Cathode plc has 2 divisions. The managing director has told the divisional managers that a bonus will be paid to the more profitable division. However, absolute profit as conventionally computed will not be used. Instead the ranking will be affected by the relative investments in the 2 divisions. Both of the managers have now written to claim the bonus. The following data are available:

The company's cost of capital is 10% per annum.

Required:

(a) Which method for computing profitability do you think each manager chose to show that his results were the best?
Briefly state to which manager you would award the bonus and give your reasons.

(b) Each divisional manager is actively contemplating a project with the following cash flows:

Investment of 00000 now, giving expected net cash inflows beginning in one year's time of f4000 per annum for 10 years. There will be no scrap value at the end of the project's life.

(i) What will be the likely investment decision each manager will make when appraising this separate project? Will each manager's decision be consistent with the company's best interest? (You are to assurne that from the first year of operation the project's net cash inflow is equivalent to net income after depreciation.)

(ii) Under which set of conditions may residual income measures lead to corporately acceptable investment decisions?

(c) Why is it important that in the multidivisional company the short-term performance measure coincides with the long term planning model to evaluate capital projects?

Division Assets at Assets at original cost net book value Net income after depreciation Electrolysis Ergometer 380 000 190000 46 000 250000 125 000 32 000