The Owens Group manages several fitness centers in Europe and Asia. The home office staff of The Owens Group evaluates managers of the Owens divisions by keeping track of the rate of return each division earns on the average level of assets invested at the division. The home office staff considers 20 percent, which is The Owens Group’s after-tax cost of capital, to be the minimum acceptable annual rate of return on average investment. When a division’s rate of return drops below 20 percent, division management can expect an unpleasant investigation by the home office and perhaps some firings. When the rate of return exceeds 20 percent and grows through time, the home office staff is invariably pleased and rewards division management.
When the rate of return exceeds 20 percent but declines over time, the home office staff sends out unpleasant memoranda and cuts the profit-sharing bonuses of the division managers.
In Division A, average assets employed during the year amount to $60,000. Division A has been earning 40 percent per year on its average investment for several years. Management of Division A is proud of its extraordinary record—earning a steady 40 percent per year.
In Division B, average assets employed during the year also amount to $60,000.
Division B has been earning 25 percent per year on its average investment. In the preceding three years, the rate of return on investment was 20 percent, 22 percent, and 23 percent, respectively. Management of Division B is proud of its record of steadily boosting earnings.
New investment opportunities have arisen at both Division A and Division B. In both cases, the new investment opportunity will require a cash outlay today of $30,000 and will provide a rate of return on investment of 30 percent for each of the next eight years. The average amount of assets invested in the project will be $30,000 for each of the next eight years. Both new investment opportunities have positive net present value when the discount rate is 20 percent per year (the after-tax cost of capital of The Owens Group).
When word of the new opportunities reached the home office staff, the prospects of the two new investments pleased the staff, because both investments would yield a better-than average return for The Owens Group.
Management of Division A computed its rate of return on investment both with and without the new investment project and decided not to undertake the project. Management of Division B computed its rate of return on investment both with and without the new investment project and decided to undertake it.
When word of the two divisions’ actions reached the home office staff, it was perplexed.
Why did Division A’s management turn down such a good opportunity? What in the behavior of the home office staff induced Division A’s management to reject the new project? Is management of Division B doing a better job than management of Division A?
What may the home office do to give Division A an incentive to act in a way more consistent with the well-being of The Owens Group?