Final answer:
Residual income can incentivize managers to pursue profitable investments that would be neglected if decisions were based solely on ROI. This is because it allows consideration of the actual profit over the minimum required return, rather than just the investment's impact on ROI percentage. External sources of capital, like borrowing or attracting investors, are often necessary for sustainable growth and continued investment opportunities.
Step-by-step explanation:
Residual income is a financial performance measure that can provide an incentive for managers to make profitable investments, which might otherwise be rejected under solely an ROI (return on investment) approach. While ROI evaluates performance based on the ratio of operating income to capital employed, which could potentially disincentivize managers from pursuing projects that might lower their overall ROI despite being profitable, residual income focuses on the actual dollar amount of operating income earned above a minimum required return on capital. This can encourage managers to undertake additional projects as long as they generate more than the cost of capital, leading to potentially more robust investment decisions and growth for the company.
Firms often need to reinvest profits for continued growth and operations, especially during periods when external capital sources are necessary. If a firm only relied on its profits, it might not endure through challenging financial times or capitalize on important investment opportunities. Thus, seeking financial capital from outside investors, through means such as borrowing from banks or issuing bonds, might be necessary for sustainability and expansion.