Which statement explains how RI mitigates ROI drawbacks?

Which statement explains how RI mitigates ROI drawbacks?

• A. ROI ignores the cost of capital and focuses on short-term gain.
• B. ROI focuses on short-term cash flows alone.
• C. ROI rewards only efficiency without capital cost consideration.
• D. RI accounts for the cost of capital and promotes investing in profitable assets.

Answer: (D)

Residual income (RI) fixes ROI by bringing the cost of capital into the performance measure. It uses RI = operating income minus (invested capital × cost of capital). This means a project only adds value if it earns more than the company’s minimum required return on its capital. If it doesn’t cover the cost of capital, RI is negative, signaling no value creation. This addresses ROI’s drawbacks because ROI can look good even when the capital employed isn’t earning enough to cover its cost, or it can favor projects that raise the ROI simply by reducing the denominator or improving short-term efficiency without delivering true value. RI ensures that investments are judged by whether they generate returns above the hurdle rate, so profitable assets are promoted and less attractive ones are avoided, aligning decisions with wealth creation.

Residual income (RI) fixes ROI by bringing the cost of capital into the performance measure. It uses RI = operating income minus (invested capital × cost of capital). This means a project only adds value if it earns more than the company’s minimum required return on its capital. If it doesn’t cover the cost of capital, RI is negative, signaling no value creation.

This addresses ROI’s drawbacks because ROI can look good even when the capital employed isn’t earning enough to cover its cost, or it can favor projects that raise the ROI simply by reducing the denominator or improving short-term efficiency without delivering true value. RI ensures that investments are judged by whether they generate returns above the hurdle rate, so profitable assets are promoted and less attractive ones are avoided, aligning decisions with wealth creation.