Question

Sinclair Company* A. EQUIPMENT REPLACEMENT Sinclair Company is considering the purchase of new equipment to perform operations currently being performed on different, less efficient equipment. The purchase price is $250,000, delivered and installed. A Sinclair production engineer estimates that the new equipment will produce savings of $72,000 in labor and other direct costs annually, as compared with the present equipment. She estimates the proposed equipment’s economic life at five years, with zero salvage value. The present equipment is in good working order and will last, physically, for at least five more years. The company can borrow money at 9 percent, although it would not plan to negotiate a loan specifically for the purchase of this equipment. The company requires a return of at least 15 percent before taxes on an investment of this type. Taxes are to be disregarded.

Questions

1. Assuming the present equipment has zero book value and zero salvage value, should the company buy the proposed equipment?

2. Assuming the present equipment is being depreciated at a straight-line rate of 10 percent that it has a book value of $135,000 (cost, $225,000; accumulated depreciation, $90,000), and has zero net salvage value today, should the company buy the proposed equipment?

3. Assuming the present equipment has a book value of $135,000 and a salvage value today of $75,000 and that if retained for 5 more years its salvage value will be zero, should the company buy the proposed equipment?

4. Assume the new equipment will save only $37,500 a year, but that its economic life is expected to be 10 years. If other conditions are as described in (1) Above, should the company buy the proposed equipment?

B. REPLACEMENT FOLLOWING EARLIER REPLACEMENT Sinclair Company decided to purchase the equipment described in Part A (hereafter called “model A” equipment). Two years later, even better equipment (called “model B”) comes on the market and makes the other equipment completely obsolete, with no resale value. The model B equipment costs $500,000 delivered and installed, but it is expected to result in annual savings of $160,000 over the cost of operating the model A equipment. The economic life of model B is estimated to be 5 years. Taxes are to be disregarded.

Questions

1. What action should the company take?

2. If the company decides to purchase the model B equipment, a mistake has been made somewhere, because good equipment, bought only two years previously, is being scrapped. How did this mistake come about?

C. EFFECT OF INCOME TAXES Assume that Sinclair Company expects to pay income taxes of 40 percent and that a loss on the sale or disposal of equipment is treated as a capital loss resulting in a tax saving of 28 percent of the loss. Sinclair uses an 8 percent discount rate for analyses performed on an after tax basis. Depreciation of the new equipment for tax purposes is computed using the accelerated cost recovery system (ACRS) allowances; assume that these allowances were 35, 26, 15, 12, and 12 percent for years 1 to 5, respectively. The new equipment qualifies for a 5 percent investment tax credit, which will not reduce the cost basis of the asset for calculating ACRS depreciation for tax purposes. Questions

1. Should the company buy the equipment if the facts are otherwise the same as those described in Part A (1)?

2. If the facts are otherwise the same as those described in Part A (2)?

3. If the facts are otherwise the same as those described in Part B?

D. CHANGE IN EARNINGS PATTERN Assume that the savings are expected to be $79,500 in each of the first three years and $60,750 in each of the next two years, other conditions remaining as described in Part A (1).

Questions

1. What action should the company take?

2. Why is the result here different from that in Part A (1)?

3. What effect would the inclusion of income taxes, as in Part C, have on your recommendation? (You are not expected to perform any more calculations in answering this question

Answer 1

1)

	0	1	2	3	4	5
Savings in costs		$72,000	$72,000	$72,000	$72,000	$72,000
Initial investment	-$2,50,000
Net cash flows	-$2,50,000	$72,000	$72,000	$72,000	$72,000	$72,000
Cost of capital	$1	$0.870	$0.756	$0.658	$0.572	$0.497
PV of cash flows	-$2,50,000	$62,608.70	$54,442.34	$47,341.17	$41,166.23	$35,796.72
NPV	-$8,644.83

No, the company should not purchase the new equipment as the NPV is negative.

Note: the cost of capital taken is 15% as that is the required rate of return for the project.

2) If the present equipment has a book value of $135000, and no salvage value, the NPV of the project remains unchanged without the tax consideration. Hence, since the NPV is negative, the compnay shpuld not purchase the new equipment.

3) If the salvage value today is $75000, the new NPV IS Calculated as follows:

	0	1	2	3	4	5
Savings in costs		$72,000	$72,000	$72,000	$72,000	$72,000
Initial investment	-$2,50,000
Salvage of old equipment	$75,000
Net cash flows	-$1,75,000	$72,000	$72,000	$72,000	$72,000	$72,000
Cost of capital	$1	$0.870	$0.756	$0.658	$0.572	$0.497
PV of cash flows	-$1,75,000	$62,608.70	$54,442.34	$47,341.17	$41,166.23	$35,796.72
NPV	$66,355.17

Since the NPV is positive, the company should purchase the new equipment.

4) If the economic life is increased to 10 years and savings are reduced to $37500, the new NPV is:

	0	1	2	3	4	5	6	7	8	9	10
Savings in costs		$37,500	$37,500	$37,500	$37,500	$37,500	$37,500	$37,500	$37,500	$37,500	$37,500
Initial investment	-$2,50,000
Net cash flows	-$2,50,000	$37,500	$37,500	$37,500	$37,500	$37,500	$37,500	$37,500	$37,500	$37,500	$37,500
Cost of capital	$1	$0.870	$0.756	$0.658	$0.572	$0.497	$0.432	$0.376	$0.327	$0.284	$0.247
PV of cash flows	-$2,50,000	$32,608.70	$28,355.39	$24,656.86	$21,440.75	$18,644.13	$16,212.28	$14,097.64	$12,258.82	$10,659.84	$9,269.43
NPV	-$61,796.18

Since, the NPV is negative, the company should not purchase the new equipment.