Oscar Clemente is the manager of Forbes Division of Pitt. Inc., a manufacturer o

Question

Oscar Clemente is the manager of Forbes Division of Pitt. Inc., a manufacturer of biotech products Forbes Division, which has $4.000,000 in assets, manufactures a special testing device At the beginning of the current year, Forbes invested $5.100.000 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 $5 430.000 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 S percent It would be depreciated for accounting purposes over a three-year life Depreciation would be net of the $534,000 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

Explanation / Answer

The division's residual income can be calculated with the use of following formula:

Residual Income = Division Operating Profit - Cost of Capital*(Assets at the Beginning of the Year - Depreciation for the Year)

__________

Solution:

Total Assets at the Beginning of the Year = 4,000,000 + 5,100,000 = $9,100,000

Total Depreciation = 1,570,000 + 1,360,000 = $2,930,000

Using these values in the above formula for Residual Income, we get,

Residual Income = 3,540,000 - 12%*(9,100,000 - 2,930,000)= $2,799,600 (answer)

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