Delmore Group: ROI, residual income and a manager's investment decision
Delmore Group's instruments division has capital employed of £4.2m and budgeted annual operating profit of £756,000. The group's weighted average cost of capital is 12%, and the board evaluates divisional managers on return on investment, with a notional hurdle of 15%. The divisional manager's bonus is capped unless divisional ROI exceeds 18%. She has identified a project needing £600,000 of new investment that would generate £96,000 of additional annual operating profit for the foreseeable future. The group finance director prefers residual income for internal appraisal but has not yet persuaded the board. Central office has also offered the division a second, independent project: £250,000 of investment for £33,000 of annual profit. The division faces no capital rationing. Institutional shareholders have publicly said they expect the group to pursue any investment earning above the cost of capital.
1. Calculate divisional ROI and residual income now, and for each project and combination. Explain why the manager's decision may conflict with the shareholders' interest.
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Current: ROI = 756 ÷ 4,200 = 18.0%. RI = 756 − (12% × 4,200 = 504) = £252,000.
- Project 1: ROI = 96 ÷ 600 = 16.0%; RI = 96 − 72 = +£24,000.
- Project 2: ROI = 33 ÷ 250 = 13.2%; RI = 33 − 30 = +£3,000.
- Project 1 only: profit £852k, capital £4,800k → ROI 17.75%; RI = 852 − 576 = £276,000.
- Both: £885k ÷ £5,050k → ROI 17.52%; RI = 885 − 606 = £279,000.
Both projects earn above the 12% cost of capital, so accepting them raises shareholder value by £27,000 a year. But either one drags the division's average ROI below 18% and costs the manager her bonus. A rational manager therefore rejects both - the classic ROI under-investment problem: an average ratio penalises any project below the current average, however profitable it is for the group.
2. Recommend a performance measure to the board and set out the behavioural risks of changing it.
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Recommend residual income (or an EVA variant) with a capital charge at the 12% WACC. RI accepts every project that clears the cost of capital regardless of the existing average, so the manager's incentive lines up with the shareholders' stated expectation. Keep ROI as a reported secondary indicator, not as the bonus trigger.
Behavioural risks to manage:
- Absolute scale bias. RI favours large divisions; do not compare divisions on RI alone.
- Asset-base games. RI is sensitive to carrying values - old, depreciated assets flatter it, and managers may defer replacement capex or dispose of assets to shrink the capital charge.
- Accounting manipulation. Any profit-based measure can be managed through accruals, so pair it with cash conversion and non-financial measures (delivery, quality, safety).
- Target fairness. Move the target and the bonus formula together and prospectively; retrospective changes are read as a breach of trust and will be resisted.
The board should also be told explicitly that the 18% threshold has been suppressing investment, and be given the £27,000 annual value forgone.