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Dear Sir,
For the requirement of (iii), it is hard for me to understand the answer.
Currently division performance is measured by divisional operating profit, which discourage long term investment in refurbish existing stores because the extra depreciation relating to refurbish will negative impact the amount of operating profit.
But I do understand why the mangers are prioritize new store capital expenditure. The new store will have a higher depreciation than the old stores, the operation profit will be even lower because of the higher depreciation for the new store.
RI can discourage investment, as NBV of assets fall over time, RI automatically improves.
I don’t understand why proposed change to RI addressed existing problems.
Could you please help with it?
Thanks in advance!
Sincerely,
LilyI think the point is that new stores are preferred to refurbishment. Both chamges will increase depreciation, but will presumably also increase profits otherwise no one would ever invest in new or improved premises.
Refurbishment is likely to be regarded as an expense (eg decoration). However, as there is no charge presently calculated for the use of capital, the company effectively gets a free ride when asking for capital for new stores. Free use of lots of new capital to build swanky new stores and stimulate profits compared to bearing refurbishment expenses.
I see. Based on the division managers’ experience, to open new store will boost profit. Therefore they prefer to invest in new stores. But the board would like to control the the free ride of increasing invest in new store by using RI to have a goal congruence by considering real cash flow generating ability from the new store investment.
Thanks!
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