Question

At the end of the fiscal year Zeta Tube performs an analysis comparing current year income statement to prior year income statement.

The income statement comparison for Forklift Material Handling shows the income statement for the current and prior year.

(Amount in thousands) Current Year Prior Year
Sales $ 33,750 $ 24,750
Cost of goods sold $ 21,938 $ 16,830
Gross Profit $ 11,812 $ 7,920
Wages $ 8,775 $ 6,188
Utilities $ 675 $ 250
Repairs $ 169 $ 325
Selling $ 506 $ 200
Total expenses $ 10,125 $ 6,963
Operating income $ 1,687 $ 957
Operating income % 5% 3.87%
Total assets (investment base) $ 4,500 $ 1,500
Return on investment 37.49% 63.80%
Residual income (8% cost of capital) $ 1,327 $ 837
C. Zeta Tube has decided to upgrade their equipment in the current year (the difference in total assets from prior year to current year). Calculate the return on investment for these purchases. Was the decision to invest in additional assets in the company successful? Explain.

D. Zeta Tube determines that an 8% cost of capital is appropriate. Calculate the residual income for prior and current year. Explain how this compares to your findings in (C).

Answer 1

The equipment upgrades had a mixed impact on Zeta Tube's financial performance. They increased operating income but also led to higher expenses and a negative residual income.

C. Return on Investment for Equipment Upgrades:

1. Calculate the investment in equipment:

Current year total assets - prior year total assets = $4,500 - $1,500 = $3,000

2. Calculate the additional income (operating income increase):

Current year operating income - prior year operating income = $1,687 - $957 = $730

3. Calculate the return on investment (ROI):

ROI = (Additional income / Investment) * 100%

ROI = ($730 / $3,000) * 100% ≈ 24.33%

Interpretation: The return on investment for the equipment upgrades is 24.33%. This means that for every $1 invested in the new equipment, the company generated an additional $0.24 in operating income. While this is not as high as the overall return on investment (37.49%), it is still a positive return and suggests that the investment was generally successful.

Step-by-step explanation:

The equipment upgrades likely led to increased efficiency and production, contributing to the higher operating income in the current year.

However, the increase in expenses associated with the new equipment (e.g., depreciation, maintenance) might have reduced the overall profitability compared to the prior year.

D. Residual Income and Comparison:

1. Calculate the residual income for prior and current year:

Residual income = Operating income - (Cost of capital * Total assets)

Prior year: $957 - (8% * $1,500) = $587

Current year: $1,687 - (8% * $4,500) = -$153

2. Comparison:

The prior year residual income was positive ($587), indicating that the company earned more than the minimum acceptable return on its investments.

However, the current year residual income is negative (-$153), showing that the company's overall return on assets did not meet the desired cost of capital.

Step-by-step explanation:

Although the equipment upgrades improved operating income, they also increased the total asset base (due to the investment), leading to a higher cost of capital and ultimately a negative residual income.

This suggests that while the investment generated additional income, it did not fully cover the expected return on the increased capital employed.

Conclusion:

The equipment upgrades had a mixed impact on Zeta Tube's financial performance. They increased operating income but also led to higher expenses and a negative residual income.

This highlights the importance of carefully evaluating the potential costs and benefits of investments before making decisions.