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Hi please help. I have a question regarding f5 june 2015 q1. A division is considering investing in capital equipment costing $2·7m. The useful economic life of the equipment is expected to be 50 years, with no resale value at the end of the period. The forecast return on the initial investment is 15% per annum before depreciation. The division’s cost of capital is 7%.
What is the expected annual residual income of the initial investment?
A $0
B ($270,000)
C $162,000
D $216,000Answer: C
Divisional profit before depreciation = $2·7m x 15% = $405,000 per annum. Less depreciation = $2·7m x 1/50 = $54,000 per annum.
Divisional profit after depreciation = $351,000
Imputed interest = $2·7m x 7% = $189,000
Residual income = $162,000.My question is why for the capital employed we dont deduct the depreciation per annum? Why is the capital employed used 2.7m?
Thank you
Residual income = Pre-tax profit less imputed interest charge for capital investment.
The Q specifically asks for the residual income “of the initial investment” so imputed interest is calculated on $2.7m and not a depreciated amount.
Thank you so much for your response:)
Makes sense now.
But i am still a bit confused, may I ask if its for the initial investment at the beginning which is the reason we did not deduct the depreciation for the capital employed. Then why then for the operating profits we still deduct one year depreciation to get to pre-tax profit?
And if the question did not mention “the initial investment” would we have deducted the depreciation from the capital employed?
Thank you so muchIt’s only the investment (“capital”) for which there would be a choice of opening, closing or average amount.
For Section A and B questions, where there can be only one correct option, the Q should always specify what a calculation should be based on, if there could be more than one otherwise correct calculation. For example, S16 Q10 requires calculation of ROI “based on closing net assets”.
If for a Section C question there is no specified basis and you know, for example, that a calculation might be based on an opening balance or closing balance (or even average amount) – it will be particularly important to state the basis you have used (and not just give a numerical answer).
Brilliant! Thank you so so much.
I truly appreciate your help.The same concept applies when calculating the capital employed for ROCE?
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