Calculating Depreciation and Book Value
Your firm uses return on assets (ROA) to evaluate investment centers and is considering changing the valuation basis of assets from historical cost to current value. When the cost of the asses is updated, a price index is used to approximate replacement value. For example, a metal fabrication press, which bends and shapes metal, was bought seven years ago for $522,000. The company will add 19 percent to this cost, representing the change in the wholesale price index over the seven years. This new, higher cost figure is depreciated using the straight-line method over the same 12-year assumed life (no salvage clause).
a. Calculate depreciation expense and book value of the metal press under both historical cost and price-level- adjusted historical cost.
b. In general, what is the effect on ROA of changing valuation bases from historical cost to current values?
c. The manager of the investment center with the metal press is considering replacing it because it is becoming obsolete. Will the manger's incentives to replace the metal press change if the firm shifts from historical cost valuation to proposed price-level-adjusted historical cost valuation.
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