Question

Lord of the Rings Corporation

Lord of the Rings Corporation is considering purchasing a new state of the art microprocessor machine for its manufacturing division, the X-80, to replace their old machine “MISTY”, model G-40 (model G-40 will be sold for $15,000). Both machines have the same capacity to produce and package microprocessors for customer delivery, and both have the same remaining life of 10 years from today. The company's tax rate is 40%.

                                                                                             G-40                   X-80

Cost                                                                                 $100,000            $180,000

Accumulated depreciation                                                 60,000                   0

Salvage value in 10 years                                                       0                        0

Yearly cash operating costs                                               50,000               30,000

Yearly cash revenues                                                       270,000              270,000

Yearly depreciation expense                                               4,000                18,000

A.         Which of the following items are relevant costs and/or revenues associated with the decision to keep or replace the misty?

1.         The $4,000 yearly depreciation expense for the G-40 versus the $18,000 yearly depreciation expense for the X-80.

2.        The $1,600 yearly lower tax payments caused by the depreciation expense for the G-40 versus the $7,200 yearly lower tax payments caused by the depreciation expense for the X-80.

3.        The $180,000 cash cost of the X-80.

4.        The $100,000 cost of the G-40.

5.        The $60,000 accumulated depreciation of the G-40.

6.        The $40,000 book value of the G-40.

7.        The $15,000 cash from the sale of the G-40.

8.        The $25,000 loss on the sale of the G-40.

9.         The $10,000 lower tax payments caused by the loss on the sale of the G-40.

10.        The $50,000 yearly cash operating costs for the G-40 versus the $30,000 yearly cash operating costs for the  

X-80.

11.       The $20,000 yearly lower tax payments caused by the cash operating costs for the G-40 versus the $12,000 yearly lower tax payments caused by the cash operating costs for the X-80.

12.       The $270,000 yearly cash revenues generated by leasing the G-40 to other firms for use during the off-season versus the $270,000 yearly cash revenues from leasing the X-80 during the off-season.

13.       The $108,000 yearly increased tax payments caused by the cash revenues for the G-40 versus the $108,000 yearly increased tax payments caused by the cash revenues for the X-80.

B.         Should management (1) keep the G-40 or (2) sell the G-40 and buy the X-80? Assume NO time value of money.

C.         Suppose that the manager of the manufacturer plant receives a bonus equal to 10% of the arena’s net income before taxes (The FIRST year’s bonus is crucial). How would this effect his decision in Part B above?

D.         Suppose that the manager of the manufacturing facility receives a bonus equal to 10% off the facility’s CASH FLOW (The FIRST year’s bonus is crucial). How would this effect his decision in Part B above?

E.         Repeat requirement B assuming that there is a time value of money. Use a 10% discount rate, and assume that the cash flows occur at the end of each year.

Answer 1