Background Mala Ltd is a manufacturing company with a divisiopalised structure. Annual bonuses are only awarded to staff within this company if their division achieves the target return on investment level set by company management. The target level of return on investment for the current year is 23%. In calculating divisional return on investment, divisional assets are valued at net book values at the beginning of the year. Depreciation is charged on a straight line basis and a full year's depreciation is charged in the year of acquisition. Division R is one of the divisions within Mala Ltd. Keith Grimes, has managed this division for the past 10 years and in each of those years he and his staff have achieved the level of return on investment required to ensure that they earned bonuses. Keith is now coming to the end of his final year in the company; he will shortly be leaving to take up a more senior position with a competitor. Unfortunately it appear that this may also be the first year in which Division R staff will not receive bonuses, as the division is currently struggling to meet the 23% target. Keith is very disappointed, not only because he would have liked to the division have achieved the target in his final year, but also because he believes that his staff actually performed extraordinary well this year given the extremely difficult economic environment in which they were operating. Investment Decision One of the final decisions Keith must make before leaving relates to the acquisition of a piece of equipment. This equipment is required to perform a critical task within the manufacturing process. After much investigation, the decision has been narrowed down to two models: Model A and Model B. The net investment in other assets will not be affected by the acquisition of the equipment irrespective of which of the two models are purchased. Both of the models are well regarded within the industry. Furthermore their specifications are extremely similar; they have the same production capacity and both have a four year life, with an expected residual value of zero thereafter. The capital costs, expected net cash inflows and net present values (@23% per annum) for each of the models are as follows: Model A Model B Initial capital investment 8,750,000 10,500,000 Net cash inflows 1 2 3 3,500,000 4,375,000 4,025,000 4,725,000 6,125,000 3,500,000 4,375,000 3,500,000 4 Net present value (@23%) 1,214,763 673,400 Requirement (a) Calculate both the annual return on investment and the annual residual income for each year in respect of both models. 8 marks (b) Explain why neither return on investment nor residual income will motivate Matthew to make the best decision from the company's perspective. 5 marks (c) Comment on the bonus scheme currently in operation and suggest how it might be altered in order to reduce the dysfunctional consequences? 6 marks (d) Keith has also become aware that as an alternative to buying this equipment, Division R could engage another company to undertake the work performed by the equipment. This other company would be paid a rate per unit of output that they work on. Suggest the issues which should be considered when evaluating such an option. You are not required to provide calculations to support your suggestions. 6 marks Background Mala Ltd is a manufacturing company with a divisiopalised structure. Annual bonuses are only awarded to staff within this company if their division achieves the target return on investment level set by company management. The target level of return on investment for the current year is 23%. In calculating divisional return on investment, divisional assets are valued at net book values at the beginning of the year. Depreciation is charged on a straight line basis and a full year's depreciation is charged in the year of acquisition. Division R is one of the divisions within Mala Ltd. Keith Grimes, has managed this division for the past 10 years and in each of those years he and his staff have achieved the level of return on investment required to ensure that they earned bonuses. Keith is now coming to the end of his final year in the company; he will shortly be leaving to take up a more senior position with a competitor. Unfortunately it appear that this may also be the first year in which Division R staff will not receive bonuses, as the division is currently struggling to meet the 23% target. Keith is very disappointed, not only because he would have liked to the division have achieved the target in his final year, but also because he believes that his staff actually performed extraordinary well this year given the extremely difficult economic environment in which they were operating. Investment Decision One of the final decisions Keith must make before leaving relates to the acquisition of a piece of equipment. This equipment is required to perform a critical task within the manufacturing process. After much investigation, the decision has been narrowed down to two models: Model A and Model B. The net investment in other assets will not be affected by the acquisition of the equipment irrespective of which of the two models are purchased. Both of the models are well regarded within the industry. Furthermore their specifications are extremely similar; they have the same production capacity and both have a four year life, with an expected residual value of zero thereafter. The capital costs, expected net cash inflows and net present values (@23% per annum) for each of the models are as follows: Model A Model B Initial capital investment 8,750,000 10,500,000 Net cash inflows 1 2 3 3,500,000 4,375,000 4,025,000 4,725,000 6,125,000 3,500,000 4,375,000 3,500,000 4 Net present value (@23%) 1,214,763 673,400 Requirement (a) Calculate both the annual return on investment and the annual residual income for each year in respect of both models. 8 marks (b) Explain why neither return on investment nor residual income will motivate Matthew to make the best decision from the company's perspective. 5 marks (c) Comment on the bonus scheme currently in operation and suggest how it might be altered in order to reduce the dysfunctional consequences? 6 marks (d) Keith has also become aware that as an alternative to buying this equipment, Division R could engage another company to undertake the work performed by the equipment. This other company would be paid a rate per unit of output that they work on. Suggest the issues which should be considered when evaluating such an option. You are not required to provide calculations to support your suggestions. 6 marks