Question

Your organisation has decided to purchase an item of equipment expected to work 1700 hours per year (average) for a 12 year working life.

(a) Discuss, in about 200 words, two methods you could use to compare alternative options when buying this equipment.

(b) Assume that the item of equipment you decided to purchase had a purchase price of $2,900,000 and a residual value at the end of 12 years of $260,000. Tabulate the depreciation and book value for the life of the item by each of the following methods:

1) straight line 2) declining balance 3) sum of digits.

(c) Tabulate details of a sinking fund to accumulate to the original purchase price less residual value assuming an interest rate of 6%.

(d) Draw a graph showing the book values in each of the above (plotted on the same graph for comparison).

(e) Comment on the factors that an equipment owner might consider when selecting one of these methods.

(f) Assume now that you have purchased this equipment. What is the Total Annual payment required for operating the equipment? You have the following additional data:

• Maintenance costs are $60,000 in the first year

• Operator wages are $100,000 in the first year

• Storage, transport and other miscellaneous costs are $15,000 in the first year

• Money costs 8% per year Hint: Start by calculating the Capital Recovery Factor

(g) Maintenance, operator and miscellaneous costs are expected to increase at a flat rate of 4% per year over the life of the machine. Based on a Profit margin of 32%, create a table that calculates the hourly charge out rate, including profit, you would need for its hire during each year of the working life of the equipment.

(h) Also based on this hourly charge and expected operating hours, what is the expected annual income over the working life of the equipment?

Answer 1

a)

1. Two methods that can be used before buying is whether to borrow and buy or to take lease.
   • Borrow and buy: For that new debt has to be issued, which will create a Long-term asset worth its market value, equal amount of debt under liability section of the Balance sheet. Also, interest expense for the debt in Income statement. Depreciation expense and interest expense to be accounted in Income statement. Option is costly.
   • If taken on lease, financial lease; interest and depreciation expense come in Income statement. Asset is added under Long-term assets and Liability of equal value in Balance sheet. Depreciation to be accounted for in Balance sheet. Company will report higher operating cash flow, as a portion of the lease payment will be reflecting as cash outflow from financing. Lease, usually turns out to be better choice, with present value of discounted future lease obligation to be reported on the balance sheet.
   • b)Depreciation value under
     • straight line method
       • formula = (original cost - residual value)/ life-years;
       • depreciation cost = $220,000 [($2,900,000 - $260,000)/12]
       • d) as below

3) Sinking fund calculation

• Face Value = $ 2,640,000
• N=12 years
• dicount rate = 6% p.a
• Annuity: Need to claulate how much to put aside for 12years to accumulate $2,640,000 (similar to finding coupon)
• Present value = 0
• Using Texas Instrument BA-II plus calculator, it can be arrived as $171,903.38

e) Depreciation method choice:

• SLM: simple, easy to calculate, common method. Same depreciation all through out the life
• Declining balalnce method: more practical in computer making firms, where technology changes fast and asset depreciates more with smaller lives.
• SYD: Higher expense is incurred in the early years