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Payback, NPV, Managerial Incentives, Ethical Behavior

Kent Tessman, manager of a Dairy Products Division, was pleased with his division's performance over the past three years. Each year, divisional profits had increased, and he had earned a sizable bonus. (Bonuses are a linear function of the division's reported income.) He had also received considerable attention from higher management. A vice president had told him in confidence that if his performance over the next three years matched his first three, he would be promoted to higher management.

Determined to fulfill these expectations, Kent made sure that he personally reviewed every capital budget request. He wanted to be certain that any funds invested would provide good, solid returns. (The division's cost of capital is 10 percent.) At the moment, he is reviewing two independent requests. Proposal A involves automating a manufacturing operation that is currently labor intensive. Proposal B centers on developing and marketing a new ice cream product. Proposal A requires an initial outlay of $250,000, and Proposal B requires $312,500. Both projects could be funded, given the status of the division's capital budget. Both have an expected life of six years and have the following projected after-tax cash flows:

Year	Proposal A	Proposal B
1	$150,000	$(37,500)
2	125,000	(25,000)
3	75,000	(12,500)
4	37,500	212,500
5	25,000	275,000
6	12,500	337,500

After careful consideration of each investment, Kent approved funding of Proposal A and rejected Proposal B.

The present value tables provided in Exhibit 19B.1 and Exhibit 19B.2 must be used to solve the following problems.

Required:

1. Compute the NPV for each proposal. Round intermediate calculations and your final answers to the nearest dollar.

	NPV
Proposal A	$fill in the blank 1
Proposal B	$fill in the blank 2

2. Compute the payback period for each proposal. If required, round your answers to two decimal places.

	Payback Period
Proposal A	fill in the blank 3	years
Proposal B	fill in the blank 4	years

3. According to your analysis, which proposal(s) should be accepted?

Proposal AProposal BBothBoth

4. Which of the items in the list is not a possible reason for Kent's rejection of proposal B?

Its initial negative cash flows could have an unfavorable impact on his performance reviews.Its initial negative cash flows might cause trouble for the company if it is short on cash.Its NPV is not high enough to meet the target levels imposed by the company.Its NPV is not high enough to meet the target levels imposed by the company.

If you knew that there were no liquidity concerns that would justify the rejection of proposal B, would you judge Kent's behavior to be ethical?

YesNoNo