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 $5.03 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	$	16,040,000
Operating costs
Variable		2,000,000
Fixed (all cash)		7,560,000
Depreciation
New equipment		1,580,000
Other		1,330,000
Division operating profit	$	3,570,000

A sales representative from LSI Machine Company approached Oscar in October. LSI has for $6.84 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 $582,000 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?

b. What is Forbes Division’s residual income this year if Oscar acquires the new machine?

c. If Oscar acquires the new machine and operates it according to specifications, what residual income is expected for next year?

Answer 1

a.)	Forbes Division's residual Income if Oscar does not acquire the new machine
		Amount in '000'
	Investment at beginning	4,090
	Add: Additional Investment	5,030
	Less: Depreciation-New equipment	1,580
	Less: Depreciation-other	1,330
	Net book value at year end	6,210
	x required return	12%
	Minimum required return	745.2
	Expected operating Income	3,570
	Less: Minimum required income	745.2
	Residual Income	2,824.8
b.)	Forbes Division's residual Income if Oscar acquires the new machine
		Amount in '000'
	Investment at beginning	4,090
	Add: Additional Investment	6,840
	Less: Depreciation-other	1,330
	Net book value at year end	9,600
	x required return	12%
	Minimum required return	1,152
	Expected operating Income	3,570
	Less: Loss on disposal of asset ( 5,030 - 1,580 )	3,450
	Revised operating Income	120
	Less: Minimum required income	1,152
	Residual Income	-1032
c.)	Calculation of operating profit
		Amount in '000'
	Sales ( 16,040 x 110%)	17,644
	Operating Cost
	Variable ( 2,000 x 110% )	2,200
	Fixed (all cash ) ( 7,560 x 95%)	7,182
	Depreciation
	New equipment (6,840 - 582 )/3	2,086
	Other	1,330
	Operating Profit	4,846
	Calculation of minimum required return:-
		Amount in '000'
	Investment at beginning	4,090
	Add: Additional Investment	6,840
	Less: Depreciation-new equipment	2,086
	Less: Depreciation-other (1,330 x 2 )	2,660
	Net book value at year end	6,184
	x required return	12%
	Minimum required return	742.08
	Calculation of residual Income
	Operating Profit	4,846
	Less: Minimum required income	742.08
	Residual Income	4,103.92

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