The prototype one-period project at the beginning of the chapter was b

QUESTION

The prototype one-period project at the beginning of the chapter was booked at its historical cost of $400. Suppose, instead, that the accountant wrote down the investment to $360 on the balance sheet at the beginning of the period. See the investment as consisting of $360 of plant (booked to the balance sheet) and $40 advertising (which cannot be booked to the balance sheet under GAAP). Revenues of $440 are expected from the project and the required return is 10percent.a. Forecast earnings from this project for the year.b. Forecast the rate of return on the book value of this investment and also the residual earnings.c. Value the investment.
Answer: Part a Earnings = Revenue Expenses = $440 $360 = $80 Earnings in the text example were $40. This clearly shows that earnings have been generated by expensing $40 of the investment in the prior period thereby reducing $40 in expenses of year 1. Part b ROCE =

$80/$360 = 22.22% Residual Earnings = $80 (0.1*360) = $44 Part c Value = $360 + $44/1.1 = $400 The value calculate is same as that of the text despite of generation of earnings.

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