Free Lunches and ROI: A Modern Fable: To Boost Their Respective Average ROI and Increase Their Annual Performance-Based Bonuses, Two Senior Managers of a Multinational Conglomerate Transfer Divisions between Themselves. but Is There Such a Thing as a Free Lunch? (2008)

King Conglomerate was a large multinational firm with many different lines of business spread across the globe. The company was organized into divisions. As King was a conglomerate, each division had many segments that were totally independent of each other. The King board of directors was meeting with the new CEO to develop a compensation scheme to reward division heads for increasing profitability. Because of the diversity of product lines and geographic locations, it was very important to find a universal yardstick that could measure performance without any biases. The board was considering two proposals: return on investment (ROI) and residual income (RI). One senior director said, am on the board of a number of other firms, and they all use all my years of being in business, the most prevalent performance measure I have seen is ROI. Two international directors agreed. In our countries, we also use ROI extensively, they said. Another director added, don't like RI because each year we have to calculate the cost of capital. Also, if we don't want to spend months arguing with the division heads, we have to use the identical cost of capital for the entire firm. this way, we fail to reward a division head who borrows locally at a favorable rate to finance a local investment. By using ROI, we encourage division heads to search for favorable financing because it allows them to increase their ROI. With a unanimous vote, the board voted to use ROI to measure performance and to reward division heads based on the increase in their ROI from the previous year. YEAR ONE Jill and Jack were the two most successful senior managers at King Conglomerate. Both were able to successfully motivate their subordinates and were independent heads of their respective divisions. Each manager's division had 24 segments. Both Jill and Jack had an investment of about $3.5 billion. Because King used the ROI method to reward managers, both senior managers carefully chose their investments to maximize their Jill had increased her ROI annually so that she had the highest ROI in the firm. She earned $652,166,186 on an investment base of $3,384,108,100, which gave her an ROI of 19.27%. Jack earned $194,035,184 on an investment base of $3,814,521,000, giving him an ROI of 5.09%. (See Table 1.) This year, however, Jill and Jack were very glum. It was one month before the end of the fiscal year, and neither had been able to improve their ROI from last year. They knew that the CEO would be very disappointed. Jill and Jack also knew that they would receive no bonus if they could not show an increase in their respective Jill called Jack and invited him to lunch so they could brainstorm together how to beat last year's Because Jill remembered her economics professor telling the class, There is no such thing as a free lunch, she graciously offered to pay. As they were about halfway through a magnum of Dom Perignon, both Jill and Jack felt better, but they still hadn't made any headway in solving their problem. Jill said, If I could just get rid of some of my segments with the lowest ROI, it would raise my But there are no free lunches. It is not fair to the employees to fire them just so I can get a bonus. Also, the CEO would be very upset at all the bad publicity we would get, and the unions might strike. Finally, we would have to make a huge severance payout. Closing a segment is not an option for me. Jack said, If I could just buy a segment with an ROI larger than 5.09%, I could raise my But I would have to increase my investment base to buy the segment. By the time I finish paying the attorneys and accountants, I would end up lowering my ROI. As they were finishing the last two glasses of champagne, both felt a little lightheaded. Suddenly Jill said, have a great idea. …