Question

Compare and Contrast the use of return on investment and residual income in evaluating investments centers.

Answer 1

There are various methods for evaluating investments centres.
One of such two methods are return on investment and residual income method.

The following are their main points :

Return on investment

• One of the most commonly used method to compare between two projects.
• This method works on the principle that how much returns we will receive on the investment made.
• Return of Investment can be measured as ROI > 1, ROI =1 , ROI <1.

1. Investment which is profitable will have ROI >1.
2. Investment which is no profit no loss will have ROI =1.
3. Investments which is loss will have ROI <1.

Residual Income

• It measures the overall net income an investment earns.
• It involves the equity charge, which is product of equity capital and cost of capital.
• It is evaluation of business equity.
• It calculate the rate of return which is helpful for investors and managers.
• In certain cases where project shows profit, residual income method may show that such project is not profitable.