>> Let's talk about another issue with return on investment, and it has to do with the use of return on investment when we're talking about compensation and incentives. Specifically, incentive design is quite complex. It's a very challenging task inside of firms. One reason is that managers and employees may not respond as intended. They may be overly focused on their compensation and do what it takes to earn it. Let's consider this in the guise of ROI via an example scenario. In this example, we are considering Tavo T., Inc. Information is provided as follows: In the past 5 years, Tavo has grown to over 200 stores, even when the cost of capital -- which we'll describe later -- has been approximately 12%. Two of the company operated units, the A-Division and the B-Division, are among the fastest growing locations. Both are considering expanding their menus to include gluten-free offerings. Installation of the necessary ovens and purchase of the necessary equipment would cost $23,000 per store location. Currently, the A-Division has a total investment or asset base of $90,000. Store revenues on an annual basis are approximately $110,000, and expenses are 92,000. The expansion of A-Division's menu should increase profits, it's projected, by about $3,900. Similar information is available for the B-Division. The current investment in the B-Division totals $170,000. The store's revenues on an annual basis are approximately 165, and expenses are 140. Expanding B-Division's menu should increase its profits by approximately the same amount, $3,900. So we're going to assume a couple of things: first off, a 12% cost of capital. Now, cost of capital very simply represents the threshold that managers must meet for a long-scale -- large-scale investment. If they don't meet this threshold, then it's not worthwhile to the company. The cost of capital that's decided upon by upper management is informed by a number of factors. Now, the question comes up. Will the Tavo store managers, those of the A-Division and the B-Division, choose to expand to offer the gluten-free menu? So let's take a look at the return on investment of the gluten-free option. The increase in profit or the profit that earned by the gluten-free option is $3,900 for Division A and $3,900 for Division B. It's the same for each of those divisions. And the investment that's required to install the ovens and machinery is 23,000 for both of those divisions. So, therefore, just for the gluten-free investment or menu investment, we will earn a 17% return on investment. That's $3,900 divided by the investment base, $23,000. That's an even 17%. Now, going back to the threshold that's required to make an investment worth it, this option for both the A-Division and the B-Division seems worth it. It would be recommended by managers because it exceeds the 12% threshold that's required of investments. So now let's take a look at the A-Division and the B-Division before they implement this gluten-free option so what a current or normal year looks like in terms of return on investment. For the A-Division, we were told that the operating -- or the revenues for the year on an annual basis are $110,000. The expenses for the year are 92,000. The difference between those two is a rudimentary net income measure of $18,000. This is going to represent the numerator in the return on investment calculation, our income number or profit number. The investment that A-Division currently has -- it's asset based, if you will -- is $90,000. So our ROI calculation is 18,000 divided by the 90,000, yielding a 20% return on investment. On the B-Division side, we were told that revenues are $165,000. Expenses are 140, yielding a net income of $25,000. The investment base for Division B is 170,000. Dividing profit by that investment base, $25,000 in profit divided by $170,000 in investment or assets is equal to 14.7%. Now let's think about each division manager's choice to invest in the gluten-free option. If the A-Division manager invests in the option, it would be like taking a new investment and adding it to the existing situation. The new investment would be the 17% that is earned on the gluten-free investment, the $3,900 divided by the $23,000 that is required to make the investment. For Division A, this is actually less than what they're currently performing at. For Division B, they would earn the same profit based on the same investment so a new investment for Division B that would earn something that is actually greater than they're earning. So, in B-Division's world, the manager is inclined to make this investment because, when the gluten-free option is incorporated into the books of the existing company, the overall return on investment will actually increase. This is in contrast to what the A-Division manager will do. They probably will shy away from this investment, all else equal, because this is actually bringing down their overall return on investment for the firm. They are currently at 20%. They're thinking about an investment that yields 17%. When these things are combined, the overall return on investment for Division A will be lower than what they are currently performing at. So, if this is the case, Division A will not invest in the gluten free option. B-Division will. It's the same investment yielding the same profit and yielding the -- requiring the same investment. And, notably, the 17% that's earned is greater than the threshold that upper management has defined. But, yet, if we provide compensation based on return on investment, A-Division managers' compensation may decrease as a result of this investment whereas B-Division may increase. So this is an unintended consequence of using return on investment for compensation purposes. So this example highlights another problem with return on investment, specifically the potential for managers to reject profitable projects that reduce their existing return on investment. We generically refer to this as the underinvestment problem, the reason being the manager shies away from investments that are actually preferred by the firm or approved by them but hurts their own business unit's performance. Successful divisions are especially susceptible to this problem, ultimately shying away from investment opportunities that don't meet their personal needs but do so for the organization as a whole.