rate (percent) times the level of average operating assets. If residual income is positive, ROI is than the hurdle rate. If residual income is negative, ROI is than the hurdle rate. If residual income is zero, ROI is 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 $95,000 $220,000 Average operating assets 920,000 2,450,000 ROI 10.33% 8.98% Jesper requires a 6% rate of return. 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 larer divisions nenerally have a more difficult time increasing ROT because they have larger divisions generally have a more difficult time increasing ROI because they have However, it is relatively easier for larger divisions to generate larger residual income because they have Both the East and the West Divisions have access to an abditional $150,000 of investment. Each of the divisions could invest that amount in a new project with projected operating income of $12,000. 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? What decision will the West Division manager make with respect to the additional investment? 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? What decision will the West Division manager make with respect to the additional investment? Economic Value Added (EVA) Economic Value Added (EVA) is similar to residual income in that income is compared to the cost of investment used to earn that income. However, there are some key differences. EVA uses: net (after- 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 . However, it is relatively easier for larger divisions to generate larger residual give small asset bases large asset bases Vest Divisions have access to an additional $150,000 of investment. Each of the small operating income at amount in a new project with projected operating income of $12,000. First, hs are evaluated on the basis of ROI. large revenue WECISION WITTE Last Division manager make with respect to the additional investment? What decision will the West Division manager make with respect to the additional investment? 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? What decision will the West Division manager make with respect to the additional investment? 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 . However, it is relatively easier for larger divisions to generate larger residual income because they have Both the East and the West Divisions have access to an additional $150,000 of investment. Each oft divisions could invest that amount in a new project with projected operating income of $12,000. Firs 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? > What Accept fill the West Division manager make with respect to the additional investment? Decline 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? What decision will the West Division manager make with respect to the additional investment