Question
Suppose a firms managers receive bonuses that increase with the size of the firms ROE, which was 30% last year and is forecasted to remain
Suppose a firms managers receive bonuses that increase with the size of the firms ROE, which was 30% last year and is forecasted to remain at this level during the coming year provided the firm takes on no new expansion projects. Its cost of capital is 10%. Now the firm has the opportunity to make a new investment that promises 20% return on invest capital. Which of the following statements is not correct?
a. The example in this question demonstrates the serious weakness in using ROE as the primary criterion in setting executive compensation.
b. The new project should be rejected because, if it is accepted, the firm's ROE will decline from 30% because the new ROE will be a weighted average of the old 30% and the 20% returns on the new investment.
c. The new project should be accepted because it expected return exceeds the cost of the capital that will be used to finance it.
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started