Average operating assets $500,000
Net operating income $65,000
Minimum required rate of return 10%
Lease versus buy decision, ROI, residual income, EVA, manager incentives Refer to the information in Problem 15.28. The manager of Midwest 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. She 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 not assets. (In other words, the lease will be accounted for as an operating lease.)
Although it is more cost effective to purchase the equipment, she has decided to lease it.
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 Midwest Mining used EVA with this adjustment, how might the manager’s incentives and behavior change? Explain.