9-37 Equipment replacement decisions and performance evalua tion. Sean Fitzpatri
ID: 2578384 • Letter: 9
Question
9-37 Equipment replacement decisions and performance evalua tion. Sean Fitzpatrick manages the Chicago plant of Shamrock Manufacturing. A representative of Darien Engineering approaches Fitzpatrick about replacing a large piece of manufacturing equipment that Shamrock uses in its process with a more efficient model. While the representative made some compelling arguments in favor of replacing the 3-year-old equipment, Fitzpatrick is hesitant. Fitzpatrick is hoping to be promoted next ar to manager of the larger Houston plant, and he knows that the accrual-basis net operating income of the Chicago plant wil be evaluated closely as part of the promotion decision. The following information is available Conceming the equipment replacement decision: The historic cost of the old machine is $150,000. lt has a current book value of $60,000, 2 remaining years of useful life, and a market value of $36,000. Annual depreciation expense is $30,000. It is expected to . The new equipment will cost $90,000, t will have a 2-year useful life and a $0 salvage value. Shamrock The new equipment will reduce electricity costs by $17,500 per year, and will reduce direct manufacturing have a salvage value of $0 at the end of its useful life uses straight-line depreciation on all equipment. labor costs by $15,000 per year For simplicity, ignore income taxes and the time value of money 1. Assume that Fitzpatrick's priority is to receive the promotion, and he makes the equipment replacement decision based on next year's accrual-based net operating income. Which alternative would he choose? Show your calculations 2. What are the relevant factors in the decision? Which alternative is in the best interest of the company over the next 2 years? Show your caicuiations 3. At what cost would Fitzpatrick be willing to purchase the new equipment? Explain.Explanation / Answer
1. If decision is taken on accrual based net operating Income for next year:
increase in operating income on account of new machine =
reduced electricity costs + reduced direct manufacturing labour costs - additional depreciation
= $17,500 + $15,000 - ($45,000 - $30,000)
=$17,500 , sell the old machine and buy new one
2. the total cost of new equipment , sale proceeds from old equipment , total savings in the next two years are the relevant factors in this case.
best alternative over the next two years:
a. going with old machine = no cost savings
b. buying new machine: total inflow = inflow from sale of old equipment+ electricity cost and labour cost saved for 2years - outflow for new machine = $36,000+$35,000+$30,000 - $90,000 = $11,000
best alternative is b above.
3 fitzpatrick would be wiling to purchase the new equipment for upto $111,000 as derived above.
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