Question

Mead Company is considering the replacement of some of its manufacturing equipment. Information regarding the existing equipment and the potential replacement equipment follows:

Existing Equipment				Replacement Equipment
Cost	$	300,000		Cost	$	250,000
Operating expenses*		240,000		Operating expenses*		160,000
Salvage value		40,000		Salvage value		40,000
Market value		120,000		Useful life		8	years
Book value		90,000
Remaining useful life		8	years

*The amounts shown for operating expenses are the cumulative total of all such expected expenses to be incurred over the useful life of the equipment.

Required

Calculate the total relevant cost of existing equipment and the potential replacement equipments. Should the equipment be replaced?

Total cost new?

Total cost old?

Answer 1

	Existing equipment	Replacement equipment
Total relevant cost	$320000	$370000

So on the basis of relevant costs of both equipment, it is clear that relevant cost of existing equipment is less than replacement equipment. Thus equipment should not be replaced.

Explanation & Working Note;

Total relevant cost of existing equipment will be calculated with the help of opportunity cost and operating expenses. Hence let’s calculate these one by one;

Opportunity cost of exiting equipment will be calculated as follow;

Market value of existing equipment	$120000
Less: Salvage value of existing equipment	($40000)
Opportunity cost	$80000

Operating expenses of existing equipment are given = $240000

Thus, Total relevant cost of existing equipment = Opportunity cost + Operating expenses

($80000 + $240000) = $320000

Total relevant cost of potential replacement equipment will be calculated with the help of adjusted purchase price and operating expenses. Hence let’s calculate these one by one;

Adjusted purchase price of potential replacement equipment will be calculated as follow;

Cost of replacement equipment	$250000
Less: Salvage value of replacement equipment	($40000)
Adjusted purchase price	$210000

Operating expenses of replacement equipment are given = $160000

Thus, Total relevant cost of replacement equipment = Adjusted purchase price + Operating expenses

($210000 + $160000) = $370000