Question

Based on the following information, determine whether Vertically Integrated Manufacturing (VIM) earned any residual income for its shareholders:

VIM had total assets of $ 3,000,000, financed with twice as much debt capital as equity capital.

VIM’s pre-tax cost of debt is 6 percent and cost of equity capital is 10 percent.

VIM had EBIT of $ 300,000 and was taxed at a rate of 40 percent.

Calculate residual income by using the method based on deducting an equity charge.

Answer 1

Residual income is the income available in excess of cost of capital. All the cost of finances are deducted from income.

It is the value added to the shareholders.

Total Assets = 3000000

Debt / Equity = 2

Hence Debt = 3000000 * 2/3 = 2000000

Equity = 3000000 *1/3 = 1000000

Residual Income = (EBIT - Interest)(1- Tax Rate) - Equity Charge

= (300000- 200000*6%) (1- 0.4) - 1000000*10%

= 180000* 0.6 - 100000

= 8000

Hence residual income for VIM shareholders is 8000