Case 27-1

Sinclair Company.[*]

A. EQUIPMENT REPLACEMENT

Sinclair Company is considering the purchase of new equipment to perform operations currently being performed on different, less efficient equipment. The purchase price is $250,000, delivered and installed.

A Sinclair production engineer estimates that the new equipment will produce savings of $72,000 in labor and other direct costs annually, as compared with the present equipment. She estimates the proposed equipments economic life at five years, with zero salvage value. The present equipment is in good working order and will last, physically, for at least five more years.

The company can borrow money at 9 percent, although it would not plan to negotiate a loan specifically for the purchase of this equipment. The company requires a return of a least 15 percent before taxes on an investment of this type. Taxes are to be disregarded.

Questions

1. Assuming the present equipment has zero book value and zero salvage value, should the company buy the proposed equipment?

2. Assuming the present equipment is being depreciated at a straight-line rate of 10 percent, that it has a book value of $135,000 (cost, $225,000; accumulated depreciation, $135,000), and has zero net salvage value today, should the company buy the proposed equipment?

3. Assuming the present equipment has a book value of $135,000 and a salvage value today of $75,000 and that if retained for 5 more years its salvage value will be zero, should the company buy the proposed equipment?

4. Assume the new equipment will save only $37,500 a year, but that its economic life is expected to be 10 years. If other conditions are as described in (1) above, should the company buy the proposed equipment?

B. REPLACEMENT FOLLOWING EARLIER REPLACEMENT

Sinclair Company decided to purchase the equipment described in Part A (hereafter called model A equipment). Two years later, even better equipment (called model B) comes on the market and makes the other equipment completely obsolete, with no resale value. The model B equipment costs $500,000 delivered and installed, but it is expected to result in annual savings of $160,000 over the cost of operating the model A equipment. The economic life of model B is estimated to be 5 years. Taxes are to be disregarded.

Questions

1. What action should the company take?

2. If the company decides to purchase the model B equipment, a mistake has been made somewhere, because good equipment, bought only two years previously, is being scrapped. How did this mistake come about?

C. EFFECT OF INCOME TAXES

Assume that Sinclair company expects to pay income taxes of 40 percent and that a loss on the sale or disposal of equipment is treated as a capital loss resulting in a tax saving of 28 percent of the loss. Sinclair uses an 8 percent discount rate for analyses performed on an aftertax basis. Depreciation of the new equipment for tax purposes is computed using the accelerated cost recovery system (ACRs) allowances; assume that these allowances were 35, 26, 15, 12, and 12 percent for years 1 to 5, respectively. The new equipment qualifies for a 5 percent investment tax credit, which will not reduce the cost basis of the asset for calculating ACRS depreciation for tax purposes.

Questions:

Should the company buy the equipment if the facts are otherwise the same as those described in Part A(1)?

If the facts are otherwise the same as those described in Part A(2)?

If the facts are otherwise the same as those described in Part B?

D. []CHANGE IN EARNINGS PATTERN

Assume that the savings are expected to be $79,500 in each of the first 3 years and $60,750 in each of the next 2 years, other conditions remaining as described in Part A(1).

Questions:

What action should the company take?

Why is the result here different from that in Part A(1)?

1. Assuming the present equipment has zero book value and zero salvage value, should the company buy the proposed equipment? | Amount of Cash Flow | 15% factor PV of Cash flows 3.352 2,41,344 2,50,000 8,656 Item Years Annual Savi Initial investment Net Present Value NPV is negative hence th company should not buy the proposed equipment 1-5 72,000 -2,50,000 2. Assuming the present equipment is being depreciated at a straight-line rate of 10 percent, that it has a book value of $135,000 (cost, $225,000; accumulated depreciation, $135,000), and has zero net salvage value today, should the company buy the proposed equipment? Amount of Cash Flow 15% factor! PV of Cash flows 2,41,344 2,50,000 Item Years 1-5 Now 3.352 S Annual cost Savings Initial investment Salvage value of the 72,000 2,50,000 1.00 $ 8,656 Net Present Value Net present value is negaTve which means that the project is not acceptable. The company should not buy the proposed equipment because it promises a return less than the required rate of return. 3. Assuming the present equipment has a book value of $135,000 and a salvage value today of $75,000 and that if retained for 5 more years its salvage value will be zero, should the company buy the proposed equipment? Years 1-5 Now | Amount of Cash Flow 15% factor! PV of Cash flows 2,41,344 0 -2,50,000 Item 3.352 S Annual cost Savin Initial investment Salvage value of the present equipment Noww Net Present Value 72,000 2,50,000 75,000 66,344 75,000 1.00 $ Net present value is positive which means that the project is acceptable. The company should buy the proposed equipment because it promises a return greater than the required rate of return. 4. Assume the new equipment will save only $37,500 a year, but that its economic life is expected to be 10 years. If other conditions are as described in (1) above, should the c y the proposed equipment? Amount of Cash Flow 15% factor | PV of Cash flows 1,88,213 2.50,000 -61,788 Item Years 1-10 Now 5.019 $ Annual cost Savings Initial investment Net Present Value 37,500 1. Assuming the present equipment has zero book value and zero salvage value, should the company buy the proposed equipment? | Amount of Cash Flow | 15% factor PV of Cash flows 3.352 2,41,344 2,50,000 8,656 Item Years Annual Savi Initial investment Net Present Value NPV is negative hence th company should not buy the proposed equipment 1-5 72,000 -2,50,000 2. Assuming the present equipment is being depreciated at a straight-line rate of 10 percent, that it has a book value of $135,000 (cost, $225,000; accumulated depreciation, $135,000), and has zero net salvage value today, should the company buy the proposed equipment? Amount of Cash Flow 15% factor! PV of Cash flows 2,41,344 2,50,000 Item Years 1-5 Now 3.352 S Annual cost Savings Initial investment Salvage value of the 72,000 2,50,000 1.00 $ 8,656 Net Present Value Net present value is negaTve which means that the project is not acceptable. The company should not buy the proposed equipment because it promises a return less than the required rate of return. 3. Assuming the present equipment has a book value of $135,000 and a salvage value today of $75,000 and that if retained for 5 more years its salvage value will be zero, should the company buy the proposed equipment? Years 1-5 Now | Amount of Cash Flow 15% factor! PV of Cash flows 2,41,344 0 -2,50,000 Item 3.352 S Annual cost Savin Initial investment Salvage value of the present equipment Noww Net Present Value 72,000 2,50,000 75,000 66,344 75,000 1.00 $ Net present value is positive which means that the project is acceptable. The company should buy the proposed equipment because it promises a return greater than the required rate of return. 4. Assume the new equipment will save only $37,500 a year, but that its economic life is expected to be 10 years. If other conditions are as described in (1) above, should the c y the proposed equipment? Amount of Cash Flow 15% factor | PV of Cash flows 1,88,213 2.50,000 -61,788 Item Years 1-10 Now 5.019 $ Annual cost Savings Initial investment Net Present Value 37,500