Pay plan and suboptimization Thomas Owan is a division manager of Weatfarl Inc.

Question

Pay plan and suboptimization

Thomas Owan is a division manager of Weatfarl Inc. He is in the process of evaluating a $3,882,000 investment. The following net annual increases, before depreciation, in divisional income are expected during the investment’s five-year life:

All company assets are depreciated using the straight-line method. Owan receives an annual salary of $502,500 plus a bonus of 3 percent of divisional pre-tax profits. Before consideration of the potential investment project, he anticipates that his division will generate $3,882,000 annually in pre-tax profit.

a. Compute the effect of the new investment on the level of divisional pre-tax profits for years 1 through 5. If the effect is negative, enter your answer as a negative number.

b. Determine the effect of the new project on Owan’s compensation for each of the five years. If the effect is negative, enter your answer as a negative number.

Year 1 $ 278,000 Year 2 496,100 Year 3 735,300 Year 4 3,266,300 Year 5 2,918,400

Explanation / Answer

Compute the effect of the new investment on the level of divisional pre-tax profits for years 1 through 5. If the effect is negative, enter your answer as a negative number.

Determine the effect of the new project on Owan’s compensation for each of the five years. If the effect is negative, enter your answer as a negative number.

net annual increases Less Depreciation Income Before Bonus Year 1 2,78,000 776400 -4,98,400 Year 2 4,96,100 776400 -2,80,300 Year 3 7,35,300 776400 -41,100 Year 4 32,66,300 776400 24,89,900 Year 5 29,18,400 776400 21,42,000

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