Question

The TechMech Company produces and sells 6400 modular computer desks per year at a selling price of $450 each. Its current production equipment, purchased for $1,650,000 and with a five-year useful life, is only two years old. It has a terminal disposal value of $0 and is depreciated on a straight-line basis. The equipment has a current disposal price of $500,000. However, the emergence of a new moulding technology has led TechMech to consider either upgrading or replacing the production equipment. See the table below for alternatives.

All equipment costs will continue to be depreciated on a straight-line basis. For simplicity, ignore income taxes and the time value of money.

Required:

1.         Should TechMech upgrade its production line or replace it? Show your calculations.

2.         Now suppose the one-time equipment cost to replace the production equipment is somewhat negotiable. All other data are as given previously. What is the maximum one-time equipment cost that TechMech would be willing to pay to replace the old equipment rather than upgrade it?

3.         Assume that the capital expenditures to replace and upgrade the production equipment are as given in the original exercise, but that the production and sales quantity is not known. For what production and sales quantity would TechMech (a) upgrade the equipment or (b) replace the equipment?

4.         Assume that all data are as given in the original exercise, Dan Doria is TechMech’s manager, and his bonus is based on operating income. Because he is likely to relocate after about a year, his current bonus is his primary concern. Which alternative would Doria choose? Explain.

A	B	C
	Upgrade	Replace
One-time equipment costs	$2,900,000	$3,900,000
Variable manufacturing cost per desk	$145	$100
Remaining useful life of equipment (years)	3	3
Terminal disposal value of equipment	$0	$0

Answer 1

Ans 1

Particulars	Upgrde (a)	Replace (b)	Diff (a-b)
One time Equipment Costs	$2,900,000	$3,900,000	($1,000,000)
Variable Manufacturing Costs (6,400 * 145 * 3) ; (6,400 * 100 * 3)	$2,784,000	$1,920,000	$864,000
Current Disposal Price	-	($500,000)	$500,000
Total Relevant Costs	$5,684,000	$5,320,000	$364,000

Therefore, if the company replaces the production line it would be able to save $337,500 in relevant costs. Thus the company should replace the machine.

Ans 2

Let 'X' be the one time cost that the company would be willing to pay to replace the equipment instead of upgrading it.

X + $1,920,000 - $500,000 ≤ $5,684,000

X ≤ $4,264,000

Ans 3  

a) Let 'Y' be the annual production and sales quantity if equipment is upgraded.

$2,900,000 + ($145 * 3 * Y) ≤ $3,900,000 + ($100 * 3 * Y) - $500,000

$435Y - $300Y ≤ $500,000

Y ≤ 3,703 units

b) Let 'X' be the annual production and sales quantity if equipment is replaced

$2,900,000 + ($145 * 3 * Y) ≥ $3,900,000 + ($100 * 3 * Y) - $500,000

$435Y - $300Y ≥ $500,000

Y ≥ 3,703 units

Ans 4

Particulars	Upgrade	Replace
Revenue (6,400 * $450)	$2,880,000	$2,880,000
Less : Variable Cost [(6,400 * 145) ; (6,400 * 100)]	$928,000	$640,000
Less : Depreciation [($1,650,000/5 + $2,900,000/3) ; ($3,900,000/3)]	$1,296,667	$1,300,000
Less : Loss on disposal of old machine [$1650000-($1650000*2/5)-$500000		$490,000
Operating Income	$655,333	$450,000

Manager will choose to upgrade the machine as operating income is higher if machine is upgraded.