The D Division of the DEF Corporation has budgeted after-tax profits of $1 million for 2013. It has budgeted assets as of January 1, 2013, of $10 million, consisting of $4 million in current assets and $6 million in property, plant and equipment (PP&E). PP&E assets are included in the asset base at gross book value. The net book value of these assets is $3 million and they are depreciated over a 10-year period on a straight-line basis.
Senior management of DEF Corporation has approached the manager of the D Division with a proposal to upgrade some of the division's property, plant & equipment. The financial details of the proposal are as follows:
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New Equipment
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Estimated cost
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$2,000,000
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Estimated after-tax annual savings
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$300,000
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Estimated life
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10 years
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Old equipment to be replaced
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Original cost
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$1,500,000
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Original estimate of life
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10 years
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Present age
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7 years
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Present book
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$450,000
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Salvage value
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$0
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If the project is accepted, the new equipment will be purchased on January 1st, 2013.
Analysis done by the senior management of DEF Corporation has determined that the acquisition of the new equipment would improve the company's overall ROI. The manager of Division D is compensated with a base salary and is also eligible for a bonus if the Division's ROI is higher than what was budgeted. (Budgeted ROI can be determined by analyzing the status quo situation.)
Required:
- Calculate the anticipated ROI for 2013 and 2014, under the following conditions:
- Assume the investment in property, plant & equipment assets is accounted for on a gross book value basis for purposes of the ROA calculation.
- Assume the investment in property, plant & equipment is accounted for on a net book value basis for purposes of the ROA calculation.
- Based on your calculations in part (a), is the manager likely to acquire the new equipment?
- Calculate the actual ROI for 2013 and 2014 assuming the investment is overrun by $500,000 and the annual savings are only $200,000 and assuming the following conditions:
- Assume the investment in property, plant & equipment is accounted for on a gross book value basis for purposes of the ROI calculation.
- Assume the investment in property, plant & equipment is accounted for on a net book value basis for purposes of the ROI calculation.
- Regardless of your analysis in part 1, assume that the manager of Division D decides not to undertake the proposal. What action, if any, should the senior management of DEF Corporation undertake? Explain.