Chapter 14, Problem 46P

Equipment Replacement and Performance Measures

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:

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. 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.

Required

1. a.      What is Forbes Division’s ROI if Oscar docs not acquire the new machine?
2. b.      What is Forbes Division's ROI this year if Oscar acquires the new machine?
3. c.       If Oscar acquires the new machine and it operates according to specifications, what ROI is expected for next year?

To determine

Calculate the division F’s ROI if Company O does not acquire the new machine

Answer to Problem 46P

The return on investment is 60% when Company O does not acquire the new machine.

Explanation of Solution

Return on investment:

Return on investment is the amount of total profit earned by a division with its assets. The return on investment is used to check the efficiency of the unit. It shows the efficiency of the unit to utilize its assets to generate the profit.

Calculate the ROI if Company O does not acquire the new machine:

$\begin{array}{c}\text{Return on investment = }\frac{\text{After-tax divisonal income}}{\text{Divisonal asstes}}\\ =\frac{\$3,750,000}{\$6,250,000\text{ (1)}}\\ =\text{ 60\%}\end{array}$

Thus, the return on investment is 60% when Company O does not acquire the new machine.

Working note 1:

Calculate the net asset value:

Particulars	Amount
Opening asset value	$4,000,000
Add: addition in the year	$5,000,000
Total asset value	$9,000,000
Less: depreciation on new equipment	$1,500,000
Less: depreciation on others	$1,250,000
Net asset value	$6,250,000

Table: (1)

To determine

Calculate the division F’s ROI if Company O acquires the new machine

Answer to Problem 46P

The return on investment is 2.7% when Company O does not acquire the new machine.

Explanation of Solution

Divisional ROI:

Divisional ROI is the return on investment for a division of a business. It is calculated by dividing the operating profit of the division from the divisional assets.

Calculate the ROI if Company O acquires the new machine:

$\begin{array}{c}\text{Return on investment = }\frac{\text{After-tax divisonal income}}{\text{Divisonal asstes}}\\ =\frac{\$250,000\text{ (3)}}{\$9,250,000\text{ (2)}}\\ =\text{ 2}\text{.70\%}\end{array}$

Thus, the return on investment is 2.7% when Company O does not acquire the new machine.

Working note 2:

Calculate the net asset value:

Particulars	Amount
Opening asset value	$4,000,000
Add: improvement  in the asset	$6,500,000
Total asset value	$10,500,000
Less: depreciation on others	$1,250,000
Net asset value	$9,250,000

Table: (2)

Working note 3:

Calculate the after-tax divisional profit:

Particulars	Amount
Operating profit	$3,750,000
Less: loss on old equipment	$5,000,000
Add: saving in the depreciation of old equipment	$1,500,000
Net operating profit	$250,000

Table: (3)

To determine

Calculate the ROI if the company acquires a new machine and operates it according to specifications.

Answer to Problem 46P

The return on investment is 83.75% if the company acquires a new machine and operates it according to specifications.

Explanation of Solution

Divisional income:

A business may be operating in various departments or units. Each unit has its own cost and profit structure. The profit of a specific unit is called divisional income. It is calculated by deducting the divisional expense from the divisional profit.

Calculate the ROI if Company O acquires the new machine:

$\begin{array}{c}\text{Return on investment = }\frac{\text{After-tax divisonal income}}{\text{Divisonal asstes}}\\ =\frac{\$5,025,000\text{ (4)}}{\$6,000,000\text{ (5)}}\\ =\text{ 83}\text{.75\%}\end{array}$

Thus, the return on investment is 83.75% when Company O does not acquire the new machine.

Working note 4:

Calculate the divisional operating income:

Particulars	Amount (a)	% change (b)	Net amount $\text{c = (a }\pm \text{ (\% change)}$
Sales	$16,000,000	+10%	$17,600,000
Operating costs:
Variable	$2,000,000	+10%	$2,200,000
Fixed	$7,500,000	-5%	$7,125,000
Deprecation:
New equipment(6)	$1,500,000		$2,000,000
Others	$1,250,000		$1,250,000
Divisional operating profit			$5,025,000

Table: (4)

Working note 5:

Calculate the net asset value:

Particulars	Amount
Opening asset value	$4,000,000
Add: improvement  in the asset	$6,500,000
Total asset value	$10,500,000
Less: depreciation on others $(2\times \text{ \$1,250,000)}$	$2,500,000
Less: depreciation on improved assets(6)	$2,000,000
Net asset value	$6,000,000

Table: (5)

Working note 6:

Calculate the depreciation on new equipment:

$\begin{array}{c}\text{Depreciation = }\frac{\text{Cost of the asset - Scrap value}}{\text{Life of the asset}}\\ =\frac{\$6,500,000\text{ - \$500,000}}{3}\\ =\text{ \$2,000,000}\end{array}$