Question

Problem 14-57 (Algo) Compare Historical, Net Book Value to Gross Book Value, Residual Income (LO 14-3, 5) The Ste. Marie Division of Pacific Media Corporation just started operations. It purchased depreciable assets costing $65 million and having a four-year expected life, after which the assets can be salvaged for $13 million. In addition, the division has $65 million in assets that are not depreciable. After four years, the division will have $65 million available from these nondepreciable assets. This means that the division has invested $130 million in assets with a salvage value of $78 million. Annual depreciation is $13 million. Annual operating cash flows are $32 million. In computing ROI, this division uses end-of-year asset values in the denominator. Depreciation is computed on a straight-line basis, recognizing the salvage values noted. Ignore taxes. Assume that the company uses a 12 percent cost of capital. Required: a. Compute residual income, using net book value for each year. b. Compute residual income, using gross book value for each year. (Enter your answers in thousands of dollars.) Residual Income Net Book Gross Book Value Value Year 1 Year 2 Year 3 Year 4

a. Compute residual income, using net book value for each year.

b. Compute residual income, using gross book value for each year.

Answer 1

	Residual Income ( in thousands of dollars )
	Net Book Value	Gross Book Value
Year 1	$ 4,960	$ 3,400
Year 2	6,520	3,400
Year 3	8,080	3,400
Year 4	9,640	3,400

Residual Income = Net Operating Income - ( Book Value of Assets * Cost of Capital )

Net Operating Income = Annual Operating Cash Flows - Annual Depreciation = $ 32,000,000 - $ 13,000,000 = $ 19,000,000

	Net Book Value	Gross Book Value
Year 1	RI = [$ 19,000,000 - $ ( 130,000,000 - 13,000,000 ) * 12 % ] = $ 4,960,000	RI = $ 19,000,000 - $ ( 130,000,000 x 12 % ) = $ 3,400,000
Year 2	RI = [ $ 19,000,000 - $ ( 130,000,000 - 2 * 13,000,000 ) * 12 % ] = $ 6,520,000	RI = $ 19,000,000 - $ ( 130,000,000 x 12 % ) = $ 3,400,000
Year 3	RI = [ $ 19,000,000 - $ ( 130,000,000 - 3 x 13,000,000 ) * 12 % = $ 8,080,000	RI = $ 19.000,000 - $ ( 130,000,000 x 12 % ) = $ 3,400,000
Year 4	RI = [ $ 19,000,000 - $ ( 130,000,000 - 4 * 13,000,000 ) * 12 % ] = $ 9,640,000	RI = $ ( 19,000,000 - $ ( 130,000,000 x 12 % ) = $ 3,400,000