Page 123 - Microsoft Word - 00 P1 IW Prelims.docx

Divisional performance appraisal and transfer pricing

Comparison of ROI and RI

Test your understanding 1

Division Z has the following financial performance:

Operating profit $40,000

Capital employed $150,000

Cost of capital 10%

The division has a new investment opportunity, costing $10,000 and yielding
an annual profit of $2,000

Required:

Would the division invest on the basis of:

(a) ROI?

Current ROI = ($40k ÷ $150k) × 100 26.7%

ROI with new investment = ($42k ÷ $160k) × 100 26.3%

ROI of new investment = ($2k ÷ $10k) × 100 20.0 %

Decision: The division would not accept the investment since it would
reduce the division’s ROI.

(b) RI?

Current RI = $40k – (10% × $150k) $25k

RI with new investment = $42k – (10% × $160k) $26k

Decision: The division would accept the investment since it generates
an increase in RI of $1,000.

113