UNIT II STUDY GUIDE

Opportunity Costs and

Organizational Architecture

Course Learning Outcomes for Unit II

Upon completion of this unit, students should be able to:

1. Analyze, evaluate, and synthesize empirical studies in order to write research papers.
2. Explain opportunity cost of capital and capital budgeting.
3. Discuss basic building blocks and organizational architecture.

Reading Assignment
Chapter 3: Opportunity Cost of Capital and Capital Budgeting

Chapter 4: Organizational Architecture

Unit Lesson
One of the major themes this week centers on agency theory and associated agency costs, which are the
sum of opportunity costs of misbehavior and out-of-pocket costs for incentives and monitoring performance.
The term agency theory represents the idea of incentives and behaviors based on the relationship between a
principal (employer) who offers an incentive plan and an agent (employee) who accepts the plan to work on
behalf of the principal. This concept focuses mainly on improving the overall success of a firm and motivating
employees to work.

The incentive plan must attract and motivate qualified employees to behave according to the organization’s
goals, but doing this costs money for paying employees and for monitoring to ensure that performance
measures are valid. These payments reduce the value left for principals, so they seek to minimize them. A
company might spend so much money on incentives and reporting that no employee will ever do something
that is not in the shareholders’ best interests.

Furthermore, no qualified employee will submit to these working conditions. However, such actions are
unlikely to be economical given the high costs of the incentives and reporting compared to the costs of
administering alternative incentive plans against the cost of misbehavior. The best incentive plan is not the
one that drives the costs of misbehavior to zero, nor is it the one which spends the least on incentives and
reporting. The best plan is situated between these extremes, reflected by a level of incentives and monitoring.
In theory, this plan is the mix of incentives and monitoring mechanisms that minimizes total agency costs.
Agency theory shows that the perfect incentive system is too expensive and that some level of employee
misbehavior is desirable. Thus, the overall best system is a result of evaluating trade-offs.

Once the best system is implemented, the next step involves securing the right types of capital. Any decision
that involves an investment in order to obtain some future return is a capital budgeting decision. Typical
capital budgeting decisions include:

 Cost reduction decisions: Should new machinery be purchased to reduce costs?

 Machinery/equipment selection decisions: Which of several available machines should be
purchased?
 Lease or buy decisions: Should new equipment be leased or purchased?
 Equipment replacement decisions: Should old equipment be replaced now or later?
 Expansion decisions: Should a new plant, warehouse, or other facility be acquired to increase
capacity and sales?

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Capital investments usually earn returns that extend overly long periods of time. Thus, it is important to
recognize the time value of money when assessing investment proposals. A dollar today is worth more than a
dollar a year from now if for no other reason than that you can put a dollar in a bank today and have more
than a dollar a year from now. In other words, projects that promise earlier returns are preferable to those that
promise later returns.

Capital budgeting techniques that recognize the time value of money involve discounting cash flows. Two
methods used to make capital budgeting decisions using discounted cash flows include the net present value
method and the internal rate of return method. The goal of both methods is to ascertain which project is the
best choice for a firm.

Under the net present value method, the present value of a project’s cash inflows is compared to the present
value of the project’s cash outflows. The difference between the present value of these cash flows, called the
net present value, determines whether or not the project is an acceptable investment. Let’s look at an
example to illustrate how this concept works.

Lee Corporation is trying to decide on the purchase of a machine capable of performing some operations that
are now performed manually. The machine will cost $40,000, and it will last for four years. At the end of the
four-year period, the machine will have a zero scrap value. Use of the machine will reduce labor costs by
$17,500 per year. Lee Corporation requires a minimum pretax return of 15% on all investment projects.
Should the machine be purchased? Is this a good investment?

First we must decide whether a cash investment of $40,000 can be justified if it will result in a $17,500
reduction in cost in each of the next four years. It might appear like an easy question to answer because the
total cost savings is $70,000 ($17,500 for four years). However, the company can earn a 15% return by
investing its money elsewhere. It is not enough that the cost reductions cover just the original cost of the
machine; they must also yield a return of at least 15% or the company would be better off investing the
money.

The next step involves discounting the annual stream of $17,500 cost savings and then comparing it to the
cost of the new machine. The company’s minimum required return of 15% is used as the discount rate in the
discounting process.

Item Year Amount of Cash Flow 15% Factor PV of Cash Flows

Annual cost 1-4 17,500 2.855**from $49,962

savings present value
tables

Initial now $(40,000) 1.0 (40,000)

investment

Net present $9,962

value

Based on our analysis, the company should definitely purchase the new machine. The present value of the
cost savings is $49,962, whereas the present value of the required investment is only $40,000. When we
deduct the present value of the investment from the present value of the cost savings, we end up with a net
present value of $9,962. The general rule is to accept investments whenever the net present value is zero or
greater.

The other method normally used when making capital budgeting decisions is the internal rate of return, which
is the rate of return promised by an investment project over its useful life. The internal rate of return is
computed by finding the discount rate that equates the present value of a project’s cash outflows with the
present value of its cash inflows. Thus, the internal rate of return is the discount rate that results in a net
present value of zero.

To evaluate a project using this method, the internal rate of return is compared to the company’s minimum
required rate of return, which is usually the company’s cost of capital. If the internal rate of return is equal to,

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or greater than the required rate of return, then the project is considered to be acceptable. If the internal rate
of return is less than the required rate of return, then the project is rejected.

When we compare the two methods, the net present value method has several important advantages over
the internal rate of return method. First, this method is often simpler to use than the internal rate of return
method. Using this method may require hunting for the discount rate that results in a net present value of
zero. This can be very difficult.

Second, the internal rate of return method makes a questionable assumption. The internal rate of return
method calculates the discount rate at which an investment’s present value of all expected cash inflows
equals the present value of its expected cash outflows. Thus, it takes a reverse approach since it looks for the
rate instead of the net present value of a project. Both methods assume that cash flows generated by a
project during its useful life are immediately reinvested elsewhere. However, the two methods make different
assumptions concerning the rate of return that is earned on those cash flows. Overall, when the net present
value method and the internal rate of return method do not agree concerning the attractiveness of a project, it
is best to go with the net present value method.

Supplemental Reading
Click here to access a PDF of the Chapter 3 presentation.

Click here to access a PDF of the Chapter 4 presentation.

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