Oscar Clemente is the manager of Forbes Division of Pitt, Inc.,a manufacturer of biotech products. Forbes Division, which has $7.7million in assets, manufactures a special testing device. At thebeginning of the current year, Forbes invested $6.9 million inautomated equipment for test machine assembly. The division'sexpected income statement at the beginning of the year was asfollows:
| | | |
| Sales revenue | $ | 25,500,000 | |
| Operating costs | | | |
| Variable | | 3,900,000 | |
| Fixed (all cash) | | 9,400,000 | |
| Depreciation | | | |
| New equipment | | 2,450,000 | |
| Other | | 3,150,000 | |
| Division operating profit | $ | 6,600,000 | |
|
A sales representative from LSI Machine Company approached Oscarin October. LSI has for $8.4 million a new assembly machine thatoffers significant improvements over the equipment Oscar bought atthe beginning of the year. The new equipment would expand divisionoutput by 10 percent while reducing cash fixed costs by 5 percent.It would be depreciated for accounting purposes over a three-yearlife. Depreciation would be net of the $690,000 salvage value ofthe new machine. The new equipment meets Pitt's 12 percent cost ofcapital criterion. If Oscar purchases the new machine, it must beinstalled prior to the end of the year. For practical purposes,though, Oscar can ignore depreciation on the new machine because itwill not go into operation until the start of the next year.
The old machine, which has no salvage value, must be disposed ofto make room for the new machine.
Pitt has a performance evaluation and bonus plan based onresidual income. Pitt uses a cost of capital of 12 percent incomputing residual income. Income includes any losses on disposalof equipment. Investment is computed based on the end-of-yearbalance of assets, net book value. Ignore taxes.
Oscar Clemente is still assessing the problem of whether toacquire LSI’s assembly machine. He learns that the new machinecould be acquired next year, but if he waits until then, it willcost 14 percent more. The salvage value would still be$690,000.
Required:
Calculate the residual income for the coming year assuming thatthe new equipment is bought at the beginning of the year.(Do not round intermediate calculations. Enter your answerin thousands of dollars not in millions of dollars. Round yourfinal answers to nearest whole number value.)
