May 2019 Q1 b.
Ayittey Ltd is an organization with two divisions: A and B, each with its own cost and revenue streams. Each of the two divisions is classified as Investment center. The company’s cost of capital is 12%. Historically, investment decisions have been made by calculating the return on investment (ROI). A new manager who has recently been appointed in division A has argued that using residual income (RI) to make investment decisions would result in ‘better goal congruence’ throughout the company. The data below shows the current position of the division as at the end of 31 December, 2016:
The company is seeking to maximize shareholders wealth. Assuming that, Division A acquires a more efficient asset at GH¢15 million and Division B sold one of its assets with written down value of GH¢24 million, and profits are expected to increase and decrease by GH ¢11 million and GH¢5 million for division A and B respectively.
Required:
i) Calculate both the current Return on Investment (ROI) and Residual Income (RI) for each of the divisions. (5 marks)
View Solution
Divisional performance measurement using ROI
Division A:
ROI = Net Profit / investment x 100
= 12.49 / 82.8 x 100
=15.085%
Division B:
ROI = Net Profit / investment x 100
= 7.194 / 40.6 x 100
=17.72%
Divisional performance measurement using RI
ii) Calculate and comment on the effect of the decision to invest in the new asset and disposal of some assets will have on the current ROI and RI. (7 marks)
View Solution
Divisional performance after the new investment
Division A
ROI = Net Profit / investment x 100
= 23.49 / 97.8 x 100
= 24.02 %
Division B
ROI = Net Profit / investment x 100
= 2.194 / 16.6 x 100
= 13.21%
Residual Income after new investment.
Comment:
- If a decision about whether to proceed with the investments is made based on ROI, it is possible that the manager of Division A will accept the new proposal whereas the manager of Division B will reject the new proposal. Prior to the new investment Division A had 15.085%, though this is a bit lower than the target rate of return of 16% whiles Division B basket 17.72%. With the new investment Division A’s manager has a ROI of 24.02%, this is above the target rate of return, representing some 37.21% increase in the ROI of division A. Division B has ROI of 13.21%, this is lower than the target rate of return, representing some 25.45% reduction in the ROI of Division B.
- However, since Division B’s new ROI of 13.21% is higher than the firm’s cost of capital of 12%, accepting the new investment would encourage goal congruence and improves the firm’s overall performance. Behaviorally, Division B’s manger may not be motivated to venture into the new investment if his rewards are tired to the current level of performance. Accepting the new investment means a reduction in his incentives (bonuses).