Question

Senior managers at Criterion Products are evaluated in terms of increase in profit. In fiscal 2013, Criterion Products had net operating profit after taxes of $ 2,000,000 and invested capital of $ 20,000,000. In fiscal 2014, the company had net operating profit after taxes of $ 2,500,000 and invested capital of $ 30,000,000. Senior managers at Valcun Products are evaluated in terms of ROI. In fiscal 2013, the ROI was 18 percent while the cost of capital was only 14 percent. Near the end of fiscal 2013, managers had an opportunity to make an investment that would have yielded a return of 16 percent. However, the senior managers did not support the investment Required:

a. Explain why the senior managers at Criterion Products have an incentive to overinvest.

b. Explain why the senior managers at Valcun Products have an incentive to underinvest.

Answer 1

A. Managers at Criterion Products are evaluated on the basis of increase in profits. Any investment which yields postive returns will increase the profits of the entity and consequemtly the remuneration of managers will increase. In the year 2013 entity has ROI of 10% while it dropped to 8.33% in 2014 but the profits increased to 25000000 from 2000000. Entities ROI has worsen but the profit has increased as more investment has been made. So the managers will be motivated to overinvest even when it is not beneficial for the entity but it provides better incentives to managers.

B. Managers at Valcun Products are evaluated on the basis of ROI. Managers will have more incentive when ROI increases. Presently it has ROI of 18% and cost of capital is 14%. It had opputunity to invest which would have eanred ROI of 16%. If the entity invested in this product it would have a positive return as ROI of the project is more then Cost of Capital. But since present ROI is 18% investing in new project will have decreased the overall ROI and consequently incentive for managers would have been reduced. So managers are motivated to underinvest.