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

	Current Division Before New Investment	New Investment	Current Division after New Investment
Operating income	$                             625,000	$                     50,000	$                               675,000
Divided by: Investment	$                         4,150,000	$                  550,000	$                           4,700,000
Return on investment (ROI)	15.06%	9.09%	14.36%
Current return on investment (ROI) being realized by your division (i.e., before considering the new investment)			15.06%
ROI of your division after adding the effect of the new investment			14.36%
As manager of this division, given your incentive compensation plan, would you be motivated to make the new investment?			No
As manager of this division, I would not motivated to New investment. ( Because of new Investment is Lower ROI compared to Current division.			Reject