19.20 ROI, residual income, investment decisions, division manager’s compensation. (50 min) 1 Average investment in operating assets employed Balance at 31 December 2011 €15,750,000 Balance at 31 December 2010 (€15,750,000 ÷ 1.05) 15,000,000 Opening balance plus closing balance €30,750,000 Average balance (€30,750,000 ÷ 2) €15,375,000 ROI = Income from operations before income taxes Average operating assets employed = 15,375.000 1,845,000 = 0.12 or 12% 2 Income from operations before income taxes €1,845,000 Minimum return on average operating assets employed Average operating assets employed (€15,375,000)
× Required rate of return on invested capital (0.11) 1,691,250 Residual income €153,750 3 Yes. Frankfurt Steel’s management probably would have accepted the investment, if residual income were used. The investment opportunity would have lowered Frankfurt Steel’s 2011 ROI because the expected return (11.5%) was lower than the division’s historical returns (11.8% to 14.7%) as well as its actual 2011 ROI (12%). Management rejected the investment because bonuses are based, in part, on the performance measure of ROI. If residual income were used as a performance measure (and as a basis for bonuses, management would accept any and all investments that would increase residual income. Using residual income to reward management would create incentives for managers to accept all investments that have a rate of return in excess of 11%, a decision that is in the best interests of the company as a whole. The investment considered by management in 2011 had a rate of return of 11.5%.
