A division is considering the acquisition of a new asset that will cost $2,520,0

Question

A division is considering the acquisition of a new asset that will cost $2,520,000 and have a cash flow of $700,000 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? (Enter "ROI" answers as a percentage rounded to 1 decimal place (i.e., 32.1). Negative amounts should be indicated by a minus sign.)

Year Investment Base ROI Residual Income 1 $2,520,000 % 2 % 3 % 4 %

Explanation / Answer

Given,

New Asset = $2,520,000

Cash Flow = $700,000

Cost Of Capital / Investment = 8% on Capital

ROI (Return Of Investment) = (Gain from Investment - Cost Of Investment) / Cost Of Investment

Residual Income = Net Income - (Rate Of Return x Operating Assets)

Life of Asset = 4 years with no Salvaged Value

Depreciation = (Cost Of Asset - Salvaged Value) / Life Of Asset

Depreciation to be taken out by Straight Line Method

For 1st year

Cost Of Capital = Capital x 8% = $2,520,000 x 8% = $201,600

Depreciation = ($2,520,000 - 0) / 4 = $2,520,000 / 4 = $630,000

Hence Cost Of Asset after Depreciation = Cost Of Asset - Depreciation = $2,520,000 - $630,000

= $1,890,000

For 2nd year

Cost Of Capital = Capital x 8% = $1,890,000 x 8% = $151,200

Depreciation = $1,890,000 / 4 = $472,500

Hence Cost Of Asset after Depreciation = Cost Of Asset - Depreciation = $1,890,000 - $472,500

= $1,417,500

For 3rd year

Cost Of Capital = Capital x 8% = $1,417,500 x 8% = $113,400

Depreciation = $1,417,500 / 4 = $354,375

Hence Cost Of Asset after Depreciation = Cost Of Asset - Depreciation = $1,417,500 - $354,375

= $1,063,125

For 4th year

Cost Of Capital = Capital x 8% = $1,063,125 x 8% = $85,050

Depreciation = $1,063,125 / 4 = $265,781

Now, The ROI & Residual Income in the table format is as below

Year Investment Base ROI Residual Income 1 $2,520,000 11.5 % $2,930,200 2 $1,890,000 11.5 % $2,372,650 3 $1,417,500 11.5 % $1,954,488 4 $1,063,125 11.5 % $1,640,866

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