Question

Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of biotech products. Forbes Division, which has $4.04 million in assets, manufactures a special testing device. At the beginning of the current year, Forbes invested $5 million in automated equipment for test machine assembly. The division’s expected income statement at the beginning of the year was as follows.

Sales revenue	$	16,030,000
Operating costs
Variable		2,160,000
Fixed (all cash)		7,620,000
Depreciation
New equipment		1,680,000
Other		1,350,000
Division operating profit	$	3,220,000

A sales representative from LSI Machine Company approached Oscar in October. LSI has for $6.12 million a new assembly machine that offers significant improvements over the equipment Oscar bought at the beginning of the year. The new equipment would expand division output by 10 percent while reducing cash fixed costs by 5 percent. It would be depreciated for accounting purposes over a three-year life. Depreciation would be net of the $540,000 salvage value of the new machine. The new equipment meets Pitt's 12 percent cost of capital criterion. If Oscar purchases the new machine, it must be installed prior to the end of the year. For practical purposes, though, Oscar can ignore depreciation on the new machine because it will not go into operation until the start of the next year.

The old machine, which has no salvage value, must be disposed of to make room for the new machine.

Pitt has a performance evaluation and bonus plan based on residual income. Pitt uses a cost of capital of 12 percent in computing residual income. Income includes any losses on disposal of equipment. Investment is computed based on the end-of-year balance of assets, net book value. Ignore taxes.

Required:

a. What is Forbes Division’s residual income if Oscar does not acquire the new machine?

b. What is Forbes Division’s residual income this year if Oscar acquires the new machine?

c. If Oscar acquires the new machine and operates it according to specifications, what residual income is expected for next year?

ANSWER IN DOLLARS NOT PERCENTAGE

(Enter your answers in thousands of dollars. Negative amounts should be indicated by a minus sign. Round your answers to the nearest whole dollars)

Answer 1

a.
Investment at beg.	4040000
Add:Additional investment	5000000
Less: depreciation new equip.	-1680000
Less: depreciation other	-1350000
Net Book value of assets at year end	6010000
* required return	12%
Minimum required return	721200
operating profit	3220000
Less: Minimum required return	-721200
Residual income	2498800
b.
Investment at beg.	4040000
Add:Additional investment	6120000
Less: depreciation other	-1350000
Net Book value of assets at year end	8810000
* required return	12%
Minimum required return	1057200
operating profit	3220000
Less: Loss on disposal of assets (5000000 - 1680000)	-3320000
Revised operating income	-100000
Less: Minimum required return	-1057200
Residual income	-1257200
c.
Calculation of operating profit	Calculation
Sales	16030000+10%	17633000
Less: operating cost
Variable	2160000+10%	2376000
Fixed	7620000-5%	7239000
Depreciation:
New equip.	(6120000-540000)/3	1860000
Other depre.		1350000
Operating profit		4808000
Calculation of minimum required return
Investment at beg.	4040000
Add:Additional investment	6120000
Less: depreciation new equip.	-1860000
Less: depreciation other (1350000*2)	-2700000
Net Book value of assets at year end	5600000
* required return	12%
Minimum required return	672000
Calculation of residual income
operating profit	4808000
Less: Minimum required return	-672000
Residual income	4136000