Assume the purchase of new equipment (e.g., delivery trucks) used in a product-delivery service (such as UPS or FedEx). This equipment is needed to improve delivery service and respond to recent environmental goals embraced by the company. The cost of the new equipment is $1 million; the expected useful life of these assets is five years. Estimated salvage value at the end of five years is $0. The company in question will depreciate these assets over a five-year period using straight-line depreciation. The anticipated increase in operating income (before depreciation deductions) attributable to the use of the new equipment is $300,000. Ignore taxes.

Required

1. Generate a schedule of the year-by-year ROIs associated with this investment opportunity. For purposes of these calculations, define the investment base (denominator of the ROI ratio) as average net book value (NBV) of the assets during the year.

2. Generate a second schedule showing the year-by-year ROIs for this investment opportunity under the assumption that the denominator in the ROI calculation is defined as the gross book value of the assets to be acquired.

3. Why do the results differ in (1) and (2) above? What behavioral issue is associated with the use of (1) versus (2) above?

4. What impact would the use of an accelerated depreciation method have on the conclusions above in (1) and (2)? For example, prepare a new schedule of annual ROIs under the assumption that the double-declining-balance depreciation method is used. (Assume a switch to straight-line depreciation in year 4. Thus, the total depreciation charge over the five-year period should be $1 million.)

5. Would the use of the residual income (RI) measure of financial performance eliminate the behavioral issue raised above? Why or why not? For the options specified above in parts 1, 2, and 4, show the year-by-year RIs for this investment, based on a weighted-average cost of capital (WACC) of 10 percent. For each of the four options, base the imputed interest charge each year on a simple average of beginning-of-year and end-of-year asset values.