1.The Percentage Return for Each Project Is As Follows

10-B1

1.The percentage return for each project is as follows:

Percentage

ProjectReturn

1$1,200,000 ÷ $4,800,000 = 25%

2$ 627,000 ÷ $1,900,000 = 33%

3$ 182,000 ÷ $1,400,000 = 13%

4$ 152,000 ÷ $ 950,000 = 16%

5$ 136,500 ÷ $ 650,000 = 21%

6$ 90,000 ÷ $ 300,000 = 30%

a.Under assumption (a), projects 1, 2, 5, and 6 would be taken.

Total investment $7,650,000

Total return $2,053,500

Return on investment26.8%

Economic profit $ 906,000*

*$2,053,500 - ($7,650,000 x .15)

The manager taking the above projects would be following the company rule.

b.Under assumption (b), the rational manager will take only project 2, since this gives a return on investment of $627,000 ÷ $1,900,000 = 33% (and an economic profit of $627,000 - ($1,900,000 x .15) = $342,000). To take any further projects at lower returns would lower the overall return on capital invested. It should be noted that if this were not a new division with no capital at this time, the manager under this alternative would take only those projects which would not lower the expected rate of return on presently-invested capital.

c.Under assumption (c), the manager will take projects 1, 2, 4, 5 and 6.

Total investment $8,600,000

Total return $2,205,500

Return on capital invested 25.6%

Economic profit $ 915,500*

*$2,205,500 - ($8,600,000 x .15)

2.To maximize the earnings of the company as a whole, the division manager should be instructed to maximize economic profit. The essence of the concept of economic profit is that it requires the manager to take all projects that promise a positive return to the company over and above the cost of the capital invested. This will maximize total return to the company for the capital it has available. To maximize ROI or to use a target rate above the cost of capital means that the company (assuming that it has the money to invest) is passing up profitable opportunities. Note that by taking project 4, the division manager lowered the ROI from assumption (a) but raised the economic profit. Project 3 would lower economic profit since its gross return on investment is less than the cost of the capital needed.