Exam 3 - Practice Problems.pdf

# Project 1 exam 3 practice problems page 63 4 3 points

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Project 1

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Exam 3 – Practice Problems Page 63 4. (3 points) Based on a recent conversation with a compensation consultant, the chairwoman of Viper Squad’s board of directors is considering the possibility of changing the measure used to evaluated divisional performance and as the basis for determining a manager’s bonus from divisional return on investment (ROI) to divisional residual income (RI) defined as. RI t = I t ! ® × NA t-1 ) where r is the firm’s cost of capital If Keel Bill’s bonus was based on the residual income earned by his division, rather than on its return on investment, which of the two project(s) would he choose? Circle each of projects that he would choose and provide support for your answer. Project 1 Project 2 Because of the Conservation Property of Residual Income NPV(RI) = NPV(Cash Flow) From Q1, the NPV(Cash Flow) for both Project 1 and Project 2 are greater than 0. Therefore, Bill will approve both. 5. (4 points) Explain how the problem of under- or over- investment by division managers would be affected, if divisional performance and managerial compensation were based on a division’s return on investment measured as: ROI t = . Using a residual income based measure has the potential to overcome the under-, over- investment problem. However, the proposed measure is analogous to an ROI measure and suffers from the same problem. The manager will only choose the most efficient projects (i.e. those that increase the divisional performance measure). Consequently, under- investment will result.
Exam 3 – Practice Problems Page 64 Han-Ova Corp. uses a target bonus plan based on three performance measures in order to compensate the managers of their divisional investment centers. The performance measures are Accounting Income (AI), Return on Investment (ROI), and percentage of faulty products. The company’s cost of capital is 5%. The company’s bonus plan is described below: Accounting Income Weight Minimum Target Maximum 40% \$ 4,000,000 \$ 5,000,000 \$ 6,000,000 Bonus (% of salary) 5% 10% 15% Return on Investment 30% 10% 11% 12% Bonus \$10,000 \$15,000 \$25,000 Percentage of faulty products 30% 2% 3% 4% Bonus \$10,000 \$5,000 \$2,000 For 2012, the manager of division 96, Ch. Dolo, will be paid an annual fixed salary of \$100,000. Required: (Where necessary round your answers to 2 decimal places.) 1. (6 points) For 2012, Ch. Dolo expects Division 96 to earn an AI of \$5,200,000, to achieve an ROI of 10% and to limit the level of faulty products at 2.8%. Calculate Ch. Dolo’s expected total compensation for 2012. Ch. Dolo’s expected total compensation for 2012 \$ 2. (6 points) Before the products of Division 96 are packaged, an automated process quickly checks the quality of the products (using “goal-line technology”). At the beginning of 2012, Ch. Dolo is trying to decide whether to sell the machine at it’s current book-value of \$2,000,000. If the machine is sold, it will not be replaced.

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