200 ACCOUNTING FOR MANAGERS
than the current ROI of 10%. The effect would be to increase Division B’s ROI
slightly to 10.14% (£2.13 million/£21 million). However, the divisional preference
for B’s investment over A, because of the rewards attached to increasing ROI,
are dysfunctional to Majestic. The corporate view of Majestic would be to invest
£1 million in Division A’s project because the ROI to the business as a whole would
be 20% rather than 13%.
The disposal of the asset can be considered even without knowing its value.
If Division A currently obtains a 25% ROI, disposing of an asset with a return of
only 19% will increase its average ROI. Division B would wish to retain its asset
because it generates an ROI of 12% and disposal would reduce its average ROI
to below the current 10%. Given a choice of retaining only one, Majestic would
prefer to retain Division A’s asset as it has a higher ROI.
The difficulty with ROI as a measure of performance is that it ignores both the
difference in size between the two divisions and Majestic’s cost of capital. These
issues are addressed by the residual income method.
Using residual income (RI), the divisional performance can be compared as in
Table 13.3. In this case, we can see that Division A is contributing to shareholder
value as it generates a positive RI, while Division B is eroding its shareholder value
because the profit it generates is less than the cost of capital on the investment.
Using RI, the impact of the additional investment is shown in Table 13.4. Under
the residual income approach, Division A’s project would be accepted (positive
RI) while Division B’s would be rejected (negative RI).
Similarly for the asset disposal, Division A’s asset would be retained (ROI of
19% exceeds cost of capital of 15%), while Division B’s asset would be disposed of
(ROI of 12% is less than cost of capital of 15%).
The main problem facing Majestic is that the larger of the two divisions (both
in terms of investment and profits) is generating a negative residual income and
consequently eroding shareholder value.
Table 13.2 ROI on additional investment
AB
Additional investment £1 million £1 million
Additional contribution £200,000 £130,000
ROI on additional investment 20% 13%Table 13.3 RI on original investment
AB
Current investment £4 million £20 millionCurrent profit £1,000,000 £2,000,000
Cost of capital @ 15% £600,000 £3,000,000Residual income (profit – cost of capital) £400,000 −£1,000,000