AbigailEnterprises made a capital investment of $200,000 in new equipment for its retail division two years ago. The analysis at that time indicated that the equipment would save $70,000 in operating expenses per year over a five-year period. Discounted cash flow methods were used to evaluate the proposal. Before the purchase, the divisions ROI was 20 percent.

Jim Mc Gowan, the divisions manager, believed that the equipment had lived up to its expectations. However, the divisional performance report showed that the overall ROI for the first year in which the equipment was used was less than that in the previous year!. Mc Gowan asked the accounting department to break down the figures related to the investment to find out why it did not contribute to improving the divisionsROI.

The accounting department was able to identify the equipments contribution to the division operations. The report presented to the division manager at the end of the first year is as follows:

Reduced operating costs due to new equipment $70,000

Less depreciation at 20% of cost (40,000)

Contribution = $30,000

Investment, beginning of year 200,000

Investment, end of year 160,000

Average investment for the year 180,000

ROI = 30,000/180,000 = 16.7%

McGowan was surprised that the ROI was so low because the new equipment performed as expected. The staff analyst in the accounting department replied that the ROI used for performance evaluation differed from the methods to evaluate capital investment proposals.

Required:

1. How can using ROI as a performance measure for investment centers lead to bad decision-making? What steps can be taken to mitigate the effect?

2. Provide 2 examples of decisions the manager of an investment center might make to improve its ROI, but which may harm the future competitiveness of the firm?

3. Why is there typically a rise in ROI over time? How can this be avoided?