Question

Dash Buildings, Inc.

Ann Smith is the president of Dash Buildings, Inc. (DBI), a subsidiary of Dash, Inc., one of the new long-distance telephone companies that sprang up as a result of deregulation of long-distance telephone service in the United States. DBI is responsible for purchasing and managing real estate used by the various units of Dash. DBI acts like a private real estate investment firm - acquiring properties, managing those properties, and providing space to the other divisions of Dash. DBI occasionally rents space to other tenants when it acquires a building that has more space than is needed by Dash. DBI does not, however, purchase buildings for the express purpose of renting to non-Dash tenants. DBI is a corporation rather than a department only for reasons of legal convenience. DBI acts like any other department within Dash. DBI does not raise its own funds but receives them from the corporate treasury. When Smith first joined Dash as a property mananger, internal rate of return was the primary tool for project analysis. This often forced DBI to acquire smaller, older, less efficient buildings. Her role on a task force leading the conversion to net present value was the source of recognition that led to her eventual promotion to president of DBI. Net present value analysis had allowed DBI to acquire newer, larger, and more modern buildings. This has led to a dramatic decrease in complaints about buildings and greater overall employee satisfaction. Oversight of capital budgeting at Dash was the responsibility of the treasurer. The prior treasurer had allowed each operating unit to use its own capital investment analysis methods, with some choosing net present value, and some even choosing accounting rate of return. The new treasurer, who comes from a background in investment banking, wants to standardize analysis so proposals can be compared from one unit to the other. While the treasurer has not issued a formal policy, it is clear that he is leaning toward internal rate of return. DBI has formally evaluated as a profit center, being credited with revenue equal to the estimated cost of renting space of the same type in the local market. Smith and her employees receive bonuses based on the profit of DBI. Bonuses at DBI had been quite small in the early years, but rising rents along with some well-timed purchases at the bottom of a real estate depression made the division profitable enough to bring it up to the maximum allowable bonus. She is, therefore, able to concentrate on maximizing satisfaction, which she believes to be the source of any further career advancement. Smith is concerned that internal rate of return will force her to return to acquiring less desirable office space. Dissatisfaction and complaints about building quality could derail her career.

1) Comment on the company's methods for evaluating and rewarding success. Does the reward structure encourage optimal capital investments in DBI and the rest of the company? 2) Would you recommend that the reward structure be changed in any way?

Answer 1

1) DBI’s method of evaluating & rewarding the success is based on the profits earned by the company. Smith & her employees receive bonus based on the profits of the company.

Generally any company would reward majorly its employees only based on its profits & no other criterion. Though the performing employees deserve bonus, it is only if the company has adequate profits then it can reward bonus & any other benefits to the employees. Hence this can be a correct method for DBI or for any other company.

Similarly, the evaluation method adopted is the net present value (NPV) which compares the present value of inflows & outflows. This is also a good method especially to accept or reject investment in projects like purchase of new equipment, purchase of inventory, expansion or addition or installation of new plants etc.

2) NPV can be considered as a powerful tool for capital budgeting analysis. Capital budgeting is planning process for analyzing the investment to determine the long term investment value of a firm. It aims to maximize the wealth of the firm. Hence capital investment decisions are crucial for firm’s survival.

NPV can help the managers to decide whether a project will be profitable or not. The major benefit is that it can compare multiple projects at one time. It provides a direct measure of added profitability. All these benefits can encourage the company in making good capital budgeting decisions.

3) The company can change its reward structure from NPV to payback. This is the method used majorly by many firms. Because it can help the company in knowing how soon it can get back its cost of capital. The payback period of investment will influence the investors in decision making.

Although NPV is considered to be a favorable method by any analysts, the payback period method is considered to be the often used method by many firms.