Sunrise Corporation has a return on investment of 15%. A Sunrise division, which

Question

• Sunrise Corporation has a return on investment of 15%. A Sunrise division, which currently has a 13% ROI and $750,000 of residual income, is contemplating a massive new investment that will (1) reduce divisional ROI and (2) produce $120,000 of residual income. If Sunrise strives for goal congruence, the investment:
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  • should not be acquired because it reduces divisional ROI.
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  • should not be acquired because it produces $120,000 of residual income.
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  • should not be acquired because the division's ROI is less than the corporate ROI before the investment is considered.
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  • should be acquired because it produces $120,000 of residual income for the division.
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  • should be acquired because after the acquisition, the division's ROI and residual income are both positive numbers.

Explanation / Answer

Reason- The chief disadvantage of ROI is that for an investment that earns a rate of return greater than the company's cost of raising capital, the manager in charge of deciding about that investment may have an incentive to reject it if the investment would result in reducing the manager's ROI. The residual-income measure eliminates this disadvantage by including in the residual-income calculation the imputed interest rate, which reflects the firm's cost of capital. Any project that earns a return greater than the imputed interest rate will show a positive residual income.

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