Question

Division A is considering a project that will earn an ROA (Return on Assets) that is greater than the cost of capital, but less than the division’s ROA. Division B is considering a project that will earn an ROA that is greater than the division’s ROA, but less than the cost of capital. If both divisions are evaluated based on residual income, would these divisions accept or reject their projects?

Answer 1

If both divisions are evaluated based on residual income then Divison A would accept the project and Division B would reject the project

Residual Income measures the returns an investment earns beyond the lowest return on its cost of capital

Division A would accept the project because it has  a higher residual income as ROA is higher than the cost of capital . Residual Income is net income less any charge on cost of captial. Since the ROA is higher than the ROE, the residual income would be be higher

Division B would reject the project because it has a low or negative residual income as ROA is lower than the cost of capital . Residual Income is net income less any charge on cost of captial. Since the ROA is lower than the ROE, the residual income would be low or negatve