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Asset replacement and capital budgeting

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The plant has accumulated savings of $60,000 to acquire a new machine for quality assurance of its products. The new quality control machine cost $80,000. The extra $20,000 needed to acquire the new machine will be finance through a loan at 6% annual interest with the principal ($20,000) due at the end of the third year. The income tax rate is 0.35. The new equipment will save $35,000 each year and its economic life is 3 years. The salvage value is $30,000. Does the acquisition of this new machine satisfy the 6% minimum rate? Compute the after tax rate of return of this alternative for year two. Solve this problem using the straight line and the MACRS depreciation methods. Which depreciation method is best for year two?

Four years ago a company purchased a new copy machine. Due to deterioration, soon a new copy machine will be needed. The annual maintenance cost for the existing machine is $1,600 and increasing 100 each year. An identical copy machine can be purchased now to replace the presently owned assets. The presently owned copy machine losses each year $10,000 in resale value, compare the assets with at 10% per year and compute when the presently owed should be replace.

Same model as presently owned

Present value (when new) $75,000
Present value of new copy machine $85,000
Annual cost (old copy machine) 1,100
Annual cost (new copy machine) 1,600 and increasing
Salvage value (both machine) 15,000
Life in years (both machine) 6

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Solution Summary

This solution helps to answer asset replacement decision and some capital budgeting decisions questions.

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Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not.

The Innovative Sporting Goods Company (JSGC) was founded in 1975 in Cambridge, MA. Its founder, Andy Pratt, a mechanical engineer, had developed a sound technique of making baseball bats. Under his leadership, the company had gained national reputation. Recently, however, a new machine had been developed in the industry, which would allow manufacturers to coat the aluminum baseball bats with a special compound giving them a satin finish and making them more durable and powerful. The prototype had been presented to the respective regulatory authorities and had been approved. Upon Andy's request, Douglas Adams, the head of the design group, had tested the new product and researched the relevant cost arid production process issues that a machine replacement would entail.

Doug reported that besides the initial price tag of $350,000 for one of these machines, users would have to incur shipping, handling, and installation costs of $4500 and annual fixed operating costs of about $20,000 per machine. Currently, the company incurs fixed operating costs of $28,000 for it's coating and finishing process. Initial marketing survey results indicated that the company would be able to increase sales of its newly designed baseball bats by about 15% in the first year of introduction and thereafter at a rate of 5% per year compared with forecasted sales growth of 2% per year for the current type of baseball bats. During the most recent year, ISGC sold 220,000 baseball bats at an average price of $12.50 per unit. The newly designed bat was expected to sell for $13 per unit.

Material, labor, general, and administrative costs were expected to remain constant at $10 per unit. The increased sales and production requirements would entail an increase in accounts receivables of $54,000, an increase in accounts payables of 30,000, and an increase in inventory of $ 20,000. It was assumed that any increase in net working capital would be recovered at the end of the useful life of the machine, which was estimated to be 10 years. The existing machine was purchased 5 years ago for $225,000. The depreciation on the existing machine was being calculated using a 15-year straight-line schedule with the assumption of no residual salvage value. The machine had a current market value of $100,000, and an expected market value of $10,000 after 10 more years of use. The new machine was expected to last for ten years -- the same as the remaining life of the old machine.

The new machine would qualify as a 5-year class life asset under MACRS depreciation rates (see Table 1) and was expected to have a market value of approximately $20,000 at the end of its economic life. ISGC'S marginal tax rate was 34% and its weighted average cost of capital was estimated at 15%. Part of the cost of replacing the existing machine would be financed by a bank loan that would require an annual interest expense of 10% on the outstanding balance.

Andy knows that the new technology is the way to go. However, being cautious and conservative by nature, he does not want to implement changes that would be financially detrimental to his company. After all, he has worked too hard to let it all slip away by making lousy financial decisions. Andy has long believed in the age-old saying, " If the coat fits wear it."

Table: 1
Depreciation schedule
Modified Accelerated Cost Recovery System
Recovery Period Class

Year 3-Year 5-Year 7-Year 10-Year
1 33.00% 20.00% 14.30% 10.00%
2 45.00% 32.00% 24.50% 18.00%
3 15.00% 19.20% 17.50% 14.40%
4 7.00% 11.50% 12.50% 11.50%
5 0.00% 11.50% 8.90% 9.20%
6 0.00% 5.80% 8.90% 7.40%
7 0.00% 0.00% 8.90% 6.60%
8 0.00% 0.00% 4.50% 6.60%
9 0.00% 0.00% 0.00% 6.50%
10 0.00% 0.00% 0.00% 6.50%
11 0.00% 0.00% 0.00% 3.30%
Total 100.00% 100.00% 100.00% 100.00%

Questions:
1. Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not. Indicate how would you proceed (without making any calculations)?

2. Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the context of this case.

3. As is often the case, the marketing department has overestimated the annual sales growth. How can more conservative and realistic estimates be generated? How can these estimates be incorporated into the analysis so as to arrive at a good and well justified decision?

4. What are the relevant factors and items to be considered when estimating the initial outlay? Calculate the initial outlay for this replacement project.

5. How are the interim cash flows to be computed for the productive life of the new machinery? How is depreciation to be accounted for?

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