Question

The Singer Division of Patio Enterprises currently earns $2.34 million and has divisional assets of $19.5 million. The division manager is considering the acquisition of a new asset that will add to profit. The investment has a cost of $3,375,000 and will have a yearly cash flow of $840,000. The asset will be depreciated using the straight-line method over a six-year life and is expected to have no salvage value. Divisional performance is measured using ROI with beginning-of-year net book values in the denominator. The company’s cost of capital is 9 percent. Ignore taxes. The division manager learns that he has the option to lease the asset on a year-to-year lease for $740,000 per year. All depreciation and other tax benefits would accrue to the lessor.

Required:

a. What is the division's residual income before considering the project? (Enter your answer in dollars, not in millions.)

b. What is the division's residual income if the asset is purchased? (Enter your answer in dollars, not in millions.)

c. What is the division's residual income if the asset is leased? (Enter your answer in dollars, not in millions.)

Answer 1

Answer

a.

Residual Income = Current Income – Cost of capital of Existing Asset

= $2,340,000 – (19,500,000 * 9%)

= $2,340,000 – 1,755,000

Residual Income = $585,000

b.

New Residual Income = Old Residual Income (Before purchasing asset) + Increase in Residual Income because of purchasing asset

Increase in Residual Income because of purchasing asset = New Income – Cost of New Asset

= (Cash flow – Depreciation) – Cost of New Asset

= $840,000 - $3,375,000 / 6 Years – ($3,375,000 * 9%)

= $840,000 – 562,500 – 303,750

Increase in Residual Income because of purchasing asset = ($26,250)

New Residual Income = $585,000 + (26,250)

New Residual Income = $558,750

c.

New Residual Income = Old Residual Income (Before purchasing asset) + Increase in Residual Income because of leasing asset

Increase in Residual Income because of leasing asset = New Income – Lease Rent

= $840,000 – 740,000

= $100,000

Increase in Residual Income because of leasing asset = $100,000

New Residual Income = Current Earnings – Cost of Old Asset + Increase in Residual Income because of leasing asset

New Residual Income = $2,340,000 – (19,500,000 * 9%) + 100,000

New Residual Income = $685,000

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