A division is considering the acquisition of a new asset that will cost $2,640,000 and have a cash flow of $770,000 per year for each of the four years of its life. Depreciation is computed on a straight-line basis with no salvage value. Ignore taxes.
Required:
a. & b. What is the ROI for each year of the asset's life if the division uses beginning-of-year asset balances and net book value for the computation? What is the residual income each year if the cost of capital is 8 percent?
Answer:
Annual Income = Annual Cash Flow – (Cost / No. of Life)
Annual Income = $770,000 – ($2,640,000 / 4)
Annual Income = $770,000 - $660,000
Annual Income = $110,000
Depreciation = Cost / No. of Life
Depreciation = $2,640,000 / 4 = $660,000
Cash Flow of First Year = $2,640,000
Cash Flow of Second Year = $2,640,000 - $660,000
Cash Flow of Second Year = $1,980,000
Cash Flow of Third Year = $1,980,000 - $660,000
Cash Flow of Third Year = $1,320,000
Cash Flow of Fourth Year = $1,320,000 - $660,000
Cash Flow of Fourth Year = $660,000
ROI of First Year = Annual Income / Base *100
ROI of First Year = $110,000 / $2,640,000 *100
ROI of First Year = 4.2%
ROI of Second Year = Annual Income / Base *100
ROI of Second Year = $110,000 / $1,980,000 *100
ROI of Second Year = 5.6%
ROI of Third Year = Annual Income / Base *100
ROI of Third Year = $110,000 / $1,320,000 *100
ROI of Third Year = 8.3%
ROI of Fourth Year = Annual Income / Base *100
ROI of Fourth Year = $110,000 / $660,000 *100
ROI of Fourth Year = 16.7%
Residual Income of First Year = Annual Income – (Base * Cost of
Capital)
Residual Income of First Year = $110,000 – ($2,640,000 *8%)
Residual Income of First Year = $110,000 - $211,200
Residual Income of Second Year = -$101,200
Residual Income of Second Year = Annual Income – (Base * Cost of
Capital)
Residual Income of Second Year = $110,000 – ($1,980,000 *8%)
Residual Income of Second Year = $110,000 - $158,400
Residual Income of Second Year = -$48,400
Residual Income of Third Year = Annual Income – (Base * Cost of
Capital)
Residual Income of Third Year = $110,000 – ($1,320,000 *8%)
Residual Income of Third Year = $110,000 - $105,600
Residual Income of Third Year = $4,400
Residual Income of Fourth Year = Annual Income – (Base * Cost of
Capital)
Residual Income of Fourth Year = $110,000 – ($660,000 *8%)
Residual Income of Fourth Year = $110,000 - $52,800
Residual Income of Fourth Year = $57,200
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