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ACCA Strategic Professional · Advanced Financial Management · The role and responsibility of senior financial executive/advisor

Orion Ltd's managers are paid a bonus of 2% of reported profit. A project requires an outlay of $10m now and returns $4m at the end of each of years 1, 2 and 3 (undiscounted total $12m). The cost of capital is 10%. Annuity factor for 3 years at 10% is 2.487. Straight-line depreciation over 3 years applies and the bonus is based on accounting profit after depreciation. Which conclusion is correct?

NPV is negative at about –$0.052m (9.948m inflows less 10m outlay), yet annual accounting profit is about $0.667m after depreciation. A profit-based bonus would therefore push managers to accept a value-destroying project, showing misalignment with shareholder wealth.

  1. ANPV is –$0.052m, yet accounting profit is positive each year, so the bonus scheme would encourage acceptance of a value-destroying projectCorrect
  2. BNPV is +$0.052m, so accepting is consistent with shareholder wealth
  3. CNPV is –$0.052m and accounting profit is negative each year, so managers would also reject it
  4. DNPV is +$1.948m, so the bonus scheme is aligned with shareholders

Explanation

PV of inflows = 4 × 2.487 = 9.948m. NPV = 9.948 − 10 = −$0.052m, so it destroys value. Annual depreciation is 3.333m, so accounting profit is 4 − 3.333 = $0.667m positive each year, hence profit-based bonuses reward acceptance. Options claiming positive NPV or negative profit misstate the calculation.

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