Question

The D Division of the DEF Corporation has budgeted after-tax profits of $1 million for 2013. It has budgeted assets as of January 1, 2013, of $10 million, consisting of $4 million in current assets and $6 million in property, plant and equipment (PP&E). PP&E assets are included in the asset base at gross book value. The net book value of these assets is $3 million and they are depreciated over a 10-year period on a straight-line basis.

Senior management of DEF Corporation has approached the manager of the D Division with a proposal to upgrade some of the division's property, plant & equipment. The financial details of the proposal are as follows:

New Equipment

Estimated cost

$2,000,000

Estimated after-tax annual savings

$300,000

Estimated life

10 years

Old equipment to be replaced

Original cost

$1,500,000

Original estimate of life

10 years

Present age

7 years

Present book

$450,000

Salvage value

$0

If the project is accepted, the new equipment will be purchased on January 1^st, 2013.

Analysis done by the senior management of DEF Corporation has determined that the acquisition of the new equipment would improve the company's overall ROI. The manager of Division D is compensated with a base salary and is also eligible for a bonus if the Division's ROI is higher than what was budgeted. (Budgeted ROI can be determined by analyzing the status quo situation.)

Required:

• Calculate the anticipated ROI for 2013 and 2014, under the following conditions:
• Assume the investment in property, plant & equipment assets is accounted for on a gross book value basis for purposes of the ROA calculation.
• Assume the investment in property, plant & equipment is accounted for on a net book value basis for purposes of the ROA calculation.
• Based on your calculations in part (a), is the manager likely to acquire the new equipment?
• Calculate the actual ROI for 2013 and 2014 assuming the investment is overrun by $500,000 and the annual savings are only $200,000 and assuming the following conditions:
• Assume the investment in property, plant & equipment is accounted for on a gross book value basis for purposes of the ROI calculation.
• Assume the investment in property, plant & equipment is accounted for on a net book value basis for purposes of the ROI calculation.
• Regardless of your analysis in part 1, assume that the manager of Division D decides not to undertake the proposal. What action, if any, should the senior management of DEF Corporation undertake? Explain.