Which statement explains how RI mitigates ROI drawbacks?

• A. ROI ignores the cost of capital and focuses on short-term gain.
• B. ROI focuses on short-term cash flows alone.
• C. ROI rewards only efficiency without capital cost consideration.
• D. RI accounts for the cost of capital and promotes investing in profitable assets.

Answer: (D)

Residual income works by charging a cost for the capital tied up in the investment and only rewarding profits that exceed that cost. By subtracting the capital charge from operating profit (or NOPAT), RI directly reflects whether a project genuinely creates value above the required return. This alignment means managers are incented to invest only in assets that earn more than the cost of the funds used, rather than chasing high percentage returns that may still be financed by costly capital. In other words, RI accounts for the cost of capital and promotes investing in profitable assets, addressing ROI's tendency to overlook whether the capital employed is costing enough to justify the investment. The other statements describe limitations of ROI—ignoring capital cost and focusing on short-term gains—not how RI improves decision-making.