M5-Performance Management: Part 2

Question 1

The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting projects that yield cash flows. Profitable investment center managers might be reluctant to invest in projects that might lower their ROI (especially if their bonuses are based on their investment center’s ROI), even though those projects might generate positive cash flows for the company as a whole. This characteristic is often known as the “disincentive to invest” (true or false)

Answer 1

true

Question 2

Residual income is defined as income in excess of a desired minimum return. (true or false)

Answer 2

true

Question 3

Historical weighted average cost of capital is usually used as the target or hurdle rate in the residual income approach. (true or false)

Answer 3

true

Question 4

The gross margin ratio describes the ratio of gross margin to sales and serves to evaluate a company’s profitability. (true or false)

Answer 4

true

Question 5

ROI encourages shortsighted behavior that defers or avoids investment for the sake of current ROI performance. Short-term benefits are emphasized over long-term commitments. (true or false)

Answer 5

true

Question 6

Residual income measures actual dollars that an investment earns over its required return rate. Performance evaluation on this basis will mean that desirable investment decisions will not be rejected by high-return divisions. (true or false)

Answer 6

true

Question 7

Return on assets (ROA) is a profitability ratio that produces a percentage output, making it easy to compare companies that differ in size. (true or false)

Answer 7

true

Question 8

Economic value-added is a measure that uses net operating profit after taxes (NOPAT) and compares it to the required return for the capital. Each of these components is calculated of an annual basis, so this model is well suited for evaluating performance in a given year. (true or false)

Answer 8

true

Question 9

Return on assets is a profitability measure that can be used to evaluate the efficiency of asset usage and management, and the effectiveness of business strategies to create profits. (true or false)

Answer 9

true

Question 10

The optimal imputed interest rate used in the residual income approach can be best described as the target return on investment set by the company’s management. (true or false)

Answer 10

true