Financial Performance Measures Revision

Return on Investment (ROI)

ROI, sometimes referred to as Return on Total Assets (ROTA), is the percentage return calculated by dividing a business unit's profit by the invested capital used to generate that profit. The formula is: \text{ROI} = \frac{\text{Profit}}{\text{Invested Capital}}. For example, a profit of $250,000 with an investment of $1,000,000 yields an ROI of 25%.

Residual Income

Residual income is the dollar amount of profit remaining after subtracting an imputed interest charge. The formula is: \text{Residual Income} = \text{Profit} - (\text{Invested Capital} \times \text{Interest Rate}). The interest rate is typically the required rate of return or the weighted average cost of capital (WACC). For instance, with a $250,000 profit, $1,000,000 invested capital, and a 15% imputed interest rate, the residual income is $100,000.

Weighted Average Cost of Capital (WACC)

WACC and the required rate of return are considered the same in financial management. It represents the return a business needs to earn to satisfy its owners and debt providers. Capital is not free; owners and debt holders expect returns. A balance sheet shows the capital structure, including long-term debt and equity. The cost of capital differs between debt and equity due to varying risk profiles; debt is less risky and has a lower required rate of return.

WACC Calculation and Implications

Assuming equity holders require a 30% return and debt holders require 10%, the weighted average cost of capital can be calculated based on the capital structure. For example, with a capital structure of 25% equity and 75% debt, the WACC is 15%. This means a project must earn at least 15% to keep investors happy. The WACC is the combined cost of all capital sources. It is also the discount rate used in present value calculations.

ROI vs. Residual Income

Both ROI and residual income indicate returns above the required rate. A residual income of zero means the company is earning exactly its required rate of return. WACC is used as a hurdle rate for investments; projects not meeting this rate are not pursued. It is often used as an imputed interest rate to assess division or project performance.