The management of Ballard MicroBrew is considering the purchase of an automated

Question

The management of Ballard MicroBrew is considering the purchase of an automated bottling machine for $66,000. The machine would replace an old piece of equipment that costs $17,000 per year to operate. The new machine would cost $8,000 per year to operate. The old machine currently in use is fully depreciated and could be sold now for a salvage value of $29,000. The new machine would have a useful life of 10 years with no salvage value.

Required:

1. What is the annual depreciation expense associated with the new bottling machine?

2. What is the annual incremental net operating income provided by the new bottling machine?

3. What is the amount of the initial investment associated with this project that should be used for calculating the simple rate of return?

4. What is the simple rate of return on the new bottling machine? (Round your answer to 1 decimal place.)

Explanation / Answer

1. Depreciation Expense of new Bottling Machine = (Cost of Asset - Salvage Value) / Useful life of asset

= ($66,000 - 0) / 10 = $6,600

2. Calculation of incremental net operating income

Incremental net income = Cost of operating old asset - cost of operating new asset

= $17,000 - ($8,000 + 6,600) = $2,400 per year.

3. Intial Investment for simple return = Cost of new asset - Cash inflows from disposal of old asset

= $66,000 - 29,000 = $37,000

4. Simple return on new machine = Cost savings per year / Value of net new investment

= 2,400 / 37,000 x 100 = 6.5% Approx.

NOTE: Simple return has a disadvantage of considering even non-cash transactions like depreciation and ignoring net cash flows.

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