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?