Managerial incentives of performance evaluation based on accounting data. A firm with an opportunity cost of capital of 15 percent faces two mutually exclusive investment projects:
(1) Acquire goods at the start of the year, ship them to Japan, and sell them at the end of the year. The internal rate of return on this project is 20 percent, and it has positive net present value.
(2) Make certain expenditures today that will cause reported earnings for the year to decline. This will result, however, in large cash flows at the end of the second and third years. The internal rate of return on this project is 30 percent, and it has even larger net present value than the first project. Management observes that for the current year, the second project will result in smaller earnings reported to its shareholders than the first.
How might management's observation influence its choice between the two investment projects?