Question
Auckland plc, which has a divisionalised structure, undertakes civil engineering and mining activities. All applications by divisional management teams for funds with which to undertake
Auckland plc, which has a divisionalised structure, undertakes civil engineering and mining activities. All applications by divisional management teams for funds with which to undertake capital projects require the authorisation of the board of directors of Auckland plc. Once authorisation has been granted to a capital application, divisional management teams are allowed to choose the project for the investment.
Under the terms of the management incentive plan, which is currently in operation, the managers of each division are eligible to receive annual bonus payments which are calculated by reference to the return on investment (ROI) earned during each of the first 2 years by new investments. ROI is calculated by using the average capital employed during the year. Auckland plc depreciates its investments on a straight-line basis.
One of the most profitable divisions during recent years has been the MOA Division, which is engaged in the mining of precious metals. The MOA Divisions management is currently evaluating three projects relating to the extraction of substance xxx from different areas in its country of operation. The management of the MOA Division has been given approval by the board of the directors of Auckland plc to spend $24 million on one of the three proposals it is considering (i.e. North, East and South projects).
The following net present value (NVP) calculations have been prepared by the management accountant of the MOA Division.
| North project | East project | South project | |||
| Net cash inflow/outflow $000 | Present value at 12% $000 | Net cash inflow/outflow $000 | Present value at 12% $000 | Net cash inflow/outflow $000 | Present value at 12% $000 |
Year 0 | (24,000) | (24,000) | (24,000) | (24,000) | (24,000) | (24,000) |
Year 1 | 6,000.0 | 5,358.0 | 11,500.0 | 10,269.5 | 12,000.0 | 10,716.0 |
Year 2 | 8,000.0 | 6,376.0 | 11,500.0 | 9,165.5 | 10,000.0 | 7,970.0 |
Year 3 | 13,500.0 | 9,612.0 | 11,500.0 | 8,188.0 | 9,000.0 | 6,408.0 |
Year 4 | 10,500.0 | 6,678.0 | --- | --- | 3,000.0 | 1,908.0 |
NPV |
| 4,024.0 |
| 3,623.0 |
| 3,002.0 |
The following additional information concerning the three projects are available:
- Each of the above projects has a nil residual value.
- The life of the East project is three years. The North and South projects are expected to have a life of four years each.
- The three projects have a similar level of risk.
- Ignore taxation.
Required 1.1
Calculate ROI for the first two years for all THREE projects
Should the interests of the management of the MOA Division conflict with those of the board of directors of Auckland plc, if NPV (given in the question) and ROI calculated in requirement 1.1 are considered? Justify your answer
Calculate Residual Income (RI) for all divisions for both years. Assume that the weighted average cost of capital of Auckland plc is 12%. Also, assume that Auckland plc use average capital employed in calculating RI.
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