As the preceding discussion suggests, ideally one should evaluate managers on a project-by-project basis and look at how well managers achieve the amounts and timing of forecasted cash flows. In practice, however, companies often evaluate managers based on aggregate information, especially when multiple projects are under way at any given point in time. It is important then for companies to ensure that the method of evaluation does not conflict with the use of the NPV method for making capital budgeting decisions. For example, suppose Vector uses the accrual accounting rate of return generated in each period to assess its managers. We know that the managers should purchase the hybrid bus because it has a positive NPV of $69,840. However, they may reject the project if the AARR of 8.3% on the net initial investment is lower than the minimum accounting rate of return Vector requires them to achieve.
There is an inconsistency between promoting the NPV method as best for capital budgeting decisions and then using a different method to evaluate performance. Even though the NPV method is best for capital budgeting decisions, managers will be tempted to make capital budgeting decisions based on the method on which they are evaluated. The temptation becomes more pronounced if managers are frequently transferred (or promoted) or if their bonuses are affected by the level of year-to-year income earned under accrual accounting.
Other conflicts between decision making and performance evaluation persist even if a company uses similar measures for both purposes. If the AARR on the hybrid bus exceeds the minimum required AARR but is below Vector’s current AARR in the region, the manager may still be tempted to reject purchase of the hybrid bus because the lower AARR of the hybrid bus will reduce the AARR of the entire region and thus hurt the manager’s reported performance. Or consider an example where the cash inflows from the hybrid bus occur mostly in the later years of the project. Then, even if the project’s AARR exceeds the current AARR of the projects overseen by the manager (as well as the minimum required return), the manager may still reject the purchase because for the first few years it will have a negative effect on the rate of return earned under accrual accounting. In Chapter 24, we study these conflicts in greater depth and describe how performance evaluation models such as economic value added (EVA) help lessen these conflicts.