Return on Investment; Present Value Depreciation; Spreadsheet Application As indicated in the chapter, there are goal congruence problems associated with the use of ROI as an indicator of business unit financial performance. One such problem relates to the bias against accepting new investments because of the adverse effect on a business unit’s ROI metric. Assume, for example, that the manager of a business unit can invest in a new, depreciable asset costing $75,000 and that this asset has a 3-year life with no salvage value. Cash inflows associated with this investment are projected to be as follows: $30,000, $35,000, and $43,200. (Ignore taxes.) This scenario leads to an estimated internal rate of return (IRR) of 19.44%. Assume that the minimum required rate of return is 15%.
Required
1. Demonstrate, using the IRR function in Excel, that the IRR on this proposed investment is indeed 19.44%. 2. Calculate the year-by-year return on investment (ROI) on this proposed investment. For this problem, use the beginning-of-year book value of the asset as the denominator of your calculation each year. Assume the asset will be depreciated using the straight-line method. What incentive effects can you anticipate based on the data you generated? 3. Recalculate the year-by-year return on investment (ROI) on this proposed investment, this time using present value depreciation (defined as the change in the present value of the asset during the period). Use the project’s anticipated IRR (19.44%) as the discount factor in your calculations. As in requirement 2, define the denominator of your calculation as the beginning-of-year book value of the investment. (Hint: Your depreciation figures should be $15,417, $23,415, and $36,168, respectively, for years 1, 2, and 3.) Do the incentive effects you identified in requirement 2 change based on these calculations? 4. Calculate for each of the 3 years the residual income (RI) of this proposed investment. RI is defined as income after present value depreciation and after a capital charge assessed on the beginning-of-year book value of the asset. For these calculations, assume a 10% cost of capital (discount rate). Use the built-in function in Excel to estimate the NPV of the proposed investment. (Hint: Your answer should be approximately $13,655.) At a discount rate of 10%, determine the net present value (NPV) of the residual income (RI) figures you estimated. What is the potential value of using multiyear RI figures determined with present value depreciation?