Question

Detailed Instructions:
In a business setting, we are often asked to write a memo to communicate with internal and external professionals. To further advance your learning of memo communication, this written case requests that you prepare a memo to communicate within the company.

Background:

As the senior accountant at Technology on Demand (TOD), which manufactures mobile technology such as flip phones, smartphones, notebooks, and smartwatches, you are often asked to prepare various financial analysis necessary for decision making. Michelle Dodd, the controller, asked you to evaluate whether a piece of factory equipment should be replaced or kept.

The old piece of factory equipment was purchased four years ago for $875,000. Over the last four years, TOD has allocated depreciation based on the straight-line method. The expected salvage value is $25,000. The current book value of the factory equipment is $425,000. The operating expenses total approximately $45,000 a year. It is estimated that the residual value (market value) of the old machine is $350,000.      

The controller is contemplating whether to replace the piece of factory equipment. The replacement factory equipment would consist of a purchase price of $500,000, a useful life of eight years, salvage value of 30,000, and annual operating costs of $35,000.

In consideration of the background, prepare a memo in a Word document to submit to the controller. Your first paragraph would be an introduction paragraph of what the memo is about. Next, you will want to consider the equipment replacement decision. To add clarity to your discussion, you are to insert a table comparing the old equipment to the new equipment. In evaluating the “relevant” costs, what does your analysis show? Do you recommend that the equipment be replaced or kept ongoing for the next eight years? Why or why not?

Hint: See Equipment Replacement Decisions (LO 6-5) in chapter 6 located on page 268 and 269 of the hard copy text book. A piece of equipment with salvage value can still be serviceable after beyond its useful life. Be sure to focus on the “relevant costs.”

Answer 1

This memo is for discussing the desicion pertaining to the keep or replace decision regarding TOD. The existing machinery incurs an operating cost of 45,000$ while a new one will incur 35,000$. A machinery will cost 500,000$ to purchase against a sale value of 350,000$ of old machine. This sale of old machine prematurely will also incur capital losses which will allow tax benefit. Also, there will be an increase in cost of machine in books leading to an increased depriciation and consequently higher tax savings. The Salvage Values are 25,000$ and 30,000$ of old and new, respectively. Tax rate is considered at 20% and WACC at 8%.

Basis the calculation, we do not suggest the replacement of asset. This is because the cost incurred at the beginning of the period is not recovered even upto the time the asset is sold (i.e. 8 years).