Choice "A" is correct. The addition of an asset at year end serves to reduce both return on investment and residual income. The addition of an asset increases then denominator in the ROI computation and increases the threshold earnings required using the residual income approach. Both measures would suffer as a result of addition of assets. See illustration below: Assumptions: | Income | $ 100,000 | Assets | $ 1,000,000 | Required return | 10% | Additional asset | $ 200,000 |
Return on Investment
| Residual Income
|
|---|
| Before
| Purchase
| After
| | Before
| Purchase
| After
|
|---|
Income | $ 100,000 | | $ 100,000 | Assets | $1,000,000 | $ 200,000 | $ 1,200,000 | Assets | $ 1,000,000 | $ 200,000 | $ 1,200,000 | Required Return | 10% | | 10% | Return | 10% | | 8% | Required Income | $ 100,000 | | $ 120,000 | | | | | Income | $ 100,000 | | $ 100,000 | | | | | Difference | $ − | | $ (20,000) |
The purchase of the additional asset reduces ROI from 10% to 8% and produces negative residual income.Choices "c", "d", and "b" are incorrect, per the above illustration.
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