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Hello sir, I want to ask regarding this question from the BPP workbook. The answer shows that the cost of capital is 12% x 75,000. How to find the 12% imputed interest charge?
Vittorio’s Dugaldo’s
Profits $90,000 $135,000
Investment $500,000 $750,000Brenda and Eddie have two franchises in different parts of town and want to monitor the
performance of the two managers who have full control over investments.
Forecast results for the year are:
Vittorio is considering investing in a labor-saving piece of equipment which will cost $8,000. This will generate an increase in net profit of $1,200 each year for 10 years, after which time the equipment is expected to have no resale value. Vittorio uses straight-line depreciation.
Dugaldo has been offered a replacement oven for one of his existing ones. The existing one is written down in the books to an NBV of $2,000 and is very inefficient. Total costs are $25,000, including maintenance and depreciation. The replacement will cost $75,000 and will have no downtime and negligible maintenance costs in its early years. Depreciation will be 20% p.a. straight-line. Each oven is estimated to generate $60,000 per year before these costs are considered. The directors demand a minimum return on capital employed of 12%The final line of the question states that they require a return of 12%.
Sir, I also have another question, the next question is asking for the new RI for Dugaldo, but why is it using incremental profit not directly adding the old and new to find the new RI to be compared with the old RI?
Here is the answer:
Profit from proposal = (60,000 – 15,000) = 45,000
Existing profit = (60,000 – 25,000) = 35,000
Incremental profit 10,000
Imputed interest = 12% × 75,000 (9,000)
Incremental RI (Positive so accept) 1,000You could do as you suggest and end up with the same conclusion.
If the extra (incremental) profit is more than the extra interest charge, then the old RI must increase as a result.
Hi sir, I have two doubts in this question.
1. For the calculation of ROI of Vittorio’s new investment, we have not taken depreciation into consideration whereas for Dugaldo’s investment we have. Why so?
2. In the calculation of RI again the depreciation issue arose and why have we have calculated incremental profit in case of Dugaldo’s investment?
Thanks.
The calculation of ROI for Vittorio’s new investment does not include depreciation because the question does not specify that depreciation should be considered in the calculation. However, for Dugaldo’s investment, depreciation is taken into consideration because it is mentioned in the question that the existing oven has a net book value (NBV) and total costs, including maintenance and depreciation.
In the calculation of Residual Income (RI), the incremental profit is calculated to determine the excess profit generated by an investment compared to the minimum required return on capital employed.
For Dugaldo’s, the incremental profit is calculated by subtracting the total costs, including maintenance and depreciation, from the estimated revenue generated by the replacement oven. This incremental profit represents the additional profit generated by the investment compared to the existing oven.
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