Division managers at Creighton Aerospace are evaluated and rewarded based on ROI (return on investment) targets. In the current year, Delmar Richards, the president of the commercial products division, has an ROI target of 12 percent. If the division has an ROI of 12 percent or greater, Delmar will receive 250,000 options on Creighton stock in addition to a base salary of $400,000.
The commercial products division is considering a major investment in product development, which has a net present value of $25,000,000.However, the investment will have a negative effect on reported profit over the next two years, after which the investment will begin to have a significant positive effect on firm profitability for the next eight years.
a. Discuss the potential conflict between the company's evaluation/compensation system and Delmar's focus on the NPV of the investment in product development.
b. Suppose Delmar currently holds stock in Creighton Aerospace with a market value of $1,250,000 and has options on 500,000 shares (awarded in previous years). Is this likely to acerbate or mitigate the conflict you discussed in part a?
a. The potential conflict arises from the NPV of the investment and the use of ROI for performance evaluation. NPV is positive indicates that the investment is good for the company over the life of the investment.
ROI is calculated as ...
The solution discusses the potential conflict between the company's evaluation/compensation system and the company's focus on the NPV of the investment