Question

Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of biotech products. Forbes Division, which has $7.7 million in assets, manufactures a special testing device. At the beginning of the current year, Forbes invested $6.9 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	$	25,500,000
Operating costs
Variable		3,900,000
Fixed (all cash)		9,400,000
Depreciation
New equipment		2,450,000
Other		3,150,000
Division operating profit	$	6,600,000

A sales representative from LSI Machine Company approached Oscar in October. LSI has for $8.4 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 $690,000 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.

Oscar Clemente is still assessing the problem of whether to acquire LSI’s assembly machine. He learns that the new machine could be acquired next year, but if he waits until then, it will cost 14 percent more. The salvage value would still be $690,000.

Required:

Calculate the residual income for the coming year assuming that the new equipment is bought at the beginning of the year. (Do not round intermediate calculations. Enter your answer in thousands of dollars not in millions of dollars. Round your final answers to nearest whole number value.)

Answer 1

Residual Income

It measures the return earned by the department which is in excess of the minimum required return. Formula: =A-(B*C) A: Net Operating Income B: Minimum return required on assets C: Average operating Assets

** Year End Balances of Assets Beginning Balance                     7,700                     7,700 Additions: New Automated Equipment                     6,900                     6,900 LSI Equipment                            -                       8,400 Less: Depreciation New Automated Equipment                     2,450                     2,450 LSI Equipment (Not to be in first year as stated in question)                            -                              -   Others                     3,150                     3,150 Year End Balance                     9,000                  17,400