ROCE/RI

Question 1

what is roce and ri part of

Answer 1

the investment centre

Question 2

what does roce stand for

Answer 2

return on capital employed

Question 3

what does ri stand for

Answer 3

residual income

Question 4

what is return on investment

Answer 4

generally considered to be the key performance measure

Question 5

what are the two ways of monitoring the performance of a profit or investment centre

Answer 5

return on investment (ROI), also known as return on capital employed (ROCE),
residual income (RI)

Question 6

what two things are used interchangeably

Answer 6

return on investment (ROI),

return on capital employed (ROCE)

Question 7

why is ROI/ROCE used widely

Answer 7

meets management’s needs to ascertain that capital invested is used efficiently,
identifiable from the income statement and balance sheet,
shows how much profit has been made in relation to the amount of capital invested

Question 8

how is ROI calculated *

Answer 8

ROI = (profit/capital employed) x 100%

Question 9

what are some issues with ROI *

Answer 9

focuses attention on short-run performance (vs performance evaluation over whole life of investment),
no single agreed method for calculating ROI (different behavioural implications and dysfunctional decision making)

Question 10

what are the two common methods of calculating ROI *

Answer 10

profit after depreciation as a % of net assets employed,

profit after depreciation as a % of gross assets employed

Question 11

which is the most common method of calculating ROI

Answer 11

profit after depreciation as a % of net assets employed

Question 12

what is a problem with the method of calculating ROI ‘profit after depreciation as a 5 of net assets employed’

Answer 12

if an investment centre maintains the same annual profit, but keeps same assets without regular replacement policy, its ROI will increase year by year and give false impression of improving performance over time (due to depreciation i think, go to page which says card answer)

Question 13

what are some specific problems with ROI

Answer 13

an automatic improvement in ROI year on year simply by allowing assets to depreciate (disincentive to invest in new or replace assets),
difficulty in the comparison between investment centres

Question 14

what is the difference between profit after depreciation as a % of net assets employed, and profit after depreciation as a % of gross assets employed

Answer 14

profit after depreciation as a % of gross assets employed removes the problem of ROI increasing as the assets get older,
gross asset = book value before depreciation

Question 15

why would you choose ‘profit after depreciation as a % of gross assets employed’ instead of ‘profit after depreciation as a % of net assets employed’

Answer 15

by valuing assets at their book value before depreciation it removes the problem of ROI increasing as the assets get older

Question 16

what are some disadvantages of ‘profit after depreciation as a % of gross assets employed’ where assets are valued at their book value before depreciation *

Answer 16

does not distinguish between old and new assets,
tendency of older assets to cost more to service and maintain,
inflation and technology change affecting the cost of assets and their efficiency

Question 17

how would an ROI be different if it was for the assessment of manager’s performance

Answer 17

only include assets controllable by the manager and controllable contribution,
the controllability principle (lecture slides last week, find this slide page 6 of lecture slides for this topic)

Question 18

how would an ROI be different if it was for the assessment of the investment centre itself

Answer 18

should include all assets traceable to the centre,
plus a share of HO assets,
divisional profit

Question 19

what is a possible disadvantage of using ROI

Answer 19

taking on new investments only if they are likely to increase the ROI (not always good etc other reasons)

Question 20

what is a possible behavioural issue stemming from this situation ‘bonus depending upon meeting a target ROI”

Answer 20

altering the asset base by selling an asset,
delaying purchase,
speeding up receipts or delaying payments

Question 21

what is residual income (RI)

Answer 21

an alternative way of measuring the performance of an investment centre

Question 22

what is the residual income (RI) equation

Answer 22

RI = profit - imputed(/notional) interest charge

Question 23

for residual income (RI) do you use profit before or after depreciation

Answer 23

residual income (RI) uses profit after depreciation

Question 24

how is imputed interest charge calculated

Answer 24

imputed interest charge: normally calculated by using the company’s cost of capital

Question 25

what are the advantages of residual income (RI)

Answer 25

will increase when investments earning above the cost of capital are undertaken (and vice versa),
more flexible as different cost of capital can be applied to different divisions and different investments (depending on risk characteristics)

Question 26

how do you calculate the imputed interest charge in RI *

Answer 26

calculated by using the company’s cost of capital (12% for ex) times the total assets employed

Question 27

if RI is positive what does that mean you should do

Answer 27

accept the project