Papa’s Pizza is considering replacement of its pizza oven with a new, more energy-efficient model. Information related to the old and new pizza ovens follows:
Old oven—original cost .......... $ 60,000
Old oven—book value .......... $ 50,000
Old oven—current market value ...... $ 42,000
Old oven—annual operating cost ....... $ 14,000
New oven—purchase price ........ $ 75,000
New oven—installation cost ........ $ 2,000
New oven—annual operating cost ..... $ 6,000
The old oven had been purchased a year ago. Papa’s Pizza estimates that either oven has a remaining useful life of five years. At the end of five years, either oven would have a zero salvage value. Ignore the effect of income taxes and the time value of money.
1. Which of the costs and benefits above are relevant to the decision to replace the oven?
2. What information is irrelevant? Why is it irrelevant?
3. Should Papa’s Pizza purchase the new oven? Provide support for your answer.
4. Is there any conflict between the decision model and the incentives of the manager who has purchased the “old” oven and is considering replacing it a year later?
5. At what purchase price would Papa’s Pizza be indifferent between purchasing the new oven and continuing to use the old oven?