Question:
Sarah Birch is a division manager of Georgia Pine Inc. She is presently evaluating a potential revenue-generating investment that has an initial cost of $8,000,000 and the following characteristics: Net annual increase in divisional income before consideration of depreciation:
|
Year 1
|
$800,000
|
|
Year 2
|
1,200,000
|
|
Year 3
|
1,520,000
|
|
Year 4
|
6,400,000
|
|
Year 5
|
6,400,000
|
The project would have a 5-year life with no salvage value. All assets are depreciated according to the straight-line method. Sarah is evaluated and compensated based on the amount of pretax profit her division generates. More precisely, she receives an annual salary of $150,000 plus a bonus equal to 8 percent of divisional segment income. Before consideration of the above project, Sarah anticipates that her division will generate $9,200,000 in pretax profit.
a. Compute the effect of the new investment on the level of divisional pretax profits for years 1 through 5.
b. Determine the effect of the new project on Sarah's compensation for each of the five years.
c. Based on your computations in part (b), will Sarah be hesitant to invest in the new project? Explain.
d. Would upper management likely view the new investment favorably? Explain.