Musical Studios is considering the replacement of end of life equipment. The rel
ID: 2445845 • Letter: M
Question
Musical Studios is considering the replacement of end of life equipment. The relevant information is as follows:
REPLACEMENT
Old Machine
Machine
Original cost
$50,000
$36,000
Useful life in years
20
8
Current age in years
12
0
Book value
$30,000
Disposal value now
$7,500
Disposal value in 8 years
0
0
Cash Operating Costs - Annual
$14,000
$7,500
Using the table provided, what is the sunk cost?
A. The annual cash operating costs of the old equipment
B. The annual cash operating costs of the replacement equipment
C. The disposal value of the old equipment
D. The original cost of the old equipment
2. If the old equipment is replaced, what is the total relevant cost?
A. $58,500
B. $118,500
C. $ 88,500
D. $112,000
REPLACEMENT
Old Machine
Machine
Original cost
$50,000
$36,000
Useful life in years
20
8
Current age in years
12
0
Book value
$30,000
Disposal value now
$7,500
Disposal value in 8 years
0
0
Cash Operating Costs - Annual
$14,000
$7,500
Explanation / Answer
Part A)
The original cost of the old equipment (which is Option D)
_________
Explanation:
A cost which has already been incurred by the company (in the past) and in no way can be recovered is a sunk cost. In this case, the original cost of old equipment has no relevance in the decision making as the cost has already been incurred in the past. The company cannot modify/change this cost either today or in the future. Such a cost is not relevant for decision making purposes.
_________
Part B)
The relevant cost of the replacement can be calculated with the use of following formula:
Relevant Cost = Cost of the New Machine - Disposal Value of Old Machine + Annual Operating Expenses with New Machine*Life
_________
Using the values provided in the question, we get,
Relevant Cost = 36,000 - 7,500 + 7,500*8 = $88,500 (which is Option C)
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