With a required rate of return of 13%, operating income of $375000, and a total investment of $2650000, the residual income would be ____________?
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Answer: A. $30,500
Explanation
Residual income is calculated by subtracting the capital charge from operating income, where the charge equals total investment multiplied by the required rate. Operating income of $375,000 minus the capital charge of $344,500 ($2,650,000 * 0.13) leaves $30,500. Residual income measures the net profit an investment earns above the minimum required return. Unlike percentage-based ROI, residual income provides a dollar-value measure of shareholder value creation.
Companies use residual income to evaluate divisional performance and prevent managers from rejecting profitable projects. This metric encourages executives to pursue any opportunity yielding returns above the cost of capital. Options B, C, and D represent incorrect calculations stemming from math errors or wrong capital charges. They fail to yield the proper net residual amount.
- Subject
- Accounting and Finance
- Category
- Accounting
- Topic
- —
- Difficulty
- medium
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