Posted: August 31st, 2016
Gaines Company recently initiated a postaudit program. To motivate employees to take the program seriously, Gaines establised a bonus program. Managers receive a bonus equal to 10 percent of the amount by which actual net present value exceeds the projected net present value. Victor Holt, manager ofthe North Western Division, had an investment proposal on his desk when the new system was implemented. The investment opportunity required a $250,000 initial cash outflow and was expected to return cash inflows of $90,000 per year for the next five year. Gaines desired rate of return is 10 percent. Mr. Holt immediately reduced the estimated cash inflows to $70,000 per year and recommended accepting the project.
a. Assume that actual cash inflows turn out to be $91,000 per year. Determine the amount of Mr. Holt’s bonus if the original computation of net present value were based on $90,000 versus $70,000.
b. Speculate about the long-term effect the bonus plan is likely to have on the company.
c. As the Gaines Company ethics officer advising the financial decision-maker, recommend how to compensate managers in a way that discourages gamesmanship.
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