When the managers evaluation is based on residual income the manager should accept a project if the residual income is?
Learning Objective
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Question: Although ROI is commonly used as a divisional performance measure, some division managers dislike this measure. Why do some division managers prefer not to use ROI as a performance measure? Calculating RIQuestion: What is RI, and how does it help to prevent the conflict associated with ROI? Key EquationResidualincome=Operatingincome−(Percent costof capital × Averageoperating assets) Rather than using a ratio to evaluate performance, RI uses a dollar amount. As long as an investment yields operating profit higher than the division’s cost of acquiring capital, managers evaluated with RI have an incentive
to accept the investment. The manager’s goal is to increase RI from one period to the next. Limitation of RIQuestion: Although RI resolves some of the problems of using ROI as a performance measure, it does not provide an efficient means for comparing divisions. What is the problem with
using RI to compare divisions? Computing RI at Game Products, Inc.Question: Let’s revisit Game Products, Inc., and calculate RI for each of the three divisions. How did the three divisions perform using
RI as the measure? Figure 11.8 RI Calculations (Game Products,
Inc.) **From Figure 11.5 "ROI Calculations (Game Products, Inc.)". Key Takeaway
Review Problem 11.6This is a continuation of the Kitchen Appliances example presented in Note 11.18 "Review Problem 11.3", Note 11.26 "Review Problem 11.4", and Note 11.33 "Review Problem 11.5". Financial information for Kitchen Appliances is provided again as follows. Assume the cost of capital rate is 6 percent.
Solution to Review Problem 11.6
Licenses and AttributionsWhat is needed to calculate residual income?Residual income is calculated as net income minus a deduction for the cost of equity capital. The deduction, called the equity charge, is equal to equity capital multiplied by the required rate of return on equity (the cost of equity capital in percent).
Which of the following is true about residual income?The correct answer is B) Residual income is the income in excess of a charge for the capital that is employed to generate that income.
How does residual income work?Personal Finance
To calculate residual income, the bank subtracts the mortgage payment, property insurance, taxes, and other monthly payments—credit cards, installment accounts, or student loans from the applicant's monthly income. The amount left—which doesn't include food and utilities—is considered residual income.
Why do we need residual income in business?Residual income is an important metric because it is one of the figures that banks and lenders look at before approving loans. It helps the institutions determine whether an individual is making enough money to cater for his expenses and secure an additional loan.
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