Harbor Division has total assets (net of accumulated depreciation) of $800,000 a

Question

Harbor Division has total assets (net of accumulated depreciation) of $800,000 at the beginning of year 1. One of the assets is a machine that has a net book value of $67,000. Expected divisional income in year 1 is $85,000 including $5,900 in income generated by the machine (after depreciation). Harbor’s cost of capital is 10 percent. Harbor is considering disposing of the asset today (the beginning of year 1), but assume that Harbor has been leasing the machine for $21,000 annually. Assume also that the machine generates income of $5,900 annually after the lease payment. Harbor can cancel the lease on the machine without penalty at any time.

Required:

a. Harbor computes ROI using beginning-of-the-year net assets. What will the divisional ROI be for year 1 assuming Harbor retains the asset? (Enter your answer as a percentage rounded to 1 decimal place (i.e., 32.1).)

b. What would divisional ROI be for year 1 assuming Harbor disposes of the asset? (Enter your answer as a percentage rounded to 1 decimal place (i.e., 32.1).)

c. Harbor computes residual income using beginning-of-the-year net assets. What will the divisional residual income be for year 1 assuming Harbor retains the asset?

d. What would divisional residual income be for year 1 assuming Harbor disposes of the asset for its book value (there is no gain or loss on the sale)?

Explanation / Answer

a) ROI if Harbor retains the asset = (Expected divisional income/Total Assets)*100

= ($85,000/$800,000)*100 = 10.6%

b) If Harbor dispose the assets, then expected divisional income is reduced by 5,900 and total assets will be reduced by $67,000

ROI = [($85,000-$5,900)/($800,000-$67,000)]*100 = (79,100/$733,000)*100 = 10.8%

c) Residual income if Harbor retains the asset = [Divisional Income - (Total Assets*Cost of capital)]

= [$85,000 - (800,000*10%)] = $85,000-$80,000 = $5,000

d) Residual income if Harbor disposes the asset = [New Divisional Income - (New total Assets*Cost of capital)]

= [$79,100 - ($733,000*10%)] = $79,100-$73,300 = $5,800

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