Problem 14-39 Residual Income (LO 14-3) Oscar Clemente is the manager of Forbes
ID: 2466935 • Letter: P
Question
Problem 14-39 Residual Income (LO 14-3) 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 $ 3,750,000
A 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. Pitt uses a cost of capital of 12 percent in computing residual income. 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.
Required: (a) What is Forbes Division’s residual income if Oscar does not acquire the new machine? (Enter your answers in thousands of dollars. Negative amount should be indicated by a minus sign.)
(b) What is Forbes Division’s residual income this year if Oscar acquires the new machine? (Enter your answers in thousands of dollars.Negative amount should be indicated by a minus sign.)
(c) If Oscar acquires the new machine and operates it according to specifications, what residual income is expected for next year? (Enter your answers in thousands of dollars.Negative amount should be indicated by a minus sign.)
**Please so calculations
Explanation / Answer
(a) What is Forbes Division’s residual income if Oscar does not acquire the new machine Sales Revenue 1,60,00,000 Opearting Costs Variable Costs 20,00,000 12.50 Always As a % on sales Fixed 75,00,000 (Variable cost/Sales*100) Depreciation New equipment 15,00,000 Other 12,50,000 Cost of Capital 6,00,000 (5000000*12%) Total expenses 1,28,50,000 Forbes Residual Income 31,50,000 (c ) If Oscar acquires the new machine and operates it according to specifications, what residual income is expected for next year Sales Revenue 1,76,00,000 Increase by 10% Opearting Costs Variable Costs 22,00,000 12.5% on sales Fixed 71,25,000 Decrease by 5% Depreciation Depreciation New equipment 20,00,000 Cost of asset Scrap Value Formulae Other 12,50,000 6500000 500000 (Cost of asset-scrap value)/estimated life of asset Cost of Capital 7,80,000 2 million (6500000*12%) Total expenses 1,33,55,000 Forbes Residual Income 42,45,000 (b) Forbes Division’s residual income this year if Oscar acquires the new machine Sales Revenue 1,60,00,000 Sales revenue will not change as operations with new machine are not started Opearting Costs Variable Costs 20,00,000 Fixed 75,00,000 Depreciation New equipment 11,25,000 for Nine months Old machinery has to be disposed off before purchase of new machinery for space. So Depreciation is taken for nine months Other 12,50,000 Cost of Capital 1,95,000 On New machine for 3 months (6500000*12%) Cost of Capital 4,50,000 On Old machine value for 9 Months (5000000*12%) Loss on Sale of Machine 38,75,000 (5000000-1125000) Total expenses 1,63,95,000 Forbes Residual Income -3,95,000.00