Effects of Inflation on ROI The Carter Company uses the ROI criterion to evaluate the performance of its divisions.

The company prides itself on the formal capital-budgeting procedures it uses for approving new investments and the subsequent control procedures it has implemented to measure the performance of those new investments. Recently, however, the ROI measure.has been producing performance statistics quite at variance with the criterion used to screen the investments. The company believes that recent high inflation rates may be contributing to the erratic performance evaluation measures. The problem is well illustrated by comparing the performance of two divisions.

Division Y made a major investment 10 years ago. This investment cost $3,000,000 and had an expected life of 15 years and annual after-tax cash flows of $52????,000. The rate of return of slightly more than 15% was above the Carter Company's cost of capital. During the past 10 years, the price level had risen by 67%, and the after-tax cash flows from the investment had increased to an annual level of $800,000. The ROI for Division Y for the most recent year was computed as:

The price index was 120 10 years ago when Division Y's investment was made.
Two years ago, when Division Z made its investment, the index was 180, and in the most recent year, for which the above data were prepared, the index averaged 200.
Required Analyze this situation explaining why two divisions with such similar investments (15%
after-tax returns from the discounted cash flow analysis) are showing such disparate ROis.

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Investment book value (start-of-year) Investment book value (end-of-year) Average investment Net cash flow Depreciation Net income ROI-Division Y $1,200,000 1,000,000 $1,100,000 $ 800,000 200,000 $ 600,000 54.5% Division Z, in a different region than Division Y, made a major investment of a very similar type just two years ago. Because of the increase in construction and equip- ment costs, the investment now had cost $4,500,000. The expected life of this investment was 10 years, and the annual after-tax cash flow was $900,000. This investment also had a yield slightly in excess of 15%, so the performance measure of Division Z was expected to be similar to that of Division Y. In fact, Division Z's investment appeared to be much less profitable than Division Y's and did not even reach the expected 15% ROI cutoff fig- ure. The most recent year's data show: Investment book value (start-of-year) Investment book value (end-of-year) $4,050,000 3,600,000 Average investment $3,825,000 Net cash flow Depreciation Net income ROI-Division Z $1,000,000 450,000 $ 550,000 14.4%