CASE 27-1 B. REPLACEMENT FOLLOWING EARLIER REPLACEMENT Sinclair Company decided

Question

CASE 27-1

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?

Explanation / Answer

1_)Total benefit : 160000* 5 = 800000

Since the total benefit is more than its initial cost ,investment should be made (discount rate since not given is ignored while calculating annual benefits)

2)Since the old equipment has no resale value there will be no benefit inflow from it .As the time passes ,new models will be introduced so everytime replacing a good model with a old one is not a good financial decision to be taken by company .If a model A is good enough to satify the company's needs ,there is no need to switchover to new model .

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