The company uses a straight-line depreciation method for accounting and tax purposes — Kitchen Appliances Inc multi-division with each major product managed separate division

Kitchen Appliances, Inc., is a multi-division company with each major product line managed by a separate division. Divisional managers have complete autonomy with respect to operating and investment decisions. The company evaluates its division managers on ROI, calculated as operating income before taxes divided by net book value of assets (averaged over the year). The firm pays particular attention to year-over-year growth in ROI as well as budget-actual comparison of the measure.

Wendy Miller is the manager of the dishwasher division. Wendy expects that the operating income for the current year will be $2,400,000 before taxes. Given a net asset base of $6,800,000, the division’s ROI would be a healthy 35%, well above the average return from other divisions. This performance has been fairly representative of the way things have been going for Wendy. She expects a similar performance next year as well and is looking forward to her promotion into the C-suite (the corporate office).

Toward the end of the current year, an investment opportunity arises for Wendy—the possibility of introducing a new dishwasher model with improved features. The following table presents some salient financial information that Wendy’s managers put together for her evaluation:

.:.

The company uses a straight-line depreciation method for accounting and tax purposes.

Required:

a. Does the investment opportunity have a positive net present value? From the company’s viewpoint, should the project be accepted?

b. Will Wendy accept the project? Make a recommendation after calculating her ROI with and without the investment. Assume that investment occurs at the start of the year.

c. Assume that the company evaluates its divisional managers based on residual income, using a 12% required rate of return. What is the dishwasher division’s expected residual income for the current year (without the proposed investment)? With the proposed project?

d. Comment on why ROI and RI might lead to differing incentives regarding project investments.

SOLUTION:

(a) To evaluate the investment, let us first calculate the annual after-tax cash flow.

Pre-tax cash flows are $800,000 - $300,000 - $100,000 = $400,000.

Taxable income per year = $400,000 - $150,000 = $250,000.

Taxes paid = 0.3 × $250,000 = $75,000.

Thus, after tax cash flow per year = $400,000 - $75,000 = $325,000.

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The NPV of this proposal (at 12% rate) is $336,332.

We can also treat the cash inflow as an annuity. The annuity tables for 10 years and 12% show a factor of 5.650, meaning that the present value of the cash inflows is $1,836,322. (Notice that this amount for the PV of the cash inflows reconciles with the Net Present Value of $336,332 = $1,836,332 - $1,500,000.)

The payback period is just under five years.

Thus, the project meets corporate standards for funding. The project should be accepted.

(b) We know that Wendy’s expected ROI without the investment is:

$2,400,000 / $6,800,000 = 35.29%.

Let us now calculate her ROI with the investment:

Her new income is ($2,400,000 + $250,000) = $2,650,000

Her new asset base is (6,800,000 + $1,425,000) = $8,225,000.

Notice that the new project only adds $1,425,000, which is the average of the beginning and ending values ($1,500,000 and $1,350,000)

Thus, her revised ROI is 32.2% (=$2,650,000 / $8,225,000). Wendy is not likely to push for the project.

The RI with the new investment is $2,650,000 – (0.12 × $8,225,000) = $1,663,000.

That is, the project increases the division’s residual income. Wendy is likely to favor the project.

(d) This example illustrates the incentive to under-invest that is created when using ROI as a performance measure. Because it is a ratio, we can think of a division’s ROI as a weighted average of the ROI of all the projects undertaken by the division. If we add a new project that is below the weighted average, it will drag down the division’s ROI. Thus, the division manger would be disinclined to push for the project. The use of residual income reduces this incentive. This simple answer is enough for the case because the annual cash flows are identical over time.

A more general analysis also takes into account the pattern of cash flows and depreciation. Generally, investments generate low income and add greatly to the asset base during the early years. That is, the annual ROI of a project increases over its life. This feature adds to the problem. This feature also reduces the power of residual income to alleviate the under-investment problem. The conflict arises because accounting measures usually capture performance over one year only, while investment decisions (by definition) span many years.