Question

Which one of the following is a correct statement about residual income?

a) It evaluates performance by comparing the return of an investment centre to the total assets employed.
b) It evaluates performance by comparing the net income of an investment centre to the average common equity.
c) It evaluates performance by comparing the net income of an investment centre to a target rate of return on the average operating assets employed.
d) It evaluates performance by comparing the return on investment of an investment centre to the industry average.

Answer 1

Residual income compares the net income of an investment center to a target rate of return on average operating assets employed, reflecting the economic profit created beyond the capital cost.

Step-by-step explanation:

The correct statement about residual income is: It evaluates performance by comparing the net income of an investment centre to a target rate of return on the average operating assets employed. This means that residual income is a measure that helps to assess how much above or below a particular business unit is performing in comparison to a predefined benchmark or target rate of return set by the company.

Residual income is a useful tool for evaluating investment centers within a company because it takes into account the cost of capital employed in generating earnings. Unlike measures such as return on investment (ROI), which do not consider the cost of the capital used, residual income reflects the real economic profit created by the investment center.