Question: The Marketing division of Prime Consultants Plc is specialising in specialised overseas marketing consultancy and is already operating at a good profit. The manager of this division has now been offered a new investment opportunity to which the following information relates:
I. Initial new investment will be £3,000,000 with a project life of three years and nil residual value. The company uses straight-line depreciation method to write off the investment in its books.
II. The new project is expected to generate consultancy fee revenue of £1,900,000 p.a. The salaries of direct staff involved in this project will amount to £400,000 p.a. and will remain constant throughout the three-year period due to efficiency gains. Likewise the revenue figures of £1,900,000 p.a. will also remain constant over the three-year life of the product.
III. Other expenses for the various facilities in respect of this new project will amount to £200,000 p.a. and these will also remain constant at this level for the three-year life of the project.
IV. Return on Investment (ROI) is calculated by using the net book value of the Investment employed in the division at the start of each year.
V. The Marketing division's current ROI achieved on its other existing projects is 10.5%.
VI. The target required return (which is the cost of capital) of the company Prime Consultants Plc as a whole is pitched at 9%. Present value discount & annuity factors for 9% are given as follows:
| year (rate 9%) |
discount factor |
annuity factor |
| 1 |
0.91743 |
0.91743 |
| 2 |
0.84168 |
1.75911 |
| 3 |
0.77218 |
2.53129 |
Required: a) Discuss the acceptability of the new proposal by the manager of Marketing division if he is assessed and rewarded on his performance measured by using ROI method. Your arguments should be supported by relevant calculations for the ROI figures for all the three years life of the project.
b) How would, in your opinion, the decision on acceptability of this new project change if instead of ROI, the manager of the division was assessed and rewarded on the basis of RI (Residual Income) method? Again your arguments should be supported by relevant calculations for the RI figures for all the three years life of the project.
(c) Calculate and present the figures for Residual Income for all the three years using annuity depreciation based on a cost of capital of 9%.
(d) What is the difference between RI and EVA (economic value added)?