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Residual income and EVA
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Explains Residual income, Economic value added, Financial measures and performance measures. The advantages and disadvantages are discussed - perfect for essay writing.
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Managerial Accounting 5.10.20RI and EVA
Residual income (RI)
o RI= Operating profit – Capital charge
- Capital charge = investment (assets used to generate profit) * cost of capital
o When RI >0, accept project
o Maximises wealth of company
Advantages:
- Simple measure to compute and understand
- Uses readily available information
- Aligns decisions with shareholder wealth
- Comprises a financial measure that managers can understand
- Company has opportunity to invest $100,000 into a project that will return $25,000
- It has 20% required rate of return and 30% ROI on existing business
1) Capital charge = capital invested * interest rate
2) Investment centre profit – investment charge
3) The residual income: 5,000 > 0. Accept
Does RI overcome the disadvantages associated with ROI?
o Aids sound investment decision-making by fostering goal congruent decisions
- Takes cost of capital into account
- Align interest of company with shareholder wealth
o Does not overcome misleading signals of ROI
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