Residual Income (RI) helps investment decisions by:

• A. It ignores capital cost.
• B. It only considers payback period.
• C. It accounts for the cost of capital and allows investing in positive-value projects despite ROI signals.
• D. It focuses on break-even point.

Answer: (C)

Residual income measures economic profit by subtracting the cost of capital from the operating profit after tax. In simple terms, RI = NOPAT − (cost of capital × capital employed). A positive RI means the project earns more than the minimum required return on the capital used, so it adds value to the firm. This matters because it brings the cost of capital into the decision process, unlike other metrics that focus only on percentage returns. By evaluating absolute value created, RI lets you compare opportunities of different sizes and invest in positive-value projects even when their ROI signals are not clearly favorable. For example, with a cost of capital of 8% and capital employed of 500,000, the required return is 40,000; if NOPAT is 50,000, RI is 10,000, indicating value creation.