Question

Orange is a division of Color Inc. It buys $30k worth of new equipment each year. Equipment has a 5 year life, with no salvage value. Depreciation per unit of equipment is $6k/year. Income before depreciation, interest expense and income tax, is consistently $50k/year. Cost of capital is 15%. The manager of the division has the opportunity to lease the equipment at $8950 per year. ($30k annuity at 15%), rather than replace the equipment.

a)calculate the ROI and RI for Orange under the current system using carrying amount at the start of the year as the measure of the investment.
b) calculate the ROI and RI for Orange for the next 5 years if the manager leases rather than replace the equipment each year, again using carrying amount as the measure for investment.
c) If the manager of Orange is evaluated based on Residual income, at which point would he decide to buy equipment rather than lease it, if ever?

Please show work, thanks

Answer 1

Option 1	Replacement Option
	Particulars	Year1	Year2	Year3	Year4	Year5
	EBIT before depreciation	50000	50000	50000	50000	50000
	Less Depreciation	6000	6000	6000	6000	6000
	EBIT	44000	44000	44000	44000	44000
	Less Interest	0	0	0	0	0
	EBT	44000	44000	44000	44000	44000
	Less Taxes	13200	13200	13200	13200	13200
	EAT	30800	30800	30800	30800	30800
	Discounting Rate@15%	0.8696	0.7561	0.6575	0.5718	0.4972
	Discounted Cash Flows	26783	23289	20251	17610	15313
	Discounted Cash Inflows	103246
	Less Cash Outflows	30000
	NPV	73246
	ROI	Cash Inflows/Cash Flows
		3.4415
	RI	0
Option 2	Leasing Option
	Particulars	Year1	Year2	Year3	Year4	Year5
	Lease Rental	8950	8950	8950	8950	8950
	Discounting Rate@15%	0.8696	0.7561	0.6575	0.5718	0.4972
	Discounted Cash Flows	7783	6767	5885	5117	4450
	Total Cash Inflows	30002
	Cash Outflow for purchase	30000
	ROI	1.0001
	RI	0

Since Net Cash flows are more in Replacement option .Replace option to be chosen rather than Leasing option