Ocean Division currently earns $820,000 and has divisional assets of $4.3 millio
ID: 2451300 • Letter: O
Question
Ocean Division currently earns $820,000 and has divisional assets of $4.3 million. The division manager is considering the acquisition of a new asset that will add to profit. The investment has a cost of $679,000 and will have a yearly cash flow of $172,000. The asset will be depreciated using the straight-line method over a five-year life and is expected to have no salvage value. Divisional performance is measured using ROI with beginning-of-year net book values in the denominator. The company's cost of capital is 15 percent. Ignore taxes. The division manager learns that he has the option to lease the asset on a year-to-year lease for $152,000 per year. All depreciation and other tax benefits would accrue to the lessor.
a. What is the divison's residual income before considering the project?
b. What is the divison's residual income if the asset is purchased?
c. What is the divison's residual income if the asset is leased?
Explanation / Answer
In the above formula,
A = Department's net operating income;
B = Minimum required return on assets; and
C = Average operating assets of the department
a) Residual Income = $820000 - ($4300000 x 15%) = $820000 - $645000 = $175000
b)
depreciation per year = $679000 / 5 = $135800
Incremental net operating income per year = $172000 - $135800 = $36200
(as the depreciation and other tax benefits accrue to the lessor)
Total operating asset (with the beginning book value of operating assets) = $4300000 + $679000 = $4979000
Net Operating Income after taking the project per year = $ 820000 + $ 36200 = $856200
Residual Income = $856200 - (15% of $4979000) = $856200 - $746850 = $109350
c)
depreciation per year = $679000 / 5 = $135800
Incremental net operating income per year = $152000 - $135800 = $16200
Total operating asset (with the beginning book value of operating assets) = $4300000 + $679000 = $4979000
Net Operating Income after taking the project per year = $ 820000 + $ 16200 = $836200
Residual Income = $836200 - (15% of $4979000) = $836200 - $746850 = $89350
Residual Income (RI) = A (B × C)Related Questions
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