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Reward on the basis of after-tax residual income, invest?

Strathcona Paper rewards its managers on the basis of after tax return on investment of assets that they manage- the higher the reported return on investment, the higher the reward. The company uses the net book value to value the assets employed in the return on investment calculation. The company's cost of capital is assessed at 12% after taxes. The organization's tax rate is 35%. The manager of the logistics division is faced with an opportunity to replace an aging truck fleet. The current net income after taxes of the logistics division is $7 million, and the current investment base is valued at $50 million. The current net income after taxes and the current investment base, absent any investment in new trucks, are expected to remain at their existing levels. The investment opportunity would replace the existing fleet of trucks which have a net book value of about $100,000, with new truck costing about $50 million of the trade-in allowance for the old trucks. If kept, the old trucks would last another 5 years and have no salvage value. The new trucks would last 5 years and, have zero salvage value, and increase cash flow relative to keeping the old trucks ( through increased revenues and depreciated operating costs) by about $16 million per year. If purchased, the new trucks would be depreciated for both accounting and tax purposes on a straight-line basis.

a. From the point of view of the company, should the investment be made? Prepare Net Present Calculations to support your calculations.

b. From the point of view of the manager, should this investment be made?

c. If the manager were rewarded on the basis of after-tax residual income, would the manager want to make the investment? Show why or why not?

Solution Preview

See attached Excel file.

a. From the point of view of the company, should the investment be made? Prepare Net Present Calculations to support your calculations.

Technically, the investment should be made because the present value of the after tax cash flows and the tax benefit of additional depreciation exceed the purchase price by $81,156 (see excel analysis). However, the present value is so close to the cost of the new fleet, and ...

Solution Summary

Discussion is 317 words plus an excel spreadsheet to illustrate the computations. Comments are in everyday language suitable for a novice or someone just plain TIRED of textbook heavy terms! Relief! Clarity!

$2.19