Question

Gardenia Co. and Lantana Co. both operate in the same industry. Gardenia began its operations in 2017 with a $20 million initial investment in plant and equipment with an expected life of 10 years. Lantana's net asset base is also $20 million, but its assets are, on average, 5 years old with 10-year expected useful lives on January 1, 2017. Lantana replaces 10% of its assets each year at year-end,

while Gardenia, having just entered the industry, does not have immediate plans to replace any assets. Per year pre-tax net operating cash flow generated $3 million for Gardenia, and $5 million for Lantana. Inflation is expected to be 2% per year, and each company expects to keep pace by increasing its pre-tax net operating cash flow by 2% per year. The cost of Lantana's planned asset replacements will also increase at 2% per year. (Note: For simplicity, assume that prior to 2017, the
replacement cost of Lantana's assets remained constant.)
Required:
1. Compute return on assets for Gardenia Co. for 2017 through 2021.
2. Compute return on assets for Lantana Co. for 2017 through 2021.

Answer 1

To calculate the return on assets, divide the net operating income by the average total assets. - For Gardenia Co., the net operating income is $3 million each year, and the average total assets remain constant at $20 million. - For Lantana Co., the net operating income is $5 million each year, and the average total assets increase by 10% each year due to asset replacements.

Step-by-step explanation:

Return on Assets (ROA) Calculation:

1. Return on assets (ROA) is calculated by dividing the net operating income by the average total assets.
2. For Gardenia Co.:
   Net Operating Income = Pre-tax Net Operating Cash Flow - Annual Depreciation Expense
   Average Total Assets = Initial Investment in Plant and Equipment
3. For Lantana Co.:
   Net Operating Income = Pre-tax Net Operating Cash Flow - Annual Depreciation Expense + Depreciation Expense on Replacement Assets
   Average Total Assets = Net Asset Base

Return on Assets Calculation for Gardenia Co. for 2017 through 2021:

1. 2017:
   Net Operating Income = $3 million
   Average Total Assets = $20 million
2. 2018, 2019, 2020, 2021:
   Net Operating Income increases by 2% each year
   Average Total Assets remains constant at $20 million

Return on Assets Calculation for Lantana Co. for 2017 through 2021:

1. 2017:
   Net Operating Income = $5 million
   Average Total Assets = $20 million
2. 2018, 2019, 2020, 2021:
   Net Operating Income increases by 2% each year
   Average Total Assets increase by 10% each year due to asset replacements