Question

Gen-X Industries is developing the incremental cash flows associated with the proposed replacement of an existing machine tool with a​ new, technologically advanced one. Given the following costs related to the proposed​ project, explain whether each would be treated as a sunk cost or an opportunity cost in developing the relevant cash flows associated with the proposed replacement decision.

a. ​Gen-X would be able to use the same​ tooling, which had a book value of $ 37,000​ on the new machine tool as it had used on the old one.

b.​ Gen-X would be able to use its existing computer system to develop programs for operating the new machine tool. The old machine tool did not require these programs. Although the​ firm's computer has excess capacity​ available, the capacity could be leased to another firm for an annual fee of $19,000.

c. ​Gen-X would have to obtain additional floor space to accommodate the larger new machine tool. The space that would be used is currently being leased to another company for $11,000 per year.

d.​ Gen-X would use a small storage facility to store the increased output of the new machine tool. The storage facility was built by​ Gen-X 3 years earlier at a cost of $123,000.

Because of its unique configuration and​ location, it is currently of no use to either​ Gen-X or any other firm.  

e.​ Gen-X would retain an existing overhead​ crane, which it had planned to sell for its $178,000 market value. Although the crane was not needed with the old machine​tool, it would be used to position raw materials on the new machine tool.

Answer 1

Answer a:

Gen-X would be able to use the same​ tooling, which had a book value of $ 37,000​ on the new machine tool as it had used on the old one.

For incremental cash flows, cost of tooling is not relevant since same tooling which is used for old machine is to be used for new machine.

Answer b:

Gen-X would be able to use its existing computer system to develop programs for operating the new machine tool. The old machine tool did not require these programs. Although the​ firm's computer has excess capacity​ available, the capacity could be leased to another firm for an annual fee of $19,000.

Cost of $19,000 is opportunity cost and is relevant in incremental cash flow analysis. New machine requires these programs and had the new machine not been there this capacity could have been leased at an annual fee of $19,000.

Answer c:

Gen-X would have to obtain additional floor space to accommodate the larger new machine tool. The space that would be used is currently being leased to another company for $11,000 per year.

Amount of $11,000 is relevant for incremental cash flow analysis. Since new machine requires the additional floor space, company is going to lose lease revenue of $11,000 per year. This is an opportunity cost.

Answer d:

Gen-X would use a small storage facility to store the increased output of the new machine tool. The storage facility was built by​ Gen-X 3 years earlier at a cost of $123,000. Because of its unique configuration and​ location, it is currently of no use to either​ Gen-X or any other firm. 

It is a sunk cost and is not relevant for incremental cash flow analysis. Cost of $123,000 is sunk cost and is incurred irrespective of whether new machine is installed or not.

Answer e:

Gen-X would retain an existing overhead​ crane, which it had planned to sell for its $178,000 market value. Although the crane was not needed with the old machine​tool, it would be used to position raw materials on the new machine tool.

The market value of $178,000 at which the crane can be sold is relevant for incremental cash flow analysis. The crane to be used by new machine, could have been sold at market value. Hence the market value of crane is relevant.