Question

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 $ 3,750,000A 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. 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 15 percent more. The salvage value would still be $500,000. Other costs or revenue estimates would be apportioned on a month-by-month basis for the time each machine (either the current machine or the machine Oscar is considering) is in use. Fractions of months may be ignored. Ignore taxes.Required: Calculate ROI for the coming year assuming that the new equipment is bought at the beginning of the year. (Do not round intermediate calculations. Round your final answer to nearest whole percentage.)

Answer 1

Answer:

Forbes Division of Pitt, Inc.

Performance Report

by Oscar Clemente

ROI = $1,900,000/$4,500,000 x 100 = 42.222%

(Return on Investment = Operating Income/net book value of new investment x 100)

Explanation:

a) Forbes Division's Expected Income Statement at the beginning of the year:                                              Year 1                    Year 2

Sales revenue                          $ 16,000,000      $ 17,600,000  

Operating costs:

   Variable                                    2,000,000          2,200,000

Fixed (all cash)                             7,500,000          6,750,000

Depreciation: New equipment    1,500,000          2,000,000

                      Other                     1,250,000           1,250,000

Disposal of old equipment (loss)                           3,500,000      

Division operating profit       $ 3,750,000       $ 1,900,000

b) Return on Investment (ROI) is a financial performance measure which evaluates the efficiency of an investment, by trying to directly measure the amount of return on a particular investment, relative to the investment's cost.

c) The Formula for ROI calculation is to subtract the initial value of the investment from the final value of the investment (which equals the net return), then dividing this new number (the net return) by the cost of the investment, and, finally, multiplying it by 100.  In this Forbes Division, the operating income is taken as the difference between the initial value of the investment and the final value of the investment.