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A division is considering investing in capital equipment costing $2.7 million. The useful economic life of the equipment is expected to b 50yrs,with no resale value at the end of the period. The forecast ROI is 15% per annum before depreciation. The division’s cost of capital is 7%?
The answer was
Divisional profit before depreciation=2.7m x 15%=$405,000 per year
Less depreciation=$2.7m x1/50=$54,000 per year
Divisional profit after depreciation=$351,000
Imputed interest=$2.7m x 7%=$189,000
Residual income= $162,000
Good day sir,Pls I don’t understand why they used the capital equipment value without depreciation to calculate the imputed interest.
The forecast divisional profit has been calculated after depreciation.
The imputed interest is calculated on the amount that they are considering investing, which is $2.7M.
Thank you sir
You are welcome.