Problem:
PAYBACK, NPV, MANAGERIAL INCENTIVES, ETHICAL BEHAVIOR
Kent Tessman, manager of a Dairy Products Division , was pleased with his division's performance over the past three years. Each year, divisional profits had increased, and he had earned a sizable bonus. (Bonuses are a linear function of the division's reported income.) He had also received considerable attention from higher management. A vice president had told him in confidence that if his performance over the next three years matched his first three, he would be promoted to higher management.
Determined to fulfill these expectations, Kent made sure that he personally reviewed every capital budget request. He wanted to be certain that any funds invested would provide good, solid returns. (The division's cost of capital is 10 percent.) At the moment, he is reviewing two independent requests. Proposal A involves automating a manufacturing operation that is currently labor intensive. Proposal B centers on developing and marketing a new ice cream product. Proposal A requires an initial outlay of $250,000, and Proposal B requires $312,500. Both projects could be funded, given the status of the division's capital budget. Both have an expected life of six years and have the following projected after-tax cash flows:
|
Year
|
Proposal A
|
Proposal B
|
|
1
|
$150,000
|
$ (37,500)
|
|
2
|
125,000
|
(25,000)
|
|
3
|
75,000
|
(12,500)
|
|
4
|
37,500
|
212,500
|
|
5
|
25,000
|
275,000
|
|
6
|
12,500
|
337,500
|
After careful consideration of each investment, Kent approved funding of Proposal A and rejected Proposal B.
Required:
1. Compute the NPV for each proposal.
2. Compute the payback period for each proposal.
3. According to your analysis, which proposal(s) should be accepted? Explain.
4. Explain why Kent accepted only Proposal A. Considering the possible reasons for rejection, would you judge his behavior to be ethical? Explain.