Relevance of equipment costs. The Auto Wash Company has just today paid for and installed a special machine for polishing cars at one of its several outlets. It is the first day of the company’s fiscal year. The machine costs $20,000. Its annual cash operating costs total$15,000. The machine will have a four-year useful life and a zero terminal disposal value. After the machine has been used for only one day, a salesperson offers a different machine that promises to do the same job at annual cash operating costs of $9,000. The new machine will cost $24,000 cash, installed. The “old” machine is unique and can be sold out-right for only $10,000, minus $2,000 removal cost. The new machine, like the old one, will have a four-year useful life and zero terminal disposal value. Revenue, all in cash, will be $150,000 annually, and other cash costs will be $110,000annually, regardless of this decision. For simplicity, ignore income taxes and the time value of money.
1. a. Prepare a statement of cash receipts and disbursements for each of the four years under each alternative. What is the cumulative difference in cash flow for the four years taken together?
b. Prepare income statements for each of the four years under each alternative. Assume straight-line depreciation. What is the cumulative difference in operating income for the four years taken together?
c. What are the irrelevant items in your presentations in requirements a and b? Why are they irrelevant?
2. Suppose the cost of the “old” machine was $1 million rather than $20,000. Nevertheless, the old machine can be sold outright for only $10,000, minus $2,000 removal cost. Would the net differences in requirements 1a and 1b change? Explain.
3. Is there any conflict between the decision model and the incentives of the manager who has just purchased the “old” machine and is considering replacing it a day later?