Question

Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of blotech products. Forbes Division, which has $4 million in assets, manufactures a special testing device. At the beginning of the current year, Forbes invested $5 million in automated equipment for test machine assembly. The division's expected income statement at the beginning of the year was as follows. Sales revenue $16,000,000 Operating costs Variable 2,000,000 Fixed (all cash) 7,500,000 Depreciation New equipment 1,500,000 Other 1,250,000 Division operating profit $ 3,750,000 A sales representative from LSI Machine Company approached Oscar in October. LSI has for $6.5 million a new assembly machine that offers significant improvements over the equipment Oscar bought at the beginning of the year. The new equipment would expand division output by 10 percent while reducing cash fixed costs by 5 percent. It would be depreciated for accounting purposes over a three-year life. Depreciation would be net of the $500,000 salvage value of the new machine. The new equipment meets Pitt's 12 percent cost of capital criterion. If Oscar purchases the new machine, it must be installed prior to the end of the year. For practical purposes, though, Oscar can ignore depreciation on the new machine because it will not go into operation until the start of the next year. The old machine, which has no salvage value, must be disposed of to make room for the new machine. Pitt has a performance evaluation and bonus plan based on residual income. Pitt uses a cost of capital of 12 percent in computing residual income. Income includes any losses on disposal of equipment. Investment is computed based on the end-of-year balance of assets, net book value. Ignore taxes. Required: a. What is Forbes Division's residual income if Oscar does not acquire the new machine? b. What is Forbes Division's residual income this year if Oscar acquires the new machine? c. If Oscar acquires the new machine and operates it according to specifications, what residual income is expected for next year?

Answer 1

Solution: a) Investment at beg. Add: Additional investment Less: Depreciation New Equip Less: Depreciation-Other net book value at year end x required return Minimum required return 4000 5000 -1500 -1250 6250 12% 750 Expected operating in come Less : Minimum required return Residual income 3750 -750 3000 b) Investment at beg. Add: Additional investment Less: Depreciation-Other net book value at year end x required return Minimum required return 4000 6500 -1250 9250 12% 1110 Expected operating income as given Less : Loss on disposal of asset=(5000-1500) revised operating income Less : Minimum required return Residual income 3750 -3500 250 -1110 -860

calculation 16000*(1+0.1) 17600 calculation operating profit Sales Operating cost Variable Fixed -cash Depreciation New Other Operating profit 2200 7125 7500*(1-0.05) (6500-500)/3 2000 1250 5025 caculation of minimum required return Investment at beg. Add: Additional investment Less: Depreciation-New Equip Less: Depreciation-Other1250*2 net book value at year end x required return Minimum required return 4000 6500 -2000 -2500 6000 12% 720 calculation of Residual income Operating profit Less : Minimum required return Residual income 5025 -720 4305 Note: All answer is in thousand of dollar.