Question

As indicated in the chapter, return on investment (ROI) is well entrenched in business practice. However, its use can have negative incentive effects on managerial behavior. For example, assume you are the manager of an investment center and that your annual bonus is a function of achieved ROI for your division. You have the opportunity to invest in a project that would cost $550,000 and that would increase annual operating income of your division by $50,000. (This level of return is considered acceptable from top management’s standpoint.) Currently, your division generates annual operating profits of approximately $625,000, on an asset base (i.e., level of investment) of $4,150,000.

Required:

1. What is the current return on investment (ROI) being realized by your division (i.e., before considering the new investment)?

2. What would happen to the near-term ROI of your division after adding the effect of the new investment?

3. As manager of this division, given your incentive compensation plan, would you be motivated to make the new investment?

Answer 1

ROI = net profit / total investment

1. What is the current return on investment (ROI) being realized by your division

• ROI = $625,000 / $4,150,000 = 15.06%

2. What would happen to the near-term ROI of your division after adding the effect of the new investment?

• ROI = ($625,000 + $50,000) / ($4,150,000 + $550,000) = 14.36%

If you carry out the new project the ROI of your division will decrease.

3. As manager of this division, given your incentive compensation plan, would you be motivated to make the new investment?

• Even though the new project's return (9.1%) is considered acceptable by upper management, you will probably reject it since it will decrease your division's total ROI. When managers are assigned bonuses based on certain achievements, reducing your profitability ratio will probably result in no bonus.