A division is considering the acquisition of a new asset that will cost $2,820,000 and have a cash flow of $780,000 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?
| a | Cost of the asset | 2,820,000 | ||||
| b | Cash flow per year | 780,000 | ||||
| c | Useful Life (years) | 4 | ||||
| d | Depreciation per year (a/c) | 705,000 | ||||
| Year 1 | Year 2 | Year 3 | Year 4 | |||
| e | Opening Asset balance | 2,820,000 | 2,115,000 | 1,410,000 | 705,000 | |
| f | Depreciation | 705,000 | 705,000 | 705,000 | 705,000 | |
| g | Closing balance (e-f) | 2,115,000 | 1,410,000 | 705,000 | - | |
| h | Annual cashflow | 780,000.00 | 780,000.00 | 780,000.00 | 780,000.00 | |
| i | Annual cashflow after depreciation (h-f) | 75,000.00 | 75,000.00 | 75,000.00 | 75,000.00 | |
| j | % of ROI (i/e)*100 | 3% | 4% | 5% | 11% | |
| k | Cost of capital 8% on 28,20,000 | 225,600 | 225,600 | 225,600 | 225,600 | |
| l | Residual income () | (150,600.00) | (150,600.00) | (150,600.00) | (150,600.00) | |
Note: The asset is generating a negative residual income if the cost of capital charge of 8% is on full capital that is 282000
Scenario B, It is more ideal to charge 8% of cost of capital on the opening asset value. The calculation is below in that case.
| Year 1 | Year 2 | Year 3 | Year 4 | ||
| e | Opening Asset balance | 2,820,000 | 2,115,000 | 1,410,000 | 705,000 |
| f | Depreciation | 705,000 | 705,000 | 705,000 | 705,000 |
| g | Closing balance (e-f) | 2,115,000 | 1,410,000 | 705,000 | - |
| h | Annual cashflow | 780,000.00 | 780,000.00 | 780,000.00 | 780,000.00 |
| i | Annual cashflow after depreciation (h-f) | 75,000.00 | 75,000.00 | 75,000.00 | 75,000.00 |
| j | % of ROI (i/e)*100 | 3% | 4% | 5% | 11% |
| k | Cost of capital 8% on opening asset value | 225,600 | 169,200 | 112,800 | 56,400 |
| l | Residual income () | (150,600.00) | (94,200.00) | (37,800.00) | 18,600.00 |
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