DYSFUNCTIONAL FOCUS ON EARLY CASH FLOWS

The timing of cash flows in investment decisions can sometimes create behavioral incentives to make dysfunctional decisions. The following hypothetical scenario presents such a situation.

The Institute for Environmental Studies (IES) is a privately funded, nonprofit scientific organization based in Montreal. The organizations director of field research is scheduled to retire in two years, and the assistant director, Marie Fenwar, is hoping to be appointed to the post at that time. In her current position, Fenwar has significant administrative responsibilities, including the approval of research proposals and equipment acquisitions. Fenwar has developed a reputation for carefully scrutinizing every proposed project and keeping the institutes field research branch within its budget. Fenwar has been so successful in her job that she has been quietly assured by several members of the IES board of directors that she is in line for her bosss job. She knows, however, that her prospects depend on her continued success in keeping the field research branch in solid financial shape.

IES recently signed a contract with the U.S. and Canadian governments to do a five-year study of the effects of global warming on the migration of water fowl. The contract fee is $500,000, payable in equal annual installments over the contract term. Fenwar is now considering two alternative proposals for carrying out the study. Each proposal entails the purchase of equipment and the incurrence of various operating costs throughout the term of the contract. Fenwars normal procedure for project evaluation is to calculate each proposals NPV, using an 8 percent hurdle rate. The projected costs follow:

Year

Type of Cost

Research

Proposal I

Research

Proposal II

Time 0

Equipment acquisition*

$ 40,000

$70,000

Year 1

Operating costs

150,000

75,000

Year 2

Operating costs

120,000

75,000

Year 3

Operating costs

75,000

95,000

Year 4

Operating costs

40,000

95,000

Year 5

Operating costs

40,000

95,000

*The equipment will be obsolete at the end of the contract term.

Fenwar calculated an NPV of $1,370 for Proposal I and $(14,375) for Proposal II. After completing her NPV analysis, however, Fenwar was tempted to ignore it. These thoughts ran through her mind as she drove to work: If I approve Proposal I, the financial picture for the field research branch is going to pieces for the next two years. After a $40,000 initial investment in equipment, Im going to show losses of $50,000 and $20,000 in the first two years. Thats not going to look very good when the board considers my promotion. When she arrived at the office, Fenwar wrote a memo approving Proposal II.

Which research proposal should Fenwar have accepted? Why? Comment on the ethical issues in this scenario.