Question

Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of biotech products. Forbes Division, which has $6.9 million in assets, manufactures a special testing device. At the beginning of the current year, Forbes invested $6.6 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 $ 24,000,000 Operating costs Variable 3,600,000 Fixed (all cash) 9,100,000 Depreciation New equipment 2,300,000 Other 2,850,000 Division operating profit $ 6,150,000 A sales representative from LSI Machine Company approached Oscar in October. LSI has for $8.1 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 3-year life. Depreciation would be net of the $660,000 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. Income includes any losses on disposal of equipment. Pitt uses a cost of capital of 12 percent in computing residual income. 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 11 percent more. The salvage value would still be $660,000.Required:Calculate the residual income for the coming year assuming that the new equipment is bought at the beginning of the year. (Round your answer to the nearest dollar amount. Enter your answers in thousands of dollars not in millions of dollars)Residual Income = _______________

Answer 1

Answer:

Residual income is therefore $732,000.

Explanation:

This can be computed by following the following steps:

Step 1: Calculation of ending net book value

Particulars                                           $'000    

Beginning investment                         6,900

add: Additional investment                 8,100

Less: Depreciation - Other               (2,850)  

Ending net book value                      12,150  

Step 2: Calculation of Minimum required return

Minimum required return = Ending net book value * Required return rate = $12,150,000 * 12% = $1,458,000

Step 3: Calculation of profit (loss) on disposal

First year depreciation on investment = (Investment cost  - Salvage value) / Useful life = ($6,600,000 - $660,000) / 3 = $1,980,000

Profit (loss) on disposal = Salvage value - Investment cost  - First year depreciation on investment = $660,000 - $6,600,000 - $1,980,000 = $3,960,000 loss

Step 4: Calculation of residual income

Particulars                                                       $'000    

Given operating profit of the division             6,150

Less: Loss on disposal                                  (3,960)  

Revised operating income                             2,190

less: Minimum required return                      (1,458)  

Residual income                                               732    

Residual income is therefore $732,000.