11.15 NewTech Insulations Company is considering replacing a broken inspection m
ID: 1207938 • Letter: 1
Question
11.15 NewTech Insulations Company is considering replacing a broken inspection machine, which has been used to test the mechanical strength of electrical insula- tors, with a newer and more efficient one. If repaired, the old machine can be used for another five years, although the firm does not expect to realize any salvage value from scrapping it in five years. Alternatively, the firm can sell the machine to another firm in the industry now for $5,000. If the machine is kept, it will require an immediate $1,200 overhaul to restore it to operable condition. The overhaul will neither extend the service life originally estimated nor increase the value of the inspection machine. The operating costs are estimated at $2,000 during the firstExplanation / Answer
Assumption: 5 years life
Option I - Retain the Machinery
The outflows are Overhaul cost and additional maintenance cost per year which increase by $1000 every year. In this option there is no salvage value as it is already lapsed
In this case the total cash outflow per year is as follows:
Year 0 (Overhaul cost) - 1200
Year I - 2000 Year II - 3000 Year III - 4000 Year IV - 5000 Year V - 6000
Total cash outflow including Overhaul cost = 1200 + 2000 + 3000 + 4000 + 5000 + 6000 = 21200
Option II - Sell the existing machinery and purchasing new
The total cash netflow in this case will be cost of machinery, Maintenance, depreciation and Salvage value. The depreciation is calculated as below
(Initial cost - salvage value at the end of Year 5 ) / 5 = (10000 - 3132) / 5 = 1374 per annum
Since this non cash flow but tax deductible, we will assume tax rate @ 30% and consider the tax benefit as cash inflow i.e 1374 * 30% = 412 per annum
The total cash outflow per year is as follows:
Year 0 = Cost of new machinery - Salvage value of old machinery = 10000 - 5000 = 5000
Year I = 2000 - 412 = 1588
Year II = 2800 - 412 = 2388
Year III = 3600 - 412 = 3188
Year IV = 4400 - 412 = 3988
Year V = 5200 - 412 = 4788 - 3132 (Salvage value of machinery) = 1656
Total outflows = 5000 + 1588 + 2388 +3188 +3988 + 1656 = 17808
Based on year on year and total outflows, the Option II looks better than Option I
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