i)

Question 3

A division is considering investing in capital equipment costing 1.5m. The useful economic life of the equipment is expected to be 30 years, with no resale value at the end of the period. The forecast return on the initial investment is 20 per cent per annum before depreciation. The divisions cost of capital is 13 per cent.

Required:

c) In no more than 300 words, explain why setting transfer prices using cost plus pricing is unlikely to maximise group profits.

Expected annual operating income = Annual forecast return - Annual depreciation Initial investment = 1.5 million pounds = 1,500,000 pounds Useful economic life = 30 years. Resale value at end of useful life = 0 Annual depreciation = (Initial investment - Resale value at end of useful life)/Useful economic life = (1,500,000 - 0)/30 = 1,500,000/30 = 50,000 pounds Annual forecast return = 20% of initial investment = 20% * 1,500,000 = 300,000 pounds Expected annual operating income = Annual forecast return - Annual depreciation = 300,000 - 50,000 = 250,000 pounds Expected Annual Residual income = Expected annual operating income - (Division's cost of capital x initial investment) = 250,000 - (13%* 1,500,000) = 250,000 - 195,000 = 55,000 pounds Answer Hence, expected annual residual income of the investment = 55,000 pounds. Hope this helps. For any further clarifications, please drop in a comment