Question: “Metal Press”

Your firm uses return on assets (ROA) to evaluate investment centers and is considering changing the valuation basis of assets from historical cost to current value. When the historical cost of the asset is updated a price index is used to approximate replacement value. For example, a metal fabrication press, which bends and shapes metal, was bought seven years ago for $522,000. The company will add 19% to this cost, representing the change in the wholesale price index over the 7 years. This new, higher cost figure is depreciated using the straight-line method over the same 12 year assumed life (no salvage value.)

a. Calculate depreciation expense and book value of the metal press under both historical cost and price. Level adjusted historical cost.

b. In general what is the effect on ROA of changing valuation bases from historical cost to current values?

c. The manager of the investment center with the metal press is considering replacing it because it is becoming obsolete. Will the managers incentives to replace the metal press change if the firm shifts from historical cost valuation to the proposed price level adjusted historical cost valuation?