Question

Use the following data to work. Michael is an Internet service provider. On December 31,2014 , he bought an existing business with servers and a building worth \(\$ 400,000 .\) During \(2015,\) his business grew and he bought new servers for \(\$ 500,000 .\) The market value of some of his older servers fell by \(\$ 100,000\). What was Michael's gross investment, depreciation, and net investment during \(2015 ?\)

Short answer

Gross investment: \$500,000. Depreciation: \$100,000. Net investment: \$400,000.

Step-by-step solution

- Calculate Gross Investment

Gross investment refers to the total amount spent on new capital assets. Michael bought new servers for \( \$500,000 \) during 2015. Therefore, his gross investment for this period is \( \$500,000 \).

- Determine Depreciation

Depreciation indicates the reduction in value of existing assets. Some of Michael's older servers decreased in value by \( \$100,000 \). So, the depreciation amount is \( \$100,000 \).

- Compute Net Investment

Net investment is calculated by subtracting depreciation from gross investment. Here, it is \(\text{Gross Investment} - \text{Depreciation} = \$500,000 - \$100,000 = \$400,000. \) Therefore, Michael's net investment for 2015 is \( \$400,000 \).

Key concepts

Gross Investment

Gross investment is a fundamental concept in economic investment analysis. It refers to the total amount spent on acquiring new capital assets during a given period. For Michael, who is an internet service provider, the gross investment in 2015 was the cost of new servers. He spent \(500,000 on new servers, which means the entire amount of \)500,000 is considered his gross investment for that year.
Gross investment is an important metric because it represents the total expenditure on enhancing or expanding the asset base of a business. This amount does not account for any reduction in the value of existing assets, which is where the concept of depreciation comes into play.

Depreciation

Depreciation is the process through which the value of an asset decreases over time due to wear and tear, age, or obsolescence. In Michael's case, some of his older servers decreased in value by \(100,000 during 2015.
Depreciation is calculated annually and provides a way to allocate the cost of an asset over its useful life. It is crucial for businesses to account for depreciation because it affects the net value of their assets and, consequently, their financial health.
The depreciation amount for Michael's older servers is \)100,000 in 2015. This reduction in value must be considered when calculating net investment.

Net Investment

Net investment is derived by subtracting depreciation from gross investment. It shows the actual increase in the capital assets of a business after accounting for the reduction in value of existing assets.
For Michael, the net investment in 2015 would be calculated using the formula:
\text{Net Investment} = \text{Gross Investment} - \text{Depreciation} = \(500,000 - \)100,000 = \(400,000.
Thus, Michael's net investment for 2015 is \)400,000. This figure is significant because it indicates the real addition to the capital assets of Michael's business, factoring in the decrease in value of older servers.
Understanding net investment is crucial for assessing the true growth and expansion of a business's asset base over time.