Firm A is considering replacing an old machine it purchased 4 years ago. At the
ID: 2637679 • Letter: F
Question
Firm A is considering replacing an old machine it purchased 4 years ago. At the time, the machine cost $200,000, with an estimated life of 9 years.Straight line depreciation. Salvage value = $20,000. The selling price is estimated to be $10,000 at the end of its life.
Can sell this machine today for $80,000
When the old machine was put into use 4 years ago, it required an increase in NWC of $8,000. The $8,000 will be recovered when the old machine is sold.
Operating Cost: Fixed costs are $24,000 year; annual production is 1000 units of TV, unit price is $300, gross profit margin ((R-VC)/R) is 40%
The new machine that the firm is considering costs $200,000 and would have a useful life of 5 years. Straight-line depreciation. Estimated salvage value of $50,000, which will equal the selling price at that time. Estimated salvage value of $50,000, which will equal the selling price at that time. Using the new machine requires an investment in NWC of $20,000. The $20,000 will be recovered when the new machine is sold.
Operating CF: Installing the new machine would lower fixed costs to $12,000 per year; annual production will increase by 20% while unit price and gross margin stays the same
Information for the firm: Tax rate=40 %, r=10%
What is the change in Operating cost if the firm decides to replace it's old equipment?
Explanation / Answer
Cost of the machine = $ 2, 00, 000.
Estimated life = 9 years.
Residual value= 20,000
Depreciation =$2,00,000-$20,000/9 =$20, 000
Operating costs:
Fixed cost = $24,000 ---- (A)
Variable cost {(1000 units* $300)*60%) = $1,80,000---- (B)
Depreciation $20, 000 ----(C) (Assuming Fixed cost and Variable cost did not include depreciation)
Total operating costs = A+B+C = $2, 24, 000.
Revised Operating cost when the machine is replaced:
Fixed cost =$ 12, 000 as there is a decrease in the fixed cost.
Variable cost = 1200 *$300 *60% (1200 units considered as the production has increased by 20%).= $ 216,000
Depreciation on the new asset using Straight Line Method = ($2,00,000 = $ 50,000)/5 =$ 30, 000.
Increase in Net working capital = $ 20,000 , however there is a recovery of $ 8, 000 in net working capital due to sale of old machine, hence incremental net working capital = $ 12,000 that needs to be considered as operating cost.
Hence revised operating cost = Fixed cost +Variable cost + Depreciation + Incremenal working capital
=$12, 000+ $216, 000+$ 30,000+ $12,000
= $ 2,70, 000
Change in the operating cost =$270,000 - $224,000 = $ 46, 000
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