Ginger Company recently installed a postaudit program. To motivate their employees to take the program seriously, Ginger established a bonus program. Managers receive a bonus equal to 10 percent of the amount by which net present value exceeds the projected net present value. Jim Hey, manager of the Mid West 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 years. Ginger’s desired rate of return is 10 percent. Mr. Hey immediately reduced the estimated cash inflows to $70,000 per year and recommended accepting the project. Discuss the long-term effect the bonus plan is likely to have on the company.
Answer:
First of all we will calculate NPV under the cash flow of $ 90,000 as follow
| Year | Cash Flow | PV Factor @ 10% |
Prasent Value |
| 0 | -250,000 | 1 | -250000 |
| 1 | 90000 | 0.909091 | 81818.18 |
| 2 | 90000 | 0.826446 | 74380.17 |
| 3 | 90000 | 0.751315 | 67618.33 |
| 4 | 90000 | 0.683013 | 61471.21 |
| 5 | 90000 | 0.620921 | 55882.92 |
| 91170.81 |
So here NPV = $ 91,170
Now we will calculate NPV under the cash flow of $ 70,000 as follow
| Year | Cash Flow | PV Factor @ 10% |
Prasent Value |
| 0 | -250,000 | 1 | -250000 |
| 1 | 70000 | 0.909091 | 63636.36 |
| 2 | 70000 | 0.826446 | 57851.24 |
| 3 | 70000 | 0.751315 | 52592.04 |
| 4 | 70000 | 0.683013 | 47810.94 |
| 5 | 70000 | 0.620921 | 43464.49 |
| 15355.07 |
So here NPV = $ 15,355.07
If we take the difference of both this NPV it will come at,
= $ 91170.81 -$ 15355.07
=$ 75,815.14
Now 10% of $ 75,815
=75815.14* 0.10
=$ 7581.514
Long term effect of the bonus plan are as follow
If the company pays regular bonus then, it will be guarantees to the company that employees will stay with the company for at least as long as payments continue
This bonus scheme in the long-term makes employer more attractive to applicants employees due to a competitive pay scale
outstanding performer will receive the generous amount of bonus , while average performers will receive less amount of bonus
In the last we can say that, in the long term, bonus programs may cause distress to the company’s financial condition
