Question Tag: Return on investment

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  • 15 Marks

MA – Dec 2023 – L2 – Q1a – Divisional performance

This question assesses the ROI and RI of two divisions, Ken and Yon, and compares their performance.

Ken and Yon are two divisions of a large company that operate in similar markets. The divisions are treated as investment centres, and every month each division prepares an operating statement and submits it to the parent company. Operating statements for the two divisions for October are stated below:

Operating Statements for October Ken (GH¢000) Yon (GH¢000)
Sales revenue 900 555
Variable costs 345 312
Controllable fixed costs (includes depreciation on division assets) 433 222
Uncontrollable apportioned central costs 15 5
Divisional net assets for the year 9,760 1,260

The company currently has a target return on capital of 12% per annum. However, the company believes its cost of capital is likely to rise and it is considering increasing the target return on capital. Currently, the performance of each division and the divisional management are assessed primarily based on Return on Investment (ROI) using controllable profit.

Required:

i) Calculate the annualised Return on Investment (ROI) for divisions Ken and Yon, and discuss their relative performances. (6 marks)
ii) Calculate the annualised Residual Income (RI) using controllable profit for divisions Ken and Yon, and evaluate their division’s performances. (6 marks)
iii) Using appropriate ratios, evaluate the efficiency of the two divisions. (3 marks)

i) Return on Investment (ROI):

Discussion of relative performance:

  • Division Yon has the highest return on investment (20%) in comparison to division Ken (15%).
  • Both divisions exceed the target of 12% per annum set by the parent company. However, division Ken will be at greater risk if the target return on investment is increased.
  • Both divisions are profitable and generate a positive contribution for the group.
  • In absolute terms, division Ken is larger in terms of net assets and generates greater absolute profit than division Yon.

ii) Residual Income (RI):
Residual income = Profit before interest and tax – (Capital employed × cost of capital)

Division Ken (GH¢ million) Yon (GH¢ million)
Profit before interest and tax (annualised) 1.464 0.252
Capital employed cost of capital 1.171 0.151
Residual Income 0.293 0.101

Evaluation:

  • Division Ken contributes greater wealth for the group, demonstrated by a higher residual income.
  • Residual income is superior as it accounts for the absolute size of wealth generated rather than just relative returns.

iii) Efficiency ratios:

Division Ken is more operationally efficient with lower variable costs to sales (38.3% vs 56.2% for Yon).

  • 7 Marks

FM – May 2018 – L2 – Q1c – Divisional Performance

Calculate and analyze return on investment and residual income before and after a new investment in a division.

The Bottle Labelling Division of Crush Drink Ltd currently has capital employed of GH¢100,000 and earns an annual profit after depreciation of GH¢18,000. The divisional manager is considering an investment of GH¢10,000 in an asset which will have a ten-year life with no residual value and will earn a constant annual profit after depreciation of GH¢1,600. The cost of capital is 15%.

Required:
Calculate the following and comment on the results.
i) The return on divisional investment, before and after the new investment
ii) The divisional residual income before and after the new investment

i) Return on Divisional Investments
= Divisional Profit / Divisional Investments * 100

Before Investment After Investment
Divisional profit GH¢18,000
Divisional investment GH¢100,000
Divisional ROI 18%

Comment:
The ROI will fall in the short term if the new investment is undertaken. This is a problem which often arises with ROI, as noted in part (b) of this solution.

ii) Divisional Residual Income
= Divisional Profit – (Cost of Capital (15%) * Divisional Investment)

Before Investment After Investment
Divisional profit GH¢18,000
Imputed cost of capital (0.15 * GH¢100,000) GH¢15,000
Divisional RI GH¢3,000

Comment:
The Residual Income will increase in the short term if the new investment is undertaken.

  • 7 Marks

MA – May 2018 – L2 – Q1b – Divisional performance

Compare residual income and return on investment for divisional performance measurement, highlighting their advantages.

Compare and contrast the use of residual income and return on investment in divisional performance measurement, stating the advantages.

 

Contrasting Residual Income & Return on Investment

  • Return on investments is a financial ratio that measures the rate of return of a company’s investments. Companies use ROI to compare the efficiency of a number of investments. Residual income is another approach to measuring the performance of an investment. It is the net operating income an investment earns above the minimum required return on its operating assets.
  • The residual income (RI) for a division is calculated by deducting from the divisional profit an imputed interest charge, based on the investment in the division. The return on investment (ROI) is the divisional profit expressed as a percentage of the investment in the division.
  • It can be difficult to compare the percentage ROI results of divisions if their activities are very different: residual income can overcome this problem through the use of different interest rates for different divisions.
  • Rigid adherence to the need to maintain ROI in the short term can discourage managers from investing in new assets, since average divisional ROI tends to fall in the early stages of a new investment. Residual income can overcome this problem by highlighting projects which return more than the cost of capital.

Comparing Residual Income & Return on Investment

  • Both methods suffer from disadvantages in measuring the profit and the investment in a division which include: Assets must be valued consistently at historical cost or at replacement cost. Neither valuation basis is ideal.
  • Both methods use the same basic figure for profit and investment, but residual income produces an absolute measure whereas the return on investment is expressed as a percentage.
  • Divisions might use different bases to value inventory and to calculate depreciation. Any charges made for the use of head office services or allocations of head office assets to divisions are likely to be arbitrary.

Advantages of ROI & RI

  • Focus management’s attention upon earning the best profit possible on the capital (total assets) available.
  • Serve as a yardstick in measuring management’s efficiency and effectiveness in managing the company as a whole and its major divisions or departments.
  • Tie together the many phases of financial planning, sales objectives, cost control, and the profit goal.
  • Afford comparison of managerial results both internally and externally.
  • Develop a keener sense of responsibility and team effort in divisional and departmental managers by enabling them to measure and evaluate their own activities in the light of the results achieved by other managers.
  • 5 Marks

MA – Nov 2018 – L2 – Q1b – Divisional Performance

Evaluate the impact of scrapping an inefficient bus on the ROI of a transportation business unit.

Super Express Transport Company runs a fleet of buses on the Accra-Sunyani route, which is considered a business unit.

The following is an extract from the final accounts of the company as at the last operating year:

  • Stock of buses on that route at cost less depreciation is GH¢660,000.
  • Net operating profit is GH¢198,000.

One of the buses, bought three years ago at the cost of GH¢150,000, was not performing efficiently because it got involved in an accident just a year after it was purchased. Although the damage was minor, the Operations Manager suggested that the bus be scrapped, in spite of the fact that it earned a profit of GH¢6,000 in the year. Depreciation is at the rate of 20% p.a. on a straight-line basis.

Required:
Evaluate the effect of this proposal on the performance of the business unit, if Return on Investment (ROI) is used to measure the performance of subunits. (5 marks)

ROI without the proposal:

Profit/ Assets
GH¢198,000/ GH¢660,000
0.30 or 30%

ROI with the proposal:

GH¢192,000/600,000
0.32 or 32%

Decision:

The disposal will improve the unit’s performance.

  • 8 Marks

MA – May 2021 – L2 – Q1b – Divisional performance, Performance analysis

Evaluate the impact of a new investment on a division’s Return on Investment, Residual Income, and manager’s bonus.

b) Peah is a divisional manager of Monrovia Ltd. He is paid a bonus of 5% on the division’s residual income after charging the bonus. The division is currently considering an additional investment of GH¢200,000 with 10 years useful life but nil residual value. The investment is expected to yield a profit after depreciation of GH¢51,600. This will augment the existing capital employed of GH¢1,050,000 that currently offers GH¢264,400 profit after depreciation annually. The company’s policy is to accept investment projects that provide a return of at least 22%.

Required: i) Calculate the Return on Investment and Residual Incomes of the division before considering the new investment. (2 ½ marks)
ii) Advise the division on whether the new investment should be taken or not. (2 ½ marks)
iii) What will be the percentage change in the bonus of Peah if the new investment is added to the division’s existing operations? (3 marks)

i) Determination of divisional ROI and RI

Calculation of divisional ROI
Before the new investment:
Divisional Profit: GH¢264,400
Divisional Investment: GH¢1,050,000
Divisional ROI: 25.18%

After the new investment:
Divisional Profit: GH¢316,000
Divisional Investment: GH¢1,250,000
Divisional ROI: 25.28%

Calculation of divisional RI
Before the new investment:
Divisional Profit: GH¢264,400
Less imputed interest (22% x GH¢1,050,000): GH¢231,000
Residual Income: GH¢33,400

After the new investment:
Divisional Profit: GH¢316,000
Less imputed interest (22% x GH¢1,250,000): GH¢275,000
Residual Income: GH¢41,000

ii) Advice on the new investment:
Based on the ROI, the new investment is marginally beneficial in the short term as it slightly increases ROI to 25.28%. Based on the RI, it is beneficial as it increases residual income to GH¢41,000. Thus, the new investment should be accepted.

iii) Determination of bonus to the divisional manager:

5% bonus on residual income after charging the bonus.
Before the new investment:
5/105 x GH¢33,400 = GH¢1,590.48

After the new investment:
5/105 x GH¢41,000 = GH¢1,952.38

Percentage change in bonus:
(1,952.38 – 1,590.48) / 1,590.48 x 100 = 22.75%

  • 10 Marks

FM – April 2022 – L2 – Q4b – Introduction to Investment Appraisal

Calculate the Accounting Rate of Return (ARR) for three projects and provide advice on which projects should be undertaken based on a target ARR.

SAKAMA Ghana Ltd uses the Accounting Rate of Return (ARR) as the basis of evaluating projects for investment of its scarce financial resources. It uses its predetermined expected return on capital as the basis for the choice of investment projects. The company’s Finance team has provided the information below regarding various projects and their initial investments and net cash flows. The hurdle rate or target Accounting Rate of Return for SAKAMA Ghana Ltd is 25%.

Required:
i) Calculate the Accounting Rate of Return for each project (Average Investment basis). (7 marks)
ii) Using the target return of 25%, advise SAKAMA Ghana Ltd which projects should be undertaken. (3 marks)

i) Calculation of the Accounting Rate of Return (ARR) for each project:

Project A:

Average Annual Accounting profit =
= =200,000

Average Annual Investment =

ARR =

Project B:
Average Annual Accounting profit =
= =220,000
Average Annual Investment =

ARR =

Project C:
Average Annual Accounting profit =
Average Annual Investment =
ARR =

ii) Advice on Projects:
Given the target ARR of 25%, the projects with ARR above this target should be accepted. Therefore, SAKAMA Ghana Ltd should undertake Projects A and B as they both have ARR above the target rate, while Project C should not be undertaken as its ARR is below the target.

 

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