 Hello and welcome to the session in which we would look at residual income, R.I. and how does it relate to return on investment, R.O.I. Before we start I would like to remind you that if you are an accounting student and specifically if you are a CPA candidate I strongly suggest you check out my website farhatlectures.com. My website does not replace your CPA review course whether you are taken Becker, Roger, Gleim or Wiley. I can be a useful addition to your CPA course where I can add 10 to 15 points because I explain the material little bit more in details than a CPA review course. So here's my offer to you. Are you willing to risk $29 or $30 for a month to try out my subscription to find out whether I can add those points to you? So your risk is $30, your potential return is passing your CPA exam. And if not for anything, check out my website to find out how well is your university doing on the CPA exam. I do have lectures for other courses such as financial accounting, intermediate accounting, cost, tax, audit, finance. Please connect with me on LinkedIn and check out my recommendation, like this recording and share it on YouTube. Connect with me on Instagram and Facebook. In the prior session we looked at return on investment and R.O.I. And let's recap real quick about what we did. We were looking at two divisions and let's focus right here for now. The North Division and the South Division. And we computed the North and the South Division and we find out that the return on investments for the North Division is 20%. R.O.I. for the South Division is 13.33. And for the whole company is 14.29. Basically return on investments is operating income divided by average asset. Now in the prior session we looked at return on investment in details. This is just a review. Then we said let's introduce a new product for the North Division. Let's assume the North Division can expand by investing $200,000 under a new assets and as a result they can generate an additional 30,000 in operating income. And what we did is we computed the new return on investment and what we find out the North Division return on investment goes from 20 to 16% for the North Division if they undertake this new project, if they add the assets and add the new operating income. And what we said is this is one of the weakness of R.O.I. What happens is it de-incentifies the managers and taken on a new project. Why? Because the manager is happy with the 20% the new 16% will lower their R.O.I. However, when we look at the company overall if this manager takes on this project and we would look at R.O.I. It goes from 14.29 to 14.55. The company is better off if the manager takes the project but the manager themselves are not better off because their R.O.I goes down from 20 to 16. So residual income will overcome this moral hazard. So rather than judging the manager of the division based on R.O.I. We're going to look at R.O.I. at residual income. Now how do we compute residual income? Then we'll explain how it works. Residual income is basically taking the difference between the actual profit or income. However, we're going to compute this and the opportunity cost of capital invested in the unit. Capital invested means how much assets did we give you? So simply put we're going to judge you on how well you used the asset because if we don't give you the assets, if we don't give you those property, plant and equipment, warehouse, manufacturing facilities, we're going to have to give it to somewhere else, someone else. The resources give it to somewhere else. So this is our opportunity cost. So what is the difference between how much profit you make and the opportunity cost we have lost? Simply put we're going to take your after tax income or some sort of a profit measurement and find the difference minus the division's asset. Those are your resources multiplied by something called the R.O.I. or the required rate of return. It's a very simple straightforward concept. So how much profit did you make versus how much assets we gave you and what did we require you to earn on this asset? And how do we compute the required rate of return? The required rate of return could be called the hurdle rate. The hurdle rate is the rate that the company wants you to earn. For example, the company could have a hurdle rate of 12 percent. Another company could have a hurdle rate of 14. Now obviously if you have a 14 percent you have a higher hurdle rate. If the hurdle rate of the company is 10 percent then it's easier to overcome 10 percent. How do we come up with this hurdle rate? Generally speaking it's the cost of capital. What is the cost of capital? How much is the company required to incur in cost under debt and equity? Okay so how much what's your cost of capital? Your cost of capital could be if you have debt and equity it's the average, the weighted average of those two. If you have only equity it's the cost of equity. If you only have debt it's the cost of debt. Okay so it's the opportunity cost of the firm's asset from both debt and equity. So what else can we do with those assets if we're not going to assign those assets to your division? So let's see how does residual income overcome the weakness of overcome the weakness of return on asset. Let's go back to the same example. Now the only difference we're going to add to this example the company has a hurdle rate of 13 percent. Let's see what happened under the new assumption. Let's compute now the old residual income for this company. The old residual income which is based on before the expansion the profit for the division is 10,000 minus the division has 50,000 in asset times the hurdle rate. The company would expect you to earn 13 percent. Well the company would expect you to earn 6,500. You earn 10,000. You have a positive residual income. Everyone is happy now. Let's assume you undertake this project and now this is your new income, your new picture. Your new residual income is 40,000. Now you have 250,000 of assets multiplying by 13 percent. Your new residual income is 7,500. You more than doubled your residual income. Although your return on investment went down but if I'm judging you based on the residual income you are making more residual income. So you will undertake this project. What the residual income does is this. The residual income, one advantage of the residual income is, is you will take any project that's higher than the hurdle rate and obviously 16 percent is higher than 13 percent. Therefore you will undertake this project if you are being judged on ROI, residual income, not ROI. If you are being judged on ROI you will not take the project because your rate goes from 20 to 16. But under OI, your R-I, not OO, under R-I your residual income goes from 3,500 to 7,500. So what are the advantages and disadvantages of residual income? Minimum rate of return is taken into account. So before you, whether you accept and none accept the project, the minimum means this is the R-R-R. The required rate of return. The company's required rate of return is taken into account and managers will accept any project that's greater than or equal to to the firm required rate of return. So we are looking at the required rate of return and we are trying to beat to overcome this hurdle. Now what are the disadvantages of residual income? And I hope you already kind of, by going over this, you already kind of thinking about the disadvantages. One of the disadvantages is, remember R-I is a dollar amount versus ROI. ROI gives you a percentage, it's a ratio. Residual income is a number and when you have a number, it doesn't take into account the size of the division. Simply put, if you have more assets, you might generate more dollar amount in terms of dollar and you would look very good for residual income just because of your size versus a smaller division. They did better but you did way better than them because if you're a larger division. Versus R-I, it doesn't take into account ROI, which is the percentage, it doesn't take into account, it does take into account the size because once you factor everything as a percentage, size is factored out. And also the required rate of return may be chosen unreasonably or arbitrarily. Basically the company wants to earn, for example, 15% and there's no reasonable explanation why 15%. So if that number is chosen arbitrarily, then the manager may not take certain project, well in reality they are profitable project. At the end of this recording, I would like to remind you again to check out my website like this recording, especially if you're studying for your CPA exam, check out my website because I can be useful addition to your CPA course and check out your university or college CPA score to find out how well is your university doing. Best of luck study hard and stay