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Old Equipment Replacement

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1. Role of Old Equipment Replacement

On January 2, 2004, the S.H. Park Company installed a brand-new $87,000 special molding machine for producing a new product. The product and the machine have an expected life of three years. The machine's expected disposal value at the end of the three years is zero.

On January 3, 2004, Kimiyo Lee, a star salesperson for a machine tool manufacturer, tells Mr. Park, "I wish I had known earlier of your purchase plans. I can supply you with a technically superior machine for $99,000. The machine you just purchased can be sold for $16,000. I guarantee that our machine will save $35,000 per year in cash operating costs, although it too will have no disposal value at the end of three years."

Park examines some technical data. Although he has confidence in Lee's claims, Park contends, "I'm locked in now. My alternatives are clear: (a) Disposal will result in a loss, (b) keeping and using the 'old' equipment avoids such a loss. I have brains enough to avoid a loss when my other alternative is recognizing a loss. We've got to use that equipment until we get our money out of it."

The annual operating costs of the old machine are expected to be $60,000, exclusive of depreciation. Sales, all in cash, will be $910,000 per year. Other annual cash expenses will be $810,000 regardless of this decision. Assume that the equipment in question is the company's only fixed asset.

Ignore income taxes and the time value of money.

1. Prepare statements of cash receipts and disbursements as they would appear in each of the next three years under both alternatives. What is the total cumulative increase or decrease n cash for the three years?
2. Prepare income statements as they would appear in each of the next three years under both alternatives. Assume straight-line depreciation. What is the cumulative increase or decrease in net income for the three years?
3. Assume that the cost of the "old" equipment was $1 million rather then $87,000. Would the net difference computed in numbers 1 and 2 change? Explain.
4. As Kimiyo Lee, reply to Mr. Park's contentions.
5. What are the irrelevant items in each of your presentations for number 1 and 2? Why are they irrelevant?

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The solution explains how to decide whether to replace an old equipment with a new one.

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1. Role of Old Equipment Replacement
On January 2, 2004, the S.H. Park Company installed a brand-new $87,000 special molding machine for producing a new product. The product and the machine have an expected life of three years. The machine's expected disposal value at the end of the three years is zero.

On January 3, 2004, Kimiyo Lee, a star salesperson for a machine tool manufacturer, tells Mr. Park, "I wish I had known earlier of your purchase plans. I can supply you with a technically superior machine for $99,000. The machine you just purchased can be sold for $16,000. I guarantee that our machine will save $35,000 per year in cash operating costs, although it too will have no disposal value at the end of three years."

Park examines some technical data. Although he has confidence in Lee's claims, Park contends, "I'm locked in now. My alternatives are clear: (a) Disposal will result in a loss, (b) keeping and using the 'old' equipment avoids such a loss. I have brains enough to avoid a loss when my other alternative is recognizing a loss. We've got to use that equipment until we get our money out of it."

The annual operating costs of the old machine are expected to be $60,000, exclusive of depreciation. Sales, all in cash, will be $910,000 per year. Other annual cash expenses will be $810,000 regardless of this decision. Assume that the equipment in question is the company's only fixed asset.

Ignore income taxes and the time value of money.

1. Prepare statements of cash receipts and disbursements ...

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