Esperanza is a division manager for MegaMart. She receives a bonus based on the formula: bonus = $10,000 × (actual ROI - target ROI), with no bonus if actual ROI is less than target ROI. For this year, the target is 23%, with ROI calculated as income over the average net book value of assets.
At the start of the current year, Esperanza expects to earn $225,000 on average assets of $900,000. Absent any new investment, she expects her ROI performance to be similar in future years. She has identified a project that will require an investment of $90,000; this amount will be depreciated over three years on a straight line basis.
The project is expected to generate profit (after depreciation) of $8,000 in year 1, $12,000 in year 2, and $136,000 in year 3.
Required:
a. Determine Esperanza's projected ROI if she does not invest in the project.
b. Calculate the Net Present Value of the project, assuming that the cost of capital is 15%. Is this a profitable project?
c. Suppose Esperanza invests in the project. Calculate her updated ROI for the current year.
d. Comment on whether Esperanza is likely to invest in this project if she expects to leave the company in 2 years. Will your answer change if she expects to retire from the company in 10 years?