Professional Documents
Culture Documents
Sinclair Company is considering the purchase of new equipment to perform operations currently being
performed in different, less efficient equipment. A Sinclair production engineer estimates that the new
equipment will produce savings. She estimates the proposed the equipments economic life at five (5)
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%, although it would not plan to
negotiate a loan specifically for the purchase of this equipment. The company requires a return of at
least 15% before taxes on an investment of this type. TAXES ARE TO BE DISREGARDED.
Purchase value :
Estimated Savings:
5 years
5 years
Return requirement
2.
PART A
Investment .......................................................................................................................................................................
$250,000
Annual savings ................................................................................................................................................................
72,000
Present value of $1 a year, 5 years, 15 percent ................................................................................................................
3.352
Total present value of savings .........................................................................................................................................
241,344
Decision: Net present value = -$8,656; therefore ............................................................................................................
Do not purchase
Same as question 1.
Moral: Book value makes no difference. The figures and decision are the same as in 1. Nevertheless, a
profit center manager may not view the $135,000 write-off as irrelevant, even though it does represent a
sunk cost.yt
Q 3: Assuming that 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 (0), should the company
buy the proposed equipment?
3.
Moral: The resale value of the superseded machine reduces the amount of new funds required which (in
this case) changed the decision.
Q 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?
4.
Investment .......................................................................................................................................................................
$250,000
Annual earnings ...............................................................................................................................................................
37,500
Present value, 10 years, 15%: $37,500 * 5.019 ...............................................................................................................
188,213
Decision: Net present value = -$61,787; therefore ..........................................................................................................
Do not purchase
Moral: Although total earnings are approximately the same as in question 1 ($375,000 versus $360,000),
the present value is considerably different. It is the pattern of earnings through time that counts, not the
total amount.
Estimated Savings:
5 years
Q 1&2: What action should the company take? 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?
PART B
1.
Investment .......................................................................................................................................................................
$500,000
Annual earnings ...............................................................................................................................................................
160,000
Present value: $160,000 * 3.352 ......................................................................................................................................
536,320
Decision: Net present value = $36,320; therefore ...........................................................................................................
Purchase
(If Model A has resale value, the return would be even higher.)
2. The error arose when Model A was purchased. Assuming the situation in A(3), Model A has an
acceptable return if its economic life is 5 years. It turns out that its economic life was only two years;
consequently, Model A should not have been bought (although this is known only from hindsight).
Moral: Dont let past mistakes prevent you from making wise decisions now (i.e., sunk costs are
irrelevant).
Q 1: Should the company buy the equipment if the facts are otherwise the same as those described in
PART A(1)?
Q 2: If the facts are otherwise the same as tbhose described in PART A (2)?
Q 3: If the facts are otherwise the same as those described in PART B?
The 1981 Tax Act (and subsequent acts) with ACRS provisions usually makes this kind of a
computational nightmare for students, because of the erratic depreciation (officially, cost recovery)
amounts in years 1-5, and the absence of such amounts in later years.
We have assumed that the ACRS allowances stay at 35%, 26%, 15%, 12%, 12% for 5-year assets. The
cash flow pattern, including a 5% (assumed to be time zero) ITC, is:
PV factor ratio
175,000
.926
$162,050
130,000
.857
$111,410
75,000
.794
$59,550
60,000
.735
$44,100
60,000
.681
$40,860
$417,970
PART D
Investment .........................................................................................................................................................................
$250,000
Present value of earnings
Years 1-3: $79,500 * 2.283 (Table B) .........................................................................................................................
$181,499
Years 4-5: $60,750 * 1.069*........................................................................................................................................
64,942
Total PV of earnings ...............................................................................................................................................
$246,441
Decision: Do not purchase, since NPV = - $3,559.
*This is the difference between 3.352 and 2.283
2. Although the total earnings for the 5-year period are the same in Part D as in A(1), shifting more
of the earnings to the early years and less to the later years increases the present value from
$241,344 to $246,441.
Moral: The time pattern of earnings makes a difference.
3.
Moral: The combination of tax-shield benefits and a shift in earnings now makes the decision to purchase
a good one (even without the $12,500 ITC).