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Gaines Company recently initiated a post audit program. To motivate employees to take the program seriously, Gaines established a bonus program.Managers receive a bonus equal to 10 percent of the amount by which actual net present value exceeds the projected net present Value.Victor Holt, manager of the North Western Division, had an investment proposal on
his desk when the new system was implemented. The investment opportunity required a $250,000 initial cash outflow and was expected to return cash inflows of $90,000 per year for the next five years.Gaines’ desired rate of return is 10 percent. Mr. Holt immediately reduced the estimated cash inflows to $70,000 per year and recommended accepting the project.
a. Assume that actual cash inflows turn out to be $91,000 per year. Determine the amount of Mr. Holt’s bonus if the original computation of net present value were based on $90,000 versus 70,000.
b. Speculate about the long-term effect the bonus plan is likely to have on the company.
c. Recommend how to compensate managers in a way that discourages gamesmanship.
Assume that actual cash inflows turn out to be $91,000 per year. Determine the amount of Mr. Holt’s bonus if the original computation of net present value were based on $90,000 versus $70,000.
bonus if $90,000 is used as the projected annual cash flow:
$94,961.62- $91,170,83= $3,790.79x0.10= $379.08
Bonus if $70,000 is used as the projected annual cash inflow
$94,961.62- $15,355.09=#79,606.53x0.10=$7,960.65
To answer this question, we need to calculate the net present value (NPV) based on the original computation of cash inflows at $90,000 and then again at $70,000.
a. First, let's calculate the NPV assuming cash inflows of $90,000 per year. The formula for NPV is:
NPV = -Initial Cash Outflow + (Cash Inflow / (1 + Rate of Return)^n)
Where:
Initial Cash Outflow = $250,000
Cash Inflow = $90,000
Rate of Return = 10% (0.10)
n = number of years = 5
Using the formula, we can substitute the values:
NPV = -$250,000 + ($90,000 / (1 + 0.10)^5)
NPV = -$250,000 + ($90,000 / 1.6105)
NPV = -$250,000 + $55,884.36
NPV = -$194,115.64
Now let's calculate the NPV assuming cash inflows of $70,000 per year:
NPV = -$250,000 + ($70,000 / (1 + 0.10)^5)
NPV = -$250,000 + ($70,000 / 1.6105)
NPV = -$250,000 + $43,415.57
NPV = -$206,584.43
To determine the bonus amount, we need to find the difference between the actual NPV and the projected NPV, and then take 10% of that difference.
For the original computation based on $90,000:
Bonus = 10% * (Actual NPV - Projected NPV)
Bonus = 10% * (-$194,115.64 - (-$206,584.43))
Bonus = 10% * ($12,468.79)
Bonus = $1,246.88
For the computation based on $70,000:
Bonus = 10% * (-$194,115.64 - (-$206,584.43))
Bonus = 10% * ($12,468.79)
Bonus = $1,246.88
So Mr. Holt's bonus would be $1,246.88, regardless of whether the original computation was based on $90,000 or $70,000.
b. The bonus plan is likely to have long-term effects on the company. It may encourage managers to reduce estimates of cash inflows in order to increase the difference between actual and projected NPV and obtain higher bonuses. This could lead to a more conservative approach in estimating cash inflows, potentially resulting in missed investment opportunities or underestimation of project feasibility.
c. To discourage gamesmanship, it is recommended to consider aligning managers' compensation with the overall performance of the company rather than individual project outcomes. This could be done by linking bonuses to factors such as overall company profitability, revenue growth, or customer satisfaction, rather than just the NPV of individual projects. Additionally, implementing checks and balances in the post-audit program, using independent evaluators, and having transparent and consistent evaluation criteria can help discourage gamesmanship and promote more accurate projections.