The Caribbean Division of Mega-Entertainment Corporation just started operations

Question

The Caribbean Division of Mega-Entertainment Corporation just started operations. It purchased depreciable assets costing $25 million and having a four-year expected life, after which the assets can be salvaged for $5 million. In addition, the division has $25 million in assets that are not depreciable. After four years, the division will have $25 million available from these non-depreciable assets. This means that the division has invested $50 million in assets with a salvage value of $30 million. Annual depreciation is $5 million. Annual operating cash flows are $12.5 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 all cash flows increase 10 percent at the end of each year. This has the following effect on the assets' replacement cost and annual cash flows:

Note that "accumulated" depreciation is 10 percent of the gross book value of depreciable assets after one year, 20 percent after two years, and so forth.

Compute ROI using historical cost, net book value and gross book value. (Do not round intermediate calculations. Round your answers to 1 decimal place.)

  

Compute ROI using current cost, net book value and gross book value. (Do not round intermediate calculations. Round your answers to 1 decimal place.)

End of Year Replacement Cost Annual Cash Flow 1 $ 50,000,000 × 1.1 = $ 55,000,000 $ 12,500,000 × 1.1 = $ 13,750,000 2 $ 55,000,000 × 1.1 = $ 60,500,000 $ 13,750,000 × 1.1 = $ 15,125,000 3 Etc. Etc. 4

Explanation / Answer

Return on investment (ROI) is the net operating income expressed as a percentage of net investment. In this problem, firm has invested $50 million. Out of this amount, $25 million is depreciable asset. It has 4 years life with salvage value of $5 million. Remaining $25 million is non depreciable asset. Full $25 million is realizable after 4 years. Net investment at the end of a year is total investment minus accumulated depreciation at the end of the year. Here ROI will be calculated on year end net investment. Average investment will not be used in its calculation.

Now consider net operating income. Gross cash flow from operation is $12.5 million per year. Deduct year end depreciation from it to get net operating income On the basis of such workings calculation of ROI for each year are shown separately. Also 4 years average ROI has been calculated based on 4th year end net investment.

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In second part of the problem, instead of book value you have to consider current value of net operating profit and net investment. As per problem, current value is rising 10% in each year in comparison with the previous year. So multiply previous years figures by 1.1 to get current years figure. Calculation of ROI on yearly basis and lastly on average of the 4years are shown below:

Calculation of ROI using book value of investment and historical cost Year 1 Year 2 Year 3 Year 4 Average 1 Operating cash flow     12,500,000 12,500,000     12,500,000    12,500,000 Less Depreciation       5,000,000    5,000,000       5,000,000      5,000,000 Operating return on Investment       7,500,000    7,500,000       7,500,000      7,500,000      7,500,000 2 Investment 50,000,000 50,000,000 50,000,000 50,000,000 Less: Depreciation (acumulated)       5,000,000 10,000,000     15,000,000    20,000,000 Net Investment 45,000,000 40,000,000 35,000,000 30,000,000 30,000,000 3 ROI (1/2)*100 16.67 18.75 21.43 25.00 25.00

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