Question 1

The direct comparison of the performance of two different investment centers is difficult using residual income because residual income is an absolute measure.

Accepted Answer

Residual income is an absolute measure that does not take into account the size of the investment, making direct comparisons between different investment centers challenging without additional relative performance metrics.

Question 2

Unlike ROI, residual income does not encourage a short-run orientation.

Accepted Answer

False

Question 3

Turnover is the most common measure of performance for an investment center.

Accepted Answer

Turnover is a measure of efficiency, not necessarily performance. Return on investment (ROI) and economic value added (EVA) are more commonly used measures of performance for an investment center.

Question 4

Decentralization is usually achieved by creating units called divisions.

Accepted Answer

Decentralization involves delegating decision-making authority from a central authority to units or divisions within an organization. Therefore, the statement is true.

Question 5

Decreasing inventories leads to a reduction in return on investment (ROI).

Accepted Answer

Decreasing inventories can actually increase ROI by reducing holding costs and freeing up capital for other investments, thus potentially improving overall returns.

Question 6

A production department within the factory, such as assembly, is an example of a profit center.

Accepted Answer

A production department like assembly is typically considered a cost center because it incurs costs to produce goods but does not generate revenue directly; profit centers are responsible for both revenue generation and cost.

Question 7

The net income reduced by the total annual cost of capital is equal to the economic value added.

Accepted Answer

Economic value added (EVA) is the measure of a company's financial performance based on the residual wealth calculated by deducting the cost of capital from its operating income. Therefore, the net income reduced by the total annual cost of capital is equal to the economic value added.

Question 8

Turnover is the ratio of sales to average operating assets.

Accepted Answer

Turnover is calculated by dividing sales by the average operating assets. It measures how efficiently a company is using its assets to generate revenue.

Question 9

Basically, EVA is residual income with the cost of capital equal to the actual cost of capital for the firm (as opposed to some minimum rate of return desired by the company for other reasons).

Accepted Answer

EVA is a measure of residual income that takes into account the actual cost of capital for the firm, rather than a company's desired minimum rate of return.

Question 10

Residual income is the difference between operating income and the product of the hurdle rate and the company's average operating assets.

Accepted Answer

Residual income is calculated as operating income minus (hurdle rate x average operating assets).

Question 11

A key feature of economic value added (EVA) is that it emphasizes after-tax operating income and the actual cost of capital.

Accepted Answer

Economic value added (EVA) is a performance measure that takes into account the after-tax operating income of a business and compares it to the actual cost of capital. By emphasizing after-tax operating income, EVA provides a more accurate picture of a company's profitability than traditional measures such as net income or earnings per share. Additionally, by incorporating the actual cost of capital, EVA helps to identify opportunities for value creation by pinpointing which investments or projects are generating returns above or below their true cost of capital.

Question 12

Residual income is sometimes used to overcome the tendency of ROI to discourage investments that are profitable for the company, but that lower the division's ROI.

Accepted Answer

Residual income measures the excess of actual return earned by an investment over the minimum required return, which takes into account the cost of capital. It is a useful tool for evaluating investments that may have a lower ROI but still add value to the company. This is because residual income measures the dollar amount of value created by an investment, rather than just its return as a percentage of investment.

Question 13

In a decentralized company, overall profit margins can mask inefficiencies within the various subdivisions.

Accepted Answer

The answer of In a decentralized company, overall profit margins...

Question 14

Economic value added is just a specific way of calculating residual income.

Accepted Answer

Economic value added (EVA) is a measure of financial performance that calculates the difference between the return on a company's capital and the cost of that capital. Residual income is a similar concept, but more broadly refers to the profits a company earns above its required minimum rate of return on invested capital. EVA can be considered a specific way of calculating residual income, as it focuses specifically on economic profits.

Question 15

The use of residual income encourages managers to accept any project that earns above the minimum rate.

Accepted Answer

Residual income is a performance measure that calculates the return earned by a division or project above its required minimum rate of return. Therefore, managers are incentivized to accept projects that earn a return above the minimum rate since they will increase the residual income of the division or project, indicating a successful performance.

Question 16

Return on investment (ROI) can be calculated by multiplying margin times turnover.

Accepted Answer

ROI is calculated by dividing net profit by total investment and then multiplying by 100. Margin is the ratio of net profit to revenue, and turnover is the ratio of revenue to total assets. Therefore, ROI can be calculated by multiplying margin times turnover.

Question 17

In calculating residual income, the minimum rate of return is set by top management and is the same as the hurdle rate used for return on investment.

Accepted Answer

This is because the minimum rate of return, also known as the required rate of return, is the rate that must be achieved in order for the investment to be considered worthwhile. This minimum rate is typically set by top management and is used as the hurdle rate for calculating both Return on Investment (ROI) and Residual Income (RI).

Question 18

In a decentralized company, central management is able to focus on strategic planning and decision making.

Accepted Answer

In a decentralized company, lower-level managers are empowered to make operational decisions, allowing central management to focus more on strategic planning and broader decision making.

Question 19

Economic value added (EVA) is similar to ROI in that it links net income to capital employed.

Accepted Answer

Economic value added (EVA) is a financial performance metric that calculates the net operating profit after taxes (NOPAT) minus the cost of capital, and it measures the value a company generates from the funds invested in it. Similarly, return on investment (ROI) measures the profitability of an investment by dividing the net income by the total amount of capital invested. Therefore, they are similar in that they both relate financial performance to capital employed.

Question 20

The practice of delegating decision-making authority to lower levels of management in a company is called centralization.

Accepted Answer

The practice of delegating decision-making authority to lower levels of management in a company is called decentralization, not centralization.

Quiz 12: Performance Evaluation and Decentralization