Replace Repair Equipment Decisions
Problem 1 Repair-Replace
Jeffcoat
Management often has to decide whether to continue using an asset or replace it.
Let's assume that Jeffcoat company has a factory machine that originally cost $110,000
It has a balance in accumulated depreciation of 70,000, so the machines book value is $40,000. it has a remaining life of four years.
The company is considering replacing this machine with a new machine. The new machine will cost $120,000 and it is expected to have a zero salvage value at the end of its four-year useful life.
If the new machine is acquired variable manufacturing costs are expected to decrease from $160,000 to $125,000 annually and the old unit could be sold for $5,000.
The incremental analysis for the four year period is as follows. In this case it would be to the company's advantage to replace the equipment. The lower variable manufacturing cost due to the replacement more than offset the cost of the new equipment. Note that the $5,000 received from the sale of the old machine is relevant to the decision because it will only be received if the company chooses to replace its equipment. The book value of the old machine does not affect the decision. Book value is a sunk cost which is a cost that cannot be changed by any present or future decision. Some costs are not relevant in incremental analysis however any trade-in allowance or cash disposal value of the existing asset is relevant when you are working on this exercise. Iinclude those costs and revenue that differ across the alternatives and exclude any past or sunk cost.
Should we replace the machine ?
| Differential Analysis | Retain | Replace | Net Income Increase (Decrease) |
| Variable Manufacturing Costs | 640,000 | 500,000 | 140,000 |
| New Machine Cost | 120,000 | (120,000) | |
| Sale Of Old Machine | (5,000) | 5,000 | |
| Total | 640,000 | 615,000 | 25,000 |
160,000 x 4 years = 640,000
125,00 x 4 years = 500,000
Advantage replace the equipment. What does this simple analysis lack ? The time value of money ! A dollar today is worth more than a dollar in the future.
Problem 2 Replace Equipment
Jackson Quality Copies
Jackson’s Quality Copies is facing a decision common to many organizations: whether to invest in equipment that will last for many years or to continue with existing equipment.
Jackson’s Quality Copies will pay $50,000 for the new copier, which is expected to last 7 years. Annual maintenance costs will total $1,000 a year, labor cost savings will total $11,000 a year, and the company will sell the copier for $5,000 at the end of 7 years. The following table summarizes the cash flows related to this investment.
Amounts in parentheses are cash outflows. All other amounts are cash inflows
.
Cash Flows for Copy Machine Investment by Jackson’s Quality Copies
| Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Yr 6 | Yr 7 | |
| Purchase price | (50,000) | |||||||
| Maintenance costs | (1,000) | (1,000) | (1,000) | (1,000) | (1,000) | (1,000) | (1,000) | |
| Labor savings | 11,000 | 11,000 | 11,000 | 11,000 | 11,000 | 11,000 | 11,000 | |
| Salvage value | 5,000 | |||||||
| Total cash | (50,000) | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 | 15,000 |
The accountant at Jackson’s Quality Copies, Mike Haley, has established the cost of capital for the firm at 10 percent. Since the proposed purchase of a copy machine is of average risk to the company, Mike will use 10 percent as the required rate of return.
Net Present Value ( NPV) Calculation for Copy Machine Investment by Jackson’s Quality Copies
| Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | Yr 5 | Yr 6 | Yr 7 | |
| Purchase price | (50,000) | |||||||
| Maintenance costs | (1,000) | (1,000) | (1,000) | (1,000) | (1,000) | (1,000) | (1,000) | |
| Labor savings | 11,000 | 11,000 | 11,000 | 11,000 | 11,000 | 11,000 | 11,000 | |
| Salvage value | 5,000 | |||||||
| Total cash | (50,000) | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 | 10,000 | 15,000 |
| PV Factor @ 10% | 1.00 | .9091 | .8264 | .7513 | .6830 | .6209 | .5645 | .5152 |
| Present Value | (50,000) | 9,091 | 8,264 | 7,515 | 6,830 | 6,209 | 5,645 | 7,698 |
| Net Present Value | 1,250 |
The NPV is $1,250. Because NPV is > 0, accept the investment. (The investment provides a return greater than 10 percent.)
Problem 3 Purchase Equipment
Chip Manufacturing, Inc.
The management of Chip Manufacturing, Inc., would like to purchase a specialized production machine for $700,000. The machine is expected to have a life of 4 years, and a salvage value of $100,000. Annual maintenance costs will total $30,000. Annual labor and material savings are predicted to be $250,000. The company’s required rate of return is 15 percent
| Yr 0 | Yr 1 | Yr 2 | Yr 3 | Yr 4 | |
| Purchase price | (700,000) | ||||
| Maintenance costs | (30,000) | (30,000) | (30,000) | (30,000) | |
| Labor savings | 250,000 | 250,000 | 250,000 | 250,000 | |
| Salvage value | 100,000 | ||||
| Total cash | (700,000) | 220,000 | 220,000 | 220,000 | 320,000 |
| PV Factor @ 15% | 1.00 | .9091 | .8264 | .7513 | .6830 |
| Present Value | (700,000) | 191,312 | 166,342 | 144,650 | 182,9760 |
| Net Present Value | (14,720) |
Because the NPV is less than 0, the return generated by this investment is less than the company’s required rate of return of 15 percent. Thus Chip Manufacturing, Inc., should not purchase the specialized production machine.