One division of the Luke Educational Enterprises has depreciable assets costing

Question

One division of the Luke Educational Enterprises has depreciable assets costing $4,150,000. The cash flows from these assets for the past three years have been:

The current (i.e., replacement) costs of these assets were expected to increase 25% each year. Luke used the straight-line depreciation method; the estimated useful life is 10-years with no salvage value. For return on investment (ROI) calculations, Luke uses end-of-year balances.

What is the residual income for each year, assuming the cost of capital is 14% and Luke uses historical costs and gross book values to compute residual income?

Option A

Option B

Option C

Option D

Year Cash flows 1 $ 1,425,000 2 $ 1,460,000 3 $ 1,635,000

Explanation / Answer

Answer is Option A.

Working

Asset value 4150000 Estimated life(years) 10 Annual depreciation 415000 Year 1 Year 2 Year 3 Net cash flows A 1425000 1460000 1635000 Depreciation B 415000 415000 415000 Net income (A - B) C 1010000 1045000 1220000 Cost of capital D 14% 14% 14% Gross Assets E 4150000 4150000 4150000 ROI (D * E) F 581000 581000 581000 Residual income (C - F) I 429000 464000 639000

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