Question

Captain Kirk is a division manager at the ENTERPRISE, Inc. for which he operates a spaceship. Dark matter is an essential fuel component for space ships (you didn’t know?). Kirk’s spaceship will consume 2,000 pounds of dark matter in each of the years 2016, 2017 and 2018. So in 2016, Kirk wants to buy 6,000 pounds of dark matter for these three years. For simplicity, assume that in each of the years, the 2,000 pounds are consumed “in one go” on December 31 of that particular year. The cost of capital for ENTERPRISE, Inc. is 10% per year. Kirk is considering two competing sourcing offers: • Xenon Corp offers delivery of all 6,000 pounds in a single shipment on December 31, 2016, at a per-pound price of $100. That is, ending inventory of dark matter would be 4,000 pounds at the end of 2016 (the 6,000 pounds delivered on December 31, 2016, less the 2,000 pounds consumed immediately); 2,000 pounds at the end of 2017; and zero at the end of 2018. • Yoog Corp offers just-in-time delivery of 2,000 pounds each on December 31 of the years 2016, 2017, and 2018, at a fixed per-pound price of $107.50. That is, there will never be any inventory of dark matter if Kirk goes with Yoog’s offer. In both cases, payment is due upon delivery. Required: a. Suppose Captain Kirk is compensated based on Operating Income, calculated as revenues from his space trading activity net of COGS. Which offer will Kirk accept, that of Xenon or that of Yoog? [Hint: You don’t need to know anything about Kirk’s revenues to solve this question or any of the following.] b. Suppose now that Kirk is compensated based on Residual Income calculated as: Residual Income_t = Income_t – (10%) × Assets_(t-1) , just as we defined it in class. Divisional assets include fixed assets (about which we know nothing) and working capital items such as inventory, but not cash. Which sourcing offer will Kirk accept now, assuming he plans to stay on his current job for at least another three years? (He looks old, I know.) c. Now put yourself in the shoes of the shareholders of ENTERPRISE, Inc. Which sourcing offer would you want Kirk to accept, and why?

Answer 1

a. Suppose Captain Kirk is compensated based on Operating Income, calculated as revenues from his space trading activity net of COGS,

Kirk will accept, that of Xenon as

COGS is less ,ie. $ 100*2000 =200000 as against that of Yoog's $107.5*2000= 215000

b. Suppose Kirk is compensated based on Residual Income calculated as: Residual Income_t = Income_t – (10%) × Assets_(t-1) ,

Kirk will accept, that of Yoog   as

when 10% *(t-1)assets are subtracted, then because of higher inventory balance under Xenon, residual income will be comparatively much less in all the three years.

c. Now, shareholders of ENTERPRISE, Inc. Kirk would accept

Yoog Corp.

as the PV of inventory costs at the company's cost of capital of 10% is the least of the two , creating higher net income & wealth for them.