What conflicting incentives for managers can occur when yearly ROI is used as a performance measure and DCF is used for capital budgeting?

The following exchange occurred just after the finance staff at Diversified Electronics rejected a capital investment proposal:

David Parker (Product Development): I just dont understand why you rejected my proposal. We can expect to make $230,000 on it before tax.

Shannon West (Finance): David, get real. This product proposal does not meet our short-term ROI target of 15 percent after tax.

David: Im not so sure about the ROI target, but it is profitable$230,000 worth.

Shannon: We believe that a company like Diversified Electronics should have a return on investment of 15 percent after tax. The Professional Services division consistently comes in with a 15 percent or better ROI, while your division, Residential Products, has managed to get only 10 percent. The performance of the Aerospace Products division has been especially dismal, with an ROI of only 6 percent. We expect divisions in the future to carry their share of the load.

Diversified Electronics, a growing company in the electronics industry, had grown to its present size of more than $140 million in sales. (See Exhibits 14.19 and 14.20 for Diversifieds year 1 and year 2 income statements and balance sheets, respectively.) Diversified Electronics has three divisions, Residential Products, Aerospace Products, and Professional Services, each of which accounts for about one-third of Diversified Electronicss sales. Residential Products, the oldest division, produces furnace thermostats and similar products. The Aerospace Products division is a large job shop that builds electronic devices to customer specifications. A typical job or batch takes several months to complete. About one-half of Aerospace Productss sales are to the U.S. Defense Department. The newest of the three divisions, Professional Services, provides consulting engineering services. This division has grown tremendously since Diversified Electronics acquired it seven years ago.

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Exhibit 14.19 Income StatementsDiversified Electronics

DIVERSIFIED ELECTRONICSIncome Statements for Year 1 and Year 2(all dollar amounts in thousands, except earnings-per-share figures)Year Ended December 31
	Year 1	Year 2
Sales	$141,462	$148,220
Cost of goods sold	108,118	113,115
Gross margin	$33,344	$ 35,105
Selling and general	13,014	13,692
Profit before taxes and interest	$20,330	$ 21,413
Interest expense	1,190	1,952
Profit before taxes	$ 19,140	$ 19,461
Income tax expense	7,886	7,454
Net income	$ 11,254	$ 12,007
Earnings per share	$ 5.63	$ 6.00

Exhibit 14.20 Balance SheetsDiversified Electronics

DIVERSIFIED ELECTRONICSBalance Sheets for Year 1 and Year 2(all dollar amounts in thousands)Year Ended December 31
	Year 1	Year 2
Assets
Cash and temporary investments	$ 1,404	$ 1,469
Accounts receivable	13,688	15,607
Inventories	42,162	45,467
Total current assets	$ 57,254	$ 62,543
Plant and equipment:
Original cost	$ 107,326	$ 115,736
Accumulated depreciation	42,691	45,979
Net	$ 64,635	$ 69,757
Investments and other assets	3,143	3,119
Total assets	$125,032	$135,419
Liabilities and owners equity
Accounts payable	$ 10,720	$ 12,286
Taxes payable	1,210	1,045
Current portion of long-term debt	0	1,634
Total current liabilities	$ 11,930	$ 14,965
Deferred income taxes	559	985
Long-term debt	12,622	15,448
Total liabilities	$ 25,111	$ 31,398
Common stock	$ 47,368	$ 47,368
Retained earnings	52,553	56,653
Total owners equity	$ 99,921	$ 104,021
Total liabilities and owners equity	$125,032	$ 135,419

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Each division operates independently of the others, and corporate management treats each as a separate entity. Division managers make many of the operating decisions. Corporate management coordinates the activities of the various divisions, including the review of all investment proposals over $400,000.

Diversified Electronics measures return on investment as the divisions net income divided by total assets. Each divisions expenses include the allocated portion of corporate administrative expenses. Because each of Diversified Electronicss divisions is located in a separate facility, management can easily attribute most assets, including receivables, to specific divisions. Management allocates the corporate office assets, including the centrally controlled cash account, to the divisions on the basis of divisional revenues.

Exhibit 14.21 shows the details of David Parkers rejected product proposal.

Exhibit 14.21 DataNew Product Proposal

DIVERSIFIED ELECTRONICSFinancial Data for New Product Proposal
1.	Projected asset investment:
	Land purchase	$ 200,000
	Plant and equipmenta	800,000
		$1,000,000
2.	Cost data, before taxes (first year):
	Variable cost per unit	$ 3.00
	Differential fixed costb	$ 170,000
3.	Price/market estimate (first year):
	Unit price	$ 7.00
	Sales volume	100,000 units
Taxes: The company assumes a 40 percent tax rate for income and gains on land sale. Depreciation of plant and equipment according to tax law is as follows: year 1: 20 percent; year 2: 32 percent; year 3: 19 percent; year 4: 14.5 percent; and year 5: 14.5 percent. Taxes are paid for taxable income in year 1 at the end of year 1; taxes are paid for taxable income in year 2 at the end of year 2; and so on.
The new product is in a growth market with expected price increases of 10 percent per year. This 10 percent applies to revenues and costs except depreciation and land for years 2 through 8 (i.e., year 2 amounts will reflect a 10 percent increase over the year 1 amounts shown in the data above).
The project has an eight-year life. Land will be sold for $400,000 at the end of year 8.
Assume the gain on the sale of land is taxable at the 40 percent rate.