Question

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.

The present value tables provided in Exhibit 19B.1 and Exhibit 19B.2 must be used to solve the following problems.

Required:

1. Compute the NPV for each proposal. Round intermediate calculations and your final answers to the nearest dollar.

	NPV
Proposal A	$
Proposal B	$

2. Compute the payback period for each proposal. If required, round your answers to two decimal places.

	Payback Period
Proposal A		years
Proposal B		years

3. According to your analysis, which proposal(s) should be accepted?
Both

4. Which of the items in the list is not a possible reason for Kent's rejection of proposal B?
Its NPV is not high enough to meet the target levels imposed by the company.

If you knew that there were no liquidity concerns that would justify the rejection of proposal B, would you judge Kent’s behavior to be ethical?
No

Answer 1

a		NPV
	Proposal A	94209.99
	Proposal B	129760.17
b	Payback Period
	Proposal A	1.8	years
	Proposal B	4.64	years

3:

Both Since both have positive NPV

4: Its NPV is not high enough to meet the target levels imposed by the company. (The project has positive NPV which is good enough reason to accpt the project). No Since the PV is positive it is beneficial to the business and its rejection may not be ethical.

Workings

Year	Proposal A	Cumulative CF	Proposal B	Cumulative CF
0	-250000	-250000	-312500	-312500
1	150000	-100000	-37500	-350000
2	125000	25000	-25000	-375000
3	75000	100000	-12500	-387500
4	37500	137500	212500	-175000
5	25000	162500	275000	100000
6	12500	175000	337500	437500

Payback = Year in which Cumulative CF is last negative -(Last negative cumulative CF/ CF of next year

AutoSave © of HO- Book1 - Excel Sign in - o X File Home Insert Draw Share Comments Page Layout Formulas Data Review View Help O Tell me what you want to do - A^ ^ = = = der alle General - 2 E - A - E 3- $ - % 9 OSOS Conditional Format as Cell Formatting Table Styles Calibri 10 BI U - - i nsert" Delete - AY O T- Paste 1. Format - Sort & Find & Filter - Select Clipboard Font Alignment Number Styles Cells Editing FZ : X V C fic D A B E н 1 NPV Year Proposal A Cumulative CF Proposal B Cumulative CF Proposal A 2 =NPV(10%,B4:B9)+B3 Proposal B =NPV(10%,D4:09)+D3 3 0 4 1 5 2 -250000 150000 125000 =B3 =C3+B4 =C4+B5 -312500 -37500 -25000 =D3 =E3+D4 =E4+D5 b Payback Period Proposal A years 6 3 75000 =C5+B6 -12500 =E5+D6 =A4-C4/B5 Proposal B years =A7-E7/D8 74 37500 8 5 25000 =C6+B7 =C7+B8 212500 275000 =E6+D7 =E7+D8 Both Since both have positive NPV 12500 337500 =E8+D9 9 6 10 12