Divisional ROI versus RI: The Nordlake Components Investment Decision
Nordlake Components operates two divisions. Division A has net assets of £8.0 million and current operating profit of £1.12 million. The group cost of capital is 11%. The divisional manager is paid a bonus tied to return on investment (ROI), and the division’s current ROI is 14%, just above the group’s 11% hurdle. A new contract requires £2.0 million of additional net assets and is expected to generate £260,000 of annual operating profit, a 13% return. The contract would run for five years, with no residual value. Head office evaluates all investments using ROI before interest and tax, and divisional managers have discretion to reject projects below their current ROI. The finance director is concerned that the group may be forgoing value-adding investment, but the divisional manager argues that accepting the contract would dilute divisional performance and reduce the bonus. The group is also considering a switch to residual income (RI) or economic value added (EVA) for divisional performance measurement.
1. Calculate Division A’s ROI and RI before and after the new contract, and explain why the manager’s decision may conflict with group goals.
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ROI and RI
- Current ROI = £1.12m / £8.0m = 14.0%.
- Post-contract ROI = (£1.12m + £0.26m) / (£8.0m + £2.0m) = £1.38m / £10.0m = 13.8%.
- Current RI = £1.12m - (11% × £8.0m) = £1.12m - £0.88m = £0.24m.
- Post-contract RI = £1.38m - (11% × £10.0m) = £1.38m - £1.10m = £0.28m.
The contract earns 13%, which is above the 11% cost of capital, so it creates value. The project’s own RI is £0.26m - (11% × £2.0m) = £0.04m. Under ROI, the manager rejects because the division’s average return falls from 14.0% to 13.8%, even though group value rises. Under RI, the manager accepts because RI increases by £0.04m. This is a classic goal-congruence conflict: a bonus based on ROI encourages underinvestment and may also encourage disposal of assets with returns below the current average but above the cost of capital.
2. Recommend which performance measure Nordlake should adopt, and discuss two behavioural risks of the change.
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Recommendation
Nordlake should use RI or EVA, not ROI, as the primary financial measure for capital-allocation decisions. RI charges each division for the capital it uses and accepts any project with a positive spread over the 11% cost of capital, which aligns the manager’s incentive with group value. EVA extends this by adjusting accounting profit and capital for items such as capitalised development, provisions and leases, but it is more costly to administer.
Behavioural risks
- Size bias: RI is an absolute measure, so managers may prefer large projects simply because they add more RI, even if smaller projects have higher returns. This can be controlled by also reporting the RI spread or return on the incremental investment.
- Asset-disposal bias: managers may sell assets whose return is below the divisional average but above the cost of capital, or may delay replacement investment to protect short-term RI. This can be controlled by using replacement-cost asset bases, multi-year bonus scorecards and non-financial measures.
RI/EVA should be supported by a balanced scorecard covering quality, delivery and customer retention, and the bonus should be capped and smoothed over a three-year cycle.