Question

Your division manufactures the spare part needed to produce the main product. On January 1 of this year, you as the manager of the division invested $2 million in a new equipment. At that time, your expected income statement for this year was as follows:
Sales revenues $ 3,200,000
Operating costs:
     Variable (cash expenditures)    $ 400,000
      Fixed (cash expenditures)     1,500,000
Equipment depreciation        300,000
Other depreciation        250,000
     Total operating costs $2,450,000
Operating profits (before taxes) $   750,000
On October 25 of this year, a sales representative for Machine Specialized Company approached you and offered to rent to your division a new sophisticated machine that would be installed on December 31 of this year for an annual rental charge of $460,000. The new equipment would enable you to increase your division’s annual revenue by 10%. The more efficient machine would decrease fixed cash expenditures by 5%. You will have to write off the cost of the new equipment this year because it has no salvage value. Equipment depreciation shown in the income statement is for the new equipment.

Your bonus is determined as a percentage of your division’s operating profits before taxes. Equipment losses are included in the bonus and operating profit computation.
Ignore taxes and any effects on operations on the day of installation of the new machine. Assume that the data given in your expected income statement are the actual amounts for this year and next year if the current equipment is kept.
Required:
a. What is the difference in this year’s divisional operating profit if the new machine is rented and installed on December 31 of this year?
b. What would be the effect on next year’s divisional operating profit if the new machine is rented and installed on December 31 of this year?
c. Would you rent the new machine? Why or Why not?

Answer 1

1)

Calculation of effect of renting the machine on current year divisional profit:

If the machine is rented, then the whle cost of the new equipment purchased would need to be written off in the current year. Therefore, following is the expected income for the division in that case.

Since the complete cost of new equipment will be written off, no need to charge depreciation over the same.

Sales revenues $ 3,200,000
Operating costs:
     Variable (cash expenditures)   $ 400,000
      Fixed (cash expenditures) 1,500,000
Equipment written off 2,000,000
Other depreciation 250,000
     Total operating costs $ 4,150,000
Operating loss (before taxes) ($950,000)

Originally the profit was $750,000 but due to writting off equipment cost, the loss is $950,000.

Therefore, impact on profit is negative for this year of $1,700,000.

2)

Calculation of effect of renting the machine on next year profit

Sales Revenue ($ 3,200,000 * 1.1) $3,520,000

Operating costs:
     Variable (cash expenditures)   $ 440,000 ($400,000 * 1.1)
      Fixed (cash expenditures) 1,425,000 (1,500,000 * 0.95)

Other Depreciation 250,000

Total operating cost $2,115,000

Operating profit $1,405,000

Assuming that fixed cash expenditures include the rent of machine and net effect is reduction of 5% fixed cash expenses. Other assumption can also be taken that would decrease the profit by $450,000 equal to rent of machine.

Assumed that variable expenses will also increase by 10% same as sales revenue.

Change in profit = $1,405,000 - $750,000 = $655,000

3)

If the machine could be rent only for 1 year, then it should not be rented because the increase in profit of next year is less than the loss in the current year.

If this could be rented for a long term, then it could break even the loss incurred in the current year and also produce greater profits.

Hence for a long term this machine should be rented.