Chempromax Sdn. Bhd. (CSB) is the chemical division of a large industrial corporation. Mr. George Chan, the divisional general manager, is about to purchase new plant in order to manufacture a new product. He can buy either the Aladdin or the Zombie plant, each of which have the same capacity and expected four-year life, but which differ in their capital costs and expected net cash flows, as shown below:

Aladdin	Zombie
RM	RM
Initial capital investment	6,400,000	5,200,000
Net cash flows (before tax)
2017	2,400,000	2,600,000
2018	2,400,000	2,200,000
2019	2,400,000	1,500,000
2020	2,400,000	1,000,000
Net present value @ 16% per annum	315,634	189,615

In the above calculations, it has been assumed that the plant will be installed and paid for by the end of December 2016, and that the net cash flows accrue at the end of each calendar year. Neither plant is expected to have a residual value after decommissioning costs.

Like all other divisional managers in the corporation, Mr. Chan is expected to generate a before tax return on his divisional investment more than 16% per annum, which he is currently just managing to achieve. Anything less than a 16 per cent return will make him ineligible for a performance bonus and may reduce his pension when he retires in early 2019. In calculating divisional returns, divisional assets are valued at net book values at the beginning of the year. Depreciation is charged on a straight-line basis.

Required:

1 Explain, with appropriate calculations, why neither return on investment (ROI) nor residual income (RI) would result in goal congruence between Mr. George Chan and the top management of CSB regarding to investing in the project. 

2 Managers tend to use post-tax cash flows to evaluate investment opportunities, but to evaluate divisional managerial performance on the basis of pre-tax profits. Explain why this is so and discuss the potential problems that can arise, including suggestions as to how such problems can be overcome.

3 Discuss what steps can be taken by management to avoid dysfunctional behavior by Mr. Chan, which is motivated by accounting-based performance targets. 

4 When calculating for economic value added (EVA), explain why accounting depreciation is added back and economic depreciation deducted from the profits and capital employed. Also explain how economic depreciation can be determined. 

Answer rating: 100% (QA)

ANSWER 1 Return on Investment vs Residual Income While Mr Chan is expected to generate a beforetax return on his divisional investment of more than 16 ... View the full answer