Question

A division is considering the acquisition of a new asset that will cost $2,520,000 and have a cash flow of $700,000 per year for each of the four years of its life. Depreciation is computed on a straight-line basis with no salvage value. Ignore taxes. Required: a. & b. What is the ROI for each year of the asset's life if the division uses beginning-of-year asset balances and net book value for the computation? What is the residual income each year if the cost of capital is 8 percent? (Enter "ROI" answers as a percentage rounded to 1 decimal place (i.e., 32.1). Negative amounts should be indicated by a minus sign.)

Answer 1

initial investment = $2,520,000

cash flow for years 1 - 4 = $700,000

ROI = (cash flow - depreciation) / investment

depreciation for year 1-4 using straight-line basis = $2,520,000 / 4 = $630,000

ROI year 1 = (700,000 - 630,000) / 2,520,000 = 70,000 / 2,520,000 = 2.8%

ROI year 1 = 70,000 / 1,890,000 = 3.7%

ROI year 1 = 70,000 / 1,260,000 = 5.6%

ROI year 1 = 70,000 / 630,000 = 11.1%

cost of capital year 1 = $2,520,000 x 8% = $201,600

cost of capital year 2 = $1,890,000 x 8% = $151,200

cost of capital year 3 = $1,260,000 x 8% = $100,800

cost of capital year 4 = $630,000 x 8% = $50,400

residual income = excess income - cost of capital

residual income year 1 = $70,000 - $201,600 = -$131,600

residual income year 2 = $70,000 - $151,200 = -$81,200

residual income year 3 = $70,000 - $100,800 = -$30,800

residual income year 4 = $70,000 - $50,400 = $19,600

year net investment cash flow - dep. ROI residual income

1 $2,520,000 $70,000 2.8% ($131,600)

2 $1,890,000 $70,000 3.7% ($81,200)

3 $1,260,000 $70,000 5.6% ($30,800)

4 $630,000 $70,000 11.1% $19,600