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

David Parker (Product Development) : I just don't 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 : I'm 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 14.17 and 14.18 for Diversified's 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 Electronics's 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 Products's 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.

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 division's net income divided by total assets. Each division's expenses include the allocated portion of corporate administrative expenses. Since each of Diversified Electronics's 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 14.19 shows the details of David Parker's rejected product proposal.
Required
a. Was the decision to reject the new product proposal the right one? If top management used the discounted cash flow (DCF) method instead, what would the results be? The company uses a 15 percent after-tax cost of capital (i.e., discount rate) in evaluating projects such as these.
b. Evaluate the manner in which Diversified Electronics has implemented the investment center concept. What pitfalls did it apparently not anticipate? What, if anything, should be done with regard to the investment center approach and the use of ROI as a measure of performance?
c. What conflicting incentives for managers can occur when yearly ROI is used as a performance measure and DCF is used for capital budgeting?
DIVERSIFIED ELECTRONICS
Financial 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
4. 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. 5. 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).
6. The project has an eight-year life. Land will be sold for $400,000 at the end of year 8.
7. Assume the gain on the sale of land is taxable at the 40 percent rate.
a Annual capacity of 120,000 units.
b Includes straight-line depreciation on new plant and equipment, depreciated for eight years with no net salvage value at the end of eightyears.

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DIVERSIFIED ELECTRONICS Inoome Statemente for Year 1 and Year2 (all dollar amounts in thousands, except earnings-per-share figurea) Year Ended Dooember 31 Year 1 Year 2 $141,462 108,118 33,344 13,014 20,330 1,190 $19,140 7,886 S 11,254 $5.63 $148,220 113,115 S 35,105 13,692 $ 21,413 1,952 S 19,461 7,464 $ 12,007 $6.00 Gross margin Profit before taxes and interest-...-.. Profit before taxes Income tax expense Net income Earnings per s DIVERSIFIED ELECTRONICS Balanoe Sheeto for Year 1 and Year 2 (all dollar m unto in th uaanda) Year Ended Deoember 31 December 31 Year Year 2 Assets Cash and temporary investments Accounts receivable. . Inventories. $ 1,404 1,469 15,607 45,467 $62,543 13,688 42,162 Total current assets. Plant and equipment Original cost Accumulated depreciation 115,736 45,979 35 69,757 3,119 $125,032 $135,419 107,326 42,691 Net Investments and other assets. S 64,6 3,143 Total assets. . Liabilities and owners' equity S 10,720 12,286 1,046 1,634 S 11,930 14,965 Accounts payable... Current portion of long-term debt ._ . . . _.. Total current liabilities .- Deferred income taxes 559 12,622 Long-term debt.... 15,448 $25,111 31,398 47,368 56,653 S99,921 $104,021 $125,032 $135,419 Total liabilities.. . . Common stock 47,368 52,553 Total owners equity. Total liabilities and owners equity.......