Question:
Larry Smith is a division manager of Carroll Manufacturing Inc. Mr. Smith is presently evaluating a potential revenue generating investment that has the following characteristics: An initial cost of $1,000,000 and net annual increase in divisional income before consideration of depreciation:
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Year 1
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$100,000
|
|
Year 2
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$150,000
|
|
Year 3
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$190,000
|
|
Year 4
|
800,000
|
|
Year 5
|
800,000
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The project would have a five-year life with no salvage value. All assets are depreciated according to the straight-line method. Mr. Smith is evaluated and compensated based on the amount of pretax profit his division generates. More precisely, he receives an annual salary of $300,000 plus a bonus equal to 2 percent of divisional pretax profit. Before consideration of the above project, Mr. Smith anticipates that his division will generate $2,000,000 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 Mr. Smith's compensation for each of the five years.
c. Based on your computations in part (b), will Mr. Smith be hesitant to invest in the new project? Explain.
d. Would upper management likely view the new investment favorably? Explain.