Residual Income RI vs Return on investment ROI CPA Exam

In this video, I discuss residual income. The calculation of residual income is as follows: Residual income = operating income – (minimum required return x operating assets). Residual income is the amount of income an investment opportunity generates above the minimum level of rate of return.

Hello and welcome to this session in which we would look at residual income ri and how does it relate to return on investment r o i before we start i would like to remind you that if you are an accounting student and specifically if you are a cpa candidate i strongly suggest you check out my website my website does not replace your cpa

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Out my recommendation like this recording and share it on youtube connect with me on instagram and facebook in the prior session we looked at return on investment and roi and let’s recap real quick about what we did we were looking at two divisions and let’s focus right here for now the north division in the south division and we computed the north and the south

Division and we find out that the return on investments for the north division is 20 roi for the south division is 13.33 and for the whole company is 14.29 basically return on investments is operating income divided by average asset now in the prior session we looked at return on investment in details this is just a review then we said let’s introduce a new product

For the north division let’s assume the north division can can expand by investing 200 000 endure in new assets and as a result they can generate an additional thirty thousand in operating income and what we did is we computed the new return on investment and we find out that the north division return on investment goes from 20 to 16 percent for the north division

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If they undertake this new project if they add the assets and add the new operating income and what we said is this is one of the weakness of roi what happens is is the incentivize the managers and and taken on a new project why because the manager is happy with the 20 percent the new 16 percent will lower their roi however when we look at the company overall

If this if this manager takes on this project and we would look at roi it goes from 14.29 to 14.55 the company is better off if the manager takes the project but the manager themselves are not better off because their roi goes down from 20 to 16. so residual income will overcome this moral hazard so rather than judging the manager of the division based on roi

We’re going to look at ri at residual income now how do we compute residual income then we’ll explain how it works residual income is basically taking the difference between the actual profit or income however we’re going to compute this and the opportunity cost of capital invested in the unit capital invested means how much assets did we give you so simply put

We’re going to judge you on how well you used the asset because if we don’t give you the assets if we don’t give you those property plant and equipment warehouse manufacturing facilities we’re going to have to give it to somewhere else someone else the resources give it to somewhere else so this is our opportunity cost so what is the difference between how much

Profit you make and the opportunity cost we have lost simply put we’re going to take your after tax income or some sort of a profit measurement and find the difference minus the division’s asset those are your resources multiplied by something called the triple r or the required rate of return it’s very simple straightforward concept so how much profit did you

Make versus how much assets we gave you and what did we require you to earn on this asset and how do we compute the required rate of return the required rate of return could be called the hurdle rate the hurdle rate is the rate that the company wants you to earn for example the company could have a hurdle rate of 12 percent another company could have a hurdle

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Rate of 14. now obviously if you have a 14 you have a higher hurdle rate if the hurdle rate of the company is 10 then it’s easier to overcome 10 percent how do we come up with this hurdle rate generally speaking it’s the cost of capital what is the cost of capital how much is the company required to incur in cost under debt and equity okay so how much what’s your

Cost of capital your cost of capital could be if you have debt and equity it’s the average the weighted average of those two if you have only equity it’s the cost of equity if you only have that it’s the cost of that okay so it’s the opportunity cost of the firm’s asset from both debt and equity so what else can we do with those assets if we’re not going to assign

Those assets to your division so let’s see how does residual income overcome the weakness of overcome the weakness of return on asset let’s go back to the same example now the only difference we’re going to add to this example the company has a hurdle rate of 13 let’s see what happened under the new assumption let’s compute now the old residual income for this

Company the old residual income which is based on pr before the expansion the profit for the division is ten thousand minus the division has fifty thousand an asset times the hurdle rate the company would expect you to earn 13 percent well the ex the company would expect you to earn 6500 you earn 10 000 you have a positive residual income everyone is happy now

Let’s assume you undertake this project and now this is your new income your new picture your new residual income is forty thousand now you have two hundred and fifty thousand of assets multiplying by thirteen percent your new residual income is 7500 you more than doubled your residual income although your return on investment went down but if i’m judging you

Based on the residual income you are making more residual income so you will undertake this project what the residual income does is this the residual income one advantage of the residual income is is you will take any project that’s higher than the hurdle rate and obviously 16 is higher than 13 therefore you will undertake this project if you are being judged

On ri residual income not roi if you are being judged on roi you will not take the project because your rate goes from 20 to 16. but under oi your ri not under ri your residual income go from 3 500 to 7 500. so what are the advantages and the disadvantages of residual income minimum rate of return is taken into account so before you whether you accept and not

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Accept the project the minimum means this is the rr the required rate of return the company’s required rate of return is taken into account and managers will accept any project that’s greater than or equal to to the firm required rate of return so we are looking at the required rate of return and we are trying to beat to overcome this hurdle now what are the

Disadvantages of residual income and i hope you already kind of by going over this you already kind of thinking about the disadvantages one of the disadvantages is remember ri is a dollar amount versus roi roi gives you a percentage it’s a ratio a residual income is a number and when you have a number it doesn’t take into account the size of the division simply

Put if you have more assets you might generate more dollar amount in terms of dollar and you would look very good for residual income just because of your size versus a smaller division they did better but you did way better than them because if you’re a you’re a larger division versus ri it doesn’t take into account roi which is the percentage it doesn’t take

Into account it does take into account the size because once you factor everything as a percentage size is factored out and also the required rate of return may be chosen unreasonably or arbitrarily basically the company wants to earn for example 15 and there’s no there’s no reasonable reasonable um explanation why 15 so if that number is chosen arbitrarily then

The manager may not take certain project but when in reality they are profitable project at the end of this recording i would like to remind you again to check out my website like this recording especially if you’re studying for your cpa exam check out my website because i can be useful addition to your cpa course and check out your university or college cpa

Score to find out how well is your university doing best of luck study hard and stay

Transcribed from video
Residual Income RI vs Return on investment ROI CPA Exam By Farhat’s Accounting Lectures