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A divisional manager is evaluated by the head office using RI and therefore uses RI to
appraise projects.
Company cost of capital = 10%
New project details: Investment $600,000
3-year life
No residual value
Annual cash inflow $500,000.
Y1 Y2 Y3
Cash flow 500 500 500
Depreciation (200) (200) (200)
Profit 300 300 300
NBV 600 400 200
Imputed interest 60 40 20
Profit ? interest = residual income 240 260 280
Why the NBV for Y1 is 600 but not 400?
It is sensible to use the NBV at the start of each year in the calculation of RI, on the basis that it is the assets at the start of the year that generate the profits.