Why might ROI discourage necessary investments, and how can RI help?

• A. ROI is perfect; RI is irrelevant.
• B. ROI ignores cost of capital; RI ignores project value.
• C. ROI measures social impact; RI measures environmental impact.
• D. ROI penalizes assets with long payback; RI accounts for cost of capital and allows investing in projects with positive value despite ROI impact.

Answer: (D)

ROI and RI look at capital differently. ROI compares accounting profit to the capital invested, so when a project requires a large upfront investment, the denominator grows and the ROI can fall even if the project is worthwhile. Since ROI doesn’t deduct the cost of capital, it can mislead decision-makers into avoiding investments that would create value in the long run.

Residual income changes the lens by subtracting a charge for the cost of capital from the operating profit. RI = operating profit minus the cost of capital times invested capital. This means a project only needs to earn more than the cost of that capital to be considered value-adding. So even if ROI is depressed by a long payback or a big upfront investment, a positive RI shows the project creates value.

That’s why the correct choice emphasizes that ROI penalizes long payback assets, while RI accounts for the cost of capital and allows investing in projects with positive value despite ROI impact.