Refer to the information in Problem 16.31. The manager of Prairie Mining is considering a new project. She can buy or lease equipment that will reprocess tailings from old mines to remove any traces of gold left behind by the original separating processes. The purchase price of the equipment is $150,000. The cost to lease is $2,000 per month. The manager estimates the return (incremental revenues minus incremental expenses, including lease cost) to be $40,000 per year. She knows that purchasing the equipment will increase the value of average operating assets. If she leases the equipment, expenses will increase, but assets will not. (In other words, the lease will be accounted for as an operating lease.) Although it is more cost effective to purchase the equipment, the manager has decided to lease it.
Information From Problem 16.31
The following financial data are for the evaluation of performance for Prairie Mining:
Average operating assets .........................$500,000
Net operating income ..............................$65,000
Minimum required rate of return ......................10%
Prairie Mining currently uses return on investment to evaluate investment centre managers. An accounting intern from the local university suggested to the controller that residual income may be a better performance measure.
REQUIRED
A. Calculate the new ROI if the equipment is (1) purchased or (2) leased.
B. Calculate the new residual income if the equipment is (1) purchased or (2) leased.
C. One of the adjustments that can be made using EVA is to treat all operating lease costs as if they were purchases-in other words, to capitalize the lease. If Prairie Mining used EVA with this adjustment, how might the manager's incentives and behaviour change? Explain.