Question

For purposes of evaluating the relative financial performance of investment centers, residual income (RI) (relative to ROI) is limited in terms of ______.

Option 1:
considering non-operating income.

Option 2:
ignoring the cost of capital.

Option 3:
incorporating non-cash expenses.

Option 4:
excluding after-tax cash operating income.

Answer 1

Residual income (RI) is limited in evaluating financial performance as it ignores the cost of capital, which is crucial in understanding profit in relation to the investment made. Option 2 correctly points out this limitation of RI compared to ROI, which typically takes the cost of capital into account.

Step-by-step explanation:

When evaluating the relative financial performance of investment centers, residual income (RI) is limited in terms of ignoring the cost of capital. Residual income is a measure of the absolute amount of profit that exceeds the minimum rate of return required by a company or its investors, known as the cost of capital. Option 2 indicates this limitation, as RI could overstate the financial performance if it does not take into account the cost of the funds used to generate the profit. In contrast, return on investment (ROI) measures the efficiency with which capital is used, regardless of the actual dollar amount of return and typically accounts for the cost of capital.