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Question 1
Norway (Pty) Ltd is a divisionalised company, where the divisionalmanagers’ remuneration packages are linked to the return oninvestment of their divisions. Return on investment is based on thenet book value of assets employed in the division at the beginningof the financial year. On average, divisional managers remain intheir posts for a three-year period.
The manager of the Scandinavian division is considering twomutually exclusive alternative proposals for investing in newmachinery. These proposals both involve an initial outlay of R250000, but will yield different levels of savings over the life ofthe machinery, which is estimated at five years, after which theywill have no residual value. Norway (Pty) Ltd ‘s depreciation, iscalculated on a straight-line basis.
The savings will give rise to increased cash flows asfollows:
Year
Machine
A
Cash flows
B
Cash flows
1
80 000
100 000
2
80 000
90 000
3
80 000
80 000
4
100 000
60 000
5
100 000
40 000
Required:
1. Appraise each project, using
a) return on investment, as described above
b) net present value, using the company’s cost of capital of6%
15 marks
Based on your results from (1), explain which machine thedivisional manager is likely to choose and discuss the potentialconflict between performance measurement and investmentappraisal.