Problem:
Consider two companies: Quantum Products and Aquafin Products. Senior managers at Quantum Products are evaluated in terms of increases in profit. In fiscal 2011, Quantum Products had a net operating profit after taxes of $2,500,000 and invested capital of $25,000,000. In fiscal 2012, the company had net operating profit after taxes of $3,000,000 and invested capital of $37,500,000. Senior managers at Aquafin Products are evaluated in terms of ROI. In fiscal 2012, ROI was 16 percent while the cost of capital was only 12 percent. Near the end of fiscal 2012, managers had an opportunity to make an investment that would have yielded a return of 14 percent. However, the senior managers did not support making the investment.
a. Explain why the senior managers at Quantum Products have an incentive to over-invest.
b. Explain why the senior managers at Aquafin Products have an incentive to under-invest.