Question

Consider the following two options related to one of old machine tools in your shop:

Option 1:

You continue to use the old machine tool that was bought four years ago for $12,000. It has been fully depreciated but can be sold for $2,000. If kept, it could be used for three more years with proper maintenance and with some extra care. No salvage value is expected at the end of three years. The maintenance costs would run $10,000/year for the old machine tool.

Options 2:

You purchase a brand-new machine tool for $15,000 to replace the present equipment. Because of the nature of the product manufactured, it also has an expected economic life of three years and will have a salvage value of $5,000 at the end of that time. With the new machine tool, the expected operating and maintenance costs (with the scrap savings) amount to $3000 each year for 3 years.

For the old machine tools, what would be the amount of sunk cost that should be recognized in replacement analysis?

a. $8000

b. $9000

c. $10,000

d. $12,000

Answer 1

Ans:

OPTION-1:

Here, suppose he uses the equipment for 3 years,

then present worth of alternative :

10000/(1+r) + 10000/(1+r)^2 + 10000/(1+r)^3

=> (-) $23611.5260

OPTION-2:

Availing this option means we are replacing the exisiting old equipment. So, we sell it at $1800.(+ve cash inflow)

Now, total cost associated =

$13000 + 2000/(1+r) + 2000/(1+r)^2 + 2000/(1+r)^3 - 2000/(1+r)^3

(since , salvage value at end of 3 years is 2000, so we need to discount that too)

=> (-) $16336.205

Present worth = $1800 - $16336.205 = (-)$14536.205.

Thereby difference between the two =

Option2 - Option1 = (-)$14536.205. + $23611.5260

=> $9075.321 .