Question

A company plans to replace its manual production system with an automated one Currently 5 people (2 on first shift, 2 on second, and one on third) are used. Their annual wages are $41,250 per person. Operating and maintenance of the new automated system will be 5.5% of the first cost of the system. The income tax rate is 40% and straight line depreciation is used over a 15 year life with no salvage. Salvage is expected to be 8% of the first cost if company plans to borrow 43% of the first cost at an interest rate of 8.3%. The cost of capital is estimated at 12.9%.

How much can be spent on the first cost of the new system?

Answer 1

Annual wages are 41250 x 5 = $ 206250

The automated system seeks to replace the manual system that costs $ 206250 annually. Therefore to break even the new system must cost inclusive of all other overhead costs = $206250.

Suppose the first cost is $x.

Therefore -

• Operating and maintenance expenditure = 5.5% is not a directly attributable costs as per IAS 16 and IAS 23 so not included.
• Borrowing cost on 43% of first cost = 8.3% of 43% of x (can be capitalised)
• cost of capital for remaining amount ( 100-43= 57) = 12.9% of 57% (not capitalised)
• salvage value = 8% of x and depreciation over 15 years would be calculated after the entire cost of the asset is found out.Moreover depreciation is a revenue expenditure so cannot be capitalised. However given that income tax rate is 40% then some tax benefit may be availed as per the country's taxation system.

Therefore adding directly attributable costs we find,

x + 5.5% x + 8.3% of 43% of x = 206250

=>x + 0.055x + 0.3569x = 206250

x = 206250/1.4119 = 146079.75