Question

Case 27-1

Sinclair Company.

A. EQUIPMENT REPLACEMENT

Sinclair Company is considering the purchase of new equipment to perform operations currently being performed on different, less efficient equipment. The purchase price is $250,000, delivered and installed.

A Sinclair production engineer estimates that the new equipment will produce savings of $72,000 in labor and other direct costs annually, as compared with the present equipment. She estimates the proposed equipment’s economic life at five years, with zero salvage value. The present equipment is in good working order and will last, physically, for at least five more years.

The company can borrow money at 9 percent, although it would not plan to negotiate a loan specifically for the purchase of this equipment. The company requires a return of a least 15 percent before taxes on an investment of this type. Taxes are to be disregarded.

Questions

1. Assuming the present equipment has zero book value and zero salvage value, should the company buy the proposed equipment?

2. Assuming the present equipment is being depreciated at a straight-line rate of 10 percent, that it has a book value of $135,000 (cost, $225,000; accumulated depreciation, $135,000), and has zero net salvage value today, should the company buy the proposed equipment?

Answer 1

1-	Initial investment-		-250000
	annual savings in direct cost		72000
	Life of new machine		5
	Discount rate		15%
	year	cash flow	present value of cash flow = cash flow/(1+rr)^n r= 15%
	0	-250000	-250000
	1	72000	62608.7
	2	72000	54442.34
	3	72000	47341.17
	4	72000	41166.23
	5	72000	35796.72
	net present value	sum of present value of cash flow	-8644.83
	Machine should not be purchased as it results in negative net present value
2-	Book value makes no difference. The figures and decision are the same as in 1. Nevertheless, a profit center manager may not view the $135,000 write-off as irrelevant, even though it does represent asunk cost