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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) = $2,650,000Her 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 end-ing values ($1,500,000 and $1,350,000) Balakrishnan, Sivaramakrishnan, & Sprinkle – 2eFOR INSTRUCTOR USE ONLY12-27
Thus, her revised ROI is 32.2% (=$2,650,000 / $8,225,000). Wendy is not likely to push for the project. c.The RI without the investment is $2,400,000 – (0.12 × $6,800,000) = $1,584,000.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 av-erage of the ROI of all the projects undertaken by the division. If we add a new project that is be-low the weighted average, it will drag down the division’s ROI. Thus, the division manger wouldbe 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.Note: 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 prob-lem. 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.12.69a.Annie’s choice of performance measure (ROI) indicates that she views each store as an invest-ment center. This choice seems odd at first glance. After all, managers seem to have little control over investments – any amount over $1,000 is personally approved by Annie using somewhat subjective criteria. Further, the manager exercises limited control over the cost of the land and buildings, the primary fixed assets for a nursery.However, further reflection indicates that ROI might be a good measure. After all, inventories of plants and supplies are probably the largest item in the balance sheet for a branch. The manager exercises considerable control over inventory values both by controlling the variety and quantity of plants ordered. If Annie did not “charge” for inventory in some way, the managers have the in-centive to over-order (which is expensive) and limit the store’s profitability. All in all, we would generally agree with Annie’s classification of the stores as investment centers.