The Clampton Company decides to purchase the equipment, hereafter called Model A. Two years later, even...

The Clampton Company decides to purchase the equipment, hereafter called Model A. Two years later, even better equipment (called Model B) is available on the market and makes the other equipment completely obsolete, with no resale value. The Model B equipment costs $150,000 delivered and installed, but it is expected to result in annual savings of $40,000 over the cost of operating the Model A equipment. The economic life of Model B is estimated to be five years. It will be depreciated at a straight-line rate of 20 percent. c. what action should the company take? d. The company decides to purchase the Model B equipment, but a mistake has been made somewhere, because good equipment, bought only two years previously, is being scrapped. How did this mistake come about?

Expert Solution

C) This is a question of comparing two alternatives to decide which project or machine should be bought or which alternative is better.

In these type of questions there are multiple methods to decide. For example 1. net cash flow method in which total outflow and total inflow are compared to find the advantage or disadvantage. Similarly there are other methods like payback period (which project has the lowest period in which total cost is received back) , accounting rate of return (which project has hightest rate of return).

But the best method would be to use net present value method in which time value is also considered. And hence for all the outflows and inflows , present value is considered and then by comparing present value of outflow vs present value of inflow , net present value is decided.

So company should try to calculate net present value of the decision to buy model B. If it's postive then the decisions should be made. Since there is no discounting rate given in the question , hence the same can not be calculated here.

D) if the company is choosing to buy that model , that means company has used cash outflow method and hence ignored the present value or the time value of money.

In cash flow method

Outflow = $150000

Inflow (saving) = $40000*5 year = $200000

Net inflow = $50000

Here the mistake made is ignoring present value of money.

ekkarill92 answered 2 years ago

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