Question

The Singer Division of Patio Enterprises currently earns $3.22 million and has divisional assets of $23 million. The division manager is considering the acquisition of a new asset that will add to profit. The investment has a cost of $3,459,000 and will have a yearly cash flow of $861,000. The asset will be depreciated using the straight-line method over a six-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 11 percent. Ignore taxes. The division manager learns that he has the option to lease the asset on a year-to-year lease for $754,000 per year. All depreciation and other tax benefits would accrue to the lessor.

Required:

a. What is the division's residual income before considering the project? (Enter your answer in dollars, not in millions.)

b. What is the division's residual income if the asset is purchased? (Enter your answer in dollars, not in millions.)

c. What is the division's residual income if the asset is leased? (Enter your answer in dollars, not in millions.)

Answer 1

Solution

Singer Division – Patio Enterprises

1. Computation of Division’s residual income before considering the project:

Current income = $3,220,000

Divisional assets = $23,000,000 million

Cost of capital = 11%

Return on assets = 23,000,000 x 11% = $2,530,000

Residual income = current income – return on assets

Residual income = $3,220,000 - $2,530,000 = $690,000

1. Computation of Division’s residual income if the asset is purchased:

Residual income if the asset is purchased = current residual income + residual income if asset is purchased

Current residual income = $690,000

Estimated income from investment in asset = $861,000

Less: depreciation ($3,459,000/6 years)= $576,500

Net income= 284,500

Return on asset = 11% x 3,459,000 = $380,490

Residual income = $284,500 - $380,490 = -$95,990

Net residual income if asset is purchased = $690,000 + ($95,990) = $594,010

1. Computation of the Division’s residual income if the asset is leased:

Current residual income = 690,000

Add: cash flows from asset net of expenses –

Cash flows = $861,000

Less: annual lease payments = $754,000

Net cash flows = $107,000

Residual income when asset is leased = 690,000 + 107,000 = $797,000