6. Kingdom Products plc has several divisions making and selling products in different markets. Divisions act autonomously on a day to day basis. They are appraised, and bonuses awarded based on Return on Investment (ROI) calculated on assets at the end of the year. Management reviews the future of the company by requiring each division to provide 3 year future plans. Divisions are asked to provide details of expected Net Income before Interest and tax and the Net Assets at the end of the year. Management are concerned about the poor forecast from Minehead Division as follows. Minehead Division - 3 year plan Year1 Year 2 Year 3 HA M M Prot before interest and tax 6.0 5.4 5.0 Asset base at end of the year 45 4B 54 Management have requested the submissions of plans to improve ROI which will pay for themselves within 3 years. The plans are required to earn a positive Net Present Value (NPV) based on a discount rate of 10%. (see discount table below). The following two alternative plans have been put forward: Minehead Division - alternatives Year1 Year 2 Year 3 a) Purchase and install a special purpose machine with a life of 3 years, to improve efciency Asset purchase Efciency improvement b) increase advertising to improve brand awareness Initial outlay Benet The purchase of the machine or the increased advertising will occur at the beginning of year 1 and benets will be experienced throughout each year. Assume the machine is purchased at the beginning of year 1 and depreciated using the straight-line depreciation method. Required a) Calculate the NPV of each of the above projects and recommend which is preferred. (3 marks) b) i) Calculate the ROI for the existing forecast performance of Minehead Division and using the existing and new Investment and net income calculate the ROI for Minehead Division for each of the alternative plans. (3 marks) Question continues on next page 6 continued ii) Bonuses each year are calculated partly based on the percentage Return on c) i) Investment (ROI) above 10%. Nothing is paid (or charged) if the percentage ROI is below 10%. The bonus is calculated as 5,000 if 10% ROI is achieved. Of the percentage earned above 10%, a bonus of E1 ,000 multiplied by the % above 10% is also awarded. Calculate the total bonus for the original plan and the proposed plans. Comment on the results and indicate which proposal the manager of Minehead would prefer. (3 marks) Since the bonus system is based on exceeding 10% Return on Investment, Kingdom Products plc is considering changing their Divisional performance to Residual Income (RI) instead for their appraisal and bonus awards. Using a cost of capital of 10%, calculate the Residual Income for the original plan and the two proposed plans. (4 marks) ii) Assuming that the bonus would be paid if a positive Residual Income is earned and d) nothing would be paid if the Residual Income is negative. Indicate how a bonus should be awarded based on the level of RI earned. The method should as far as possible, compensate managers to the same extent as the previous scheme. (3 marks) Since, in most large organisations, the decisions on major investments are made centrally, not by Divisional Managers, discuss ways in which the levels of ROI or RI are relevant to a Divisional Manager's decision making. Briefly discuss whether different measures of Divisional performance should be adopted. (4 marks) Discount table 10% Year 0 1.00 1 0.909 2 0.826 3 0.751