Question

Because of rapidly advancing technology, Chicago Publications Corporation is considering replacing its existing typesetting machine with leased equipment. The old machine, purchased two years ago, has an expected useful life of six years and is in good condition. Apparently, it will continue to perform as expected for the remaining four years of its expected useful life. A four-year lease for equipment with comparable productivity can be obtained for $40,000 per year. The following data apply to the old machine: Original cost $ 480,000 Accumulated depreciation 160,000 Current market value 190,000 Estimated salvage value 10,000 Required Determine the annual opportunity cost of using the old machine. Based on your computations, recommend whether to replace it. Determine the total cost of the lease over the four-year contract. Based on your computations, recommend whether to replace the old machine.

Answer 1

(a) The original cost of old machine is sunk cost.

Opportunity cost of using old machine = Current market price – Salvage

       = 190000 – 10000 = 180000

Annual opportunity cost = 180000/4 years = $ 45000

Annual cost of lease equipment = $ 40000

Since the annual cost of using the existing machine is higher than the annual cost of leasing the equipment, the existing machine should be replaced

(b) Total cost of lease over 4 years = Total of Annual lease payments – Current market price of old machine

= (40000 * 4) – 190000 = (30000)

Total cost in existing machine = Annual cost – Salvage value

   = 0 – 10000 = (10000)

The existing machine should be replaced