Ocean Division currently earns $825,000 and has divisional assets of $2.8 millio

Question

Ocean Division currently earns $825,000 and has divisional assets of $2.8 million. The division manager is considering the acquisition of a new asset that will add to profit. The investment has a cost of $370,000 and will have a yearly cash flow of $174,000. The asset will be depreciated using the straight-line method over a six-year life and is expected to have no salvage value. Divisional performance is measured using ROI with beginning-of-year net book values in the denominator. The company's cost of capital is 20 percent. Ignore taxes. The division manager learns that he has the option to lease the asset on a year-to-year lease for $148,000 per year. All depreciation and other tax benefits would accrue to the lessor.

What is the division's residual income before considering the project? (Enter your answer in dollars, not in millions. Omit the "$" sign in your response.)

What is the division's residual income if the asset is purchased? (Enter your answer in dollars, not in millions. Do not round intermediate calculations. Round your answer to the nearest dollar amount. Omit the "$" sign in your response.)

What is the division's residual income if the asset is leased? (Enter your answer in dollars, not in millions. Omit the "$" sign in your response.)

Ocean Division currently earns $825,000 and has divisional assets of $2.8 million. The division manager is considering the acquisition of a new asset that will add to profit. The investment has a cost of $370,000 and will have a yearly cash flow of $174,000. The asset will be depreciated using the straight-line method over a six-year life and is expected to have no salvage value. Divisional performance is measured using ROI with beginning-of-year net book values in the denominator. The company's cost of capital is 20 percent. Ignore taxes. The division manager learns that he has the option to lease the asset on a year-to-year lease for $148,000 per year. All depreciation and other tax benefits would accrue to the lessor.

Explanation / Answer

Solution:-

(a) What is the division's residual income before considering the project:-

Explanation:-

825,000 - (.20 * 2,800,000) = $ 265,000

(b) What is the division's residual income if the asset is purchased:-

Explanation:-

265,000 + 174,000 - (370,000 / 6) - (.20 * 370,000) = $ 303,333.

(c) What is the division's residual income if the asset is leased:-

Explanation:-

265,000 + 174,000 - 148,000 = $ 291,000

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