Question

Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of biotech products. Forbes Division, which has $4.09 million in assets, manufactures a special testing device. At the beginning of the current year, Forbes invested $5.15 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	$	16,080,000
Operating costs
Variable		2,040,000
Fixed (all cash)		7,520,000
Depreciation
New equipment		1,600,000
Other		1,390,000
Division operating profit	$	3,530,000

A sales representative from LSI Machine Company approached Oscar in October. LSI has for $5.94 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 $516,000 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? (Negative amount should be indicated by a minus sign. Enter your answer in thousands of dollars. Round your final answers to nearest whole dollar.)

b. What is Forbes Division’s residual income this year if Oscar acquires the new machine? (Negative amount should be indicated by a minus sign. Enter your answer in thousands of dollars. Round your final answers to nearest whole dollar.)

c. If Oscar acquires the new machine and operates it according to specifications, what residual income is expected for next year? (Negative amount should be indicated by a minus sign. Enter your answer in thousands of dollars. Round your final answers to nearest whole dollar.)

Answer 1

Dear Student,

If any doubts, then feel free to ask.

Part A

Operating   income

3530000

Net investment = (4090000+5150000-1600000-1390000) = $6250000

Residual income = operating income – cost of capital = 3530000-(12%*6250000) = $2780000

Part B

Operating   income	3530000
Loss on sale (5150000-1600000)	3550000
Operating loss	(20000)

Net investment = (4090000-1390000+5940000) = 8640000

Residual income = operating income – cost of capital = (20000)-(12%*8640000) = $(1016800)

Part C

Calculate New Revenue, Variable Cost, and Fixed Cost

revenue	17688000 (16080000*110%)	Increased by 10%
Variable costs	2244000 (2040000*110%)	Increased by 10%
Fixed costs	7144000 (7520000*95%)	Decreased by 5%
Total cost	9388000

Calculate Depreciation

Current Asset Depreciation	1390000
New Asset Depreciation	1808000 (5940000-516000)/3
Total Depreciation	3198000

Calculate Operating Income

Revenue	17688000
Total cost	9388000
Total depreciation	3198000
Operating income	5102000

Net investment = ((4090000-(2*1390000))+(5940000-1808000)) = $5442000

Residual income = operating income – cost of capital = 5102000-(12%*5442000) = $4448960