Residual Income (RI), Performance Evaluation Time Horizon As referenced in the five-step proc- ess presented at the beginning of this chapter, one issue that confronts top management is selection of an appropriate time period for evaluating the financial performance of the company's investment centers. This exercise demonstrates why, in conjunction with residual income (RI), it is desirable to evaluate financial performance over a multiyear period. The primary point is that, by doing so, top management is better able to align manager goals and incentives with organizational goals.
Assume, as covered in Chapter 12, that your company uses the net present value (NPV) method to evaluate capital investment opportunities. Generally speaking, this means that a long-term invest- ment project will be undertaken if the present value of future net cash flows (after-tax) is positive when discounted at the firm's weighted-average cost of capital (WACC). The following facts pertain to an investment opportunity that is available to the manager of one of the investment centers in your company. Investment outlay cost, time period 0, equals $800,000. This amount relates to an asset with a five-year life, and no salvage value, that will be depreciated using the straight-line (SL) method. The investment is expected to increase cash inflows by $300,000 per year. Assume a discount rate of 10 per- cent, both for purposes of calculating NPV and for calculating annual residual income (RI) figures.
Required
1. Prepare a schedule that contains annual cash-flow data, annual operating income amounts, and annual residual income (RI) figures. What is the estimated NPV of the proposed investment? What is the present value (PV) of the stream of expected residual incomes (RIs) from this investment?
2. From a behavioral perspective, what is the primary implication of the analysis you conducted above in (1)?