Question

Problem 14-46 (Static) Equipment Replacement and Performance Measures (LO 14-2)

Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of biotech products. Forbes Division, which has $4 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	$	16,000,000
Operating costs
Variable		2,000,000
Fixed (all cash)		7,500,000
Depreciation
New equipment		1,500,000
Other		1,250,000
Division operating profit	$	3,750,000

A sales representative from LSI Machine Company approached Oscar in October. LSI has for $6.5 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 $500,000 salvage value of the new machine. The new equipment meets Pitt's 20 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 ROI. The return 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 ROI if Oscar does not acquire the new machine?

b. What is Forbes Division's ROI this year if Oscar acquires the new machine? (Enter your answer as a percentage rounded to 1 decimal place (i.e., 32.1).)

c. If Oscar acquires the new machine and it operates according to specifications, what ROI is expected for next year? (Enter your answer as a percentage rounded to 1 decimal place (i.e., 32.1).)

Answer 1

a)	Expected Income at the beginning of the year
			$
	Sales Revenue		16000000
	Operating cost
	Variable cost		2000000
	Contribution		14000000
	Fixed Cost all cash	7500000
	Dep:New equipment	1500000
	Dep:Other	1250000	10250000
	Net profit		3750000
	Assets(4000000-1250000)		2750000
	New Equipment(5000000-1500000)		3500000
	Total Investment		6250000
	ROI(Net profit/Total Investment)		60.00%
b)	Since the production is starting from next year we can not consider depreciation during the year
	for the new machinary. Hince ROI will be 9.09% as given below
c)	If Oscar acquires the new machine and it operates according to specifications, expected ROI for the current year and next year will be:
		Current Year	Current Year	Next year	Next year
	Sales Revenue		16000000		17600000	10% increase in output
	Operating cost
	Variable cost		2000000		2200000	10% increase in variable cost
	Contribution		14000000		15400000
	Fixed Cost all cash	7500000		7125000		cash fixed cost will reduce by 5%
	Dep:New equipment(since it is disposing with salvage value is zero)	5000000		2000000		(6500000-500000salvage value)/3 year
	Dep:Other	1250000	13750000	1250000	10375000
	Net profit		250000		5025000
	Assets(4000000-1250000)		2750000	(2750000-1250000)	1500000
	Salvage value zero		0
	New equipment purchased during the current year for next year)			(6500000-2000000)	4500000
	Total Investment		2750000		6000000
	ROI(Net profit/Total Investment)		9.09%		83.75%