The Effects of Return on Investment and Residual Income Measures on Risk-Taking in Capital Investment Decisions

Abstract

We conduct an experiment to examine the separate and interactive effects of individuals’ risk preferences and two commonly-used performance measures – return on investment (ROI) and residual income (RI) – on the riskiness of capital investment decisions. We predict and find that the use of ROI as a performance measure leads to riskier choices as compared to RI, and that this effect tends to be concentrated in relatively more risk-averse individuals. We also provide process evidence that reveals some of the ways in which performance measures affect individuals’ decisions. Our results are consistent with theory from psychology (security-potential/aspiration theory), in that ROI potentially induces more risk-taking by enabling individuals to more easily satisfy aspirations for a positive performance measure outcome than RI, thus freeing them to focus more on striving for high outcomes. Collectively, our results contribute to literature examining the effects of accounting information and performance measures on managers’ risk-taking behavior.