Bruce and Emmett (B & E) is considering a significant equipment replacement. B & E would like to replace some of their equipment before December 31, 2019. The equipment originally cost $500,000 and the equipment’s accumulated depreciation balance at the end of 2019 is will be $450,000. At this point the equipment is depreciated to its salvage value.
Your long-term asset accountant, Boris, tells you about four equipment options as follows:
The estimated life of any new equipment is 5 years.
All loans would start as of January 1, 2019
B & E would like you to analyze the four options to determine the financial impact of each decision and any non-financial considerations that may result from each decision. Additional information about each option is presented below:
Option 1: Construct the new equipment in-house and sell the old equipment for cash at a fair value of $60,000. B & E would take out a one-year construction loan for $500,000 at the time construction begins at a short-term borrowing rate of 10% for the construction Anticipated actual expenditures for constructing the equipment are $580,000. The bulk of the $580,000 will be financed with the construction loan, and the balance will be financed through accounts payable. The interest on the short-term note is due and payable by year-end. (Note: Construction is assumed to be completed at December 31,2019.)
Option 2: Exchange the equipment for a similar piece of equipment with a fair value of $600,000. The fair value of the old equipment is $60,000. B & E can borrow $540,000 on a one-year, 10% note. the balance will be funded with an accounts payable arrangement with the supplier. (Assume the exchange has commercial substance.)
Option 3: Purchase the new equipment by giving a non-interest-bearing note with five payments of $120,000 to the supplier (starting on the first day of note’s term and each year thereafter) and selling the old equipment for $60,000 cash. The first $120,000 payment would be made in late December 2019. The prevailing interest rate for obligations of this nature is 10%.
Option 4: Overhaul the existing equipment. The following expenses are anticipated under this approach: (1) The normal annual cost for lubrication and replacement of minor parts to maintain the integrity of the exterior body would be $30,000. (2) The cost of re-wiring interior components in an overhaul would be $150,000. (3) Replacing old worn components would cost $100,000 with associated labor costs of $210,000 for installation. The overhaul is estimated to extend the useful life of the equipment another four years. (The present equipment’s original useful life was eight years, starting January 1, 2014) The costs will be financed through the end of 2019 with a one-year loan at a 10% interest rate.
(f) What if you found out that the Research and Development account included current year costs of $190,000 and R& D Equipment with a cost of $100,000 and an estimated useful life of 5 years. Describe how that would impact the financial statements (do not revise the financial statements) and prepare the necessary journal entries assuming the financial statements have not been issued yet
Answer: In the given situation B & E is searching for a viable option. As per the options given, following is the analysis:
Option 1: In this option Net cost would be $5,20,000($5,80,000 - $60,000)
OPtion 2: In this option net cot would be $5,40,000
Option 3: In this option we would have to take the present value on the basis of $1,20,000 yearly payments for 5 years and interest of 10%, So Present value would be $4,54,894. So net cost would be $4,54,894-$60,000 = $3,94,894
Option 4: Cost would be $4,90,000(sum of all the overhauling costs)
So, as per all the options Option 3 is the most viable option for B&E.
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