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Report on Sinclair Company: 27-1

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 :

$ 250,000 (delivered and installed)

Estimated Savings:

$ 72,000 (annually in labor and other direct cost as compared


with present equip)

Proposed Equipment ECO-LIFE:

5 years

Present Equipment life:

5 years

Can borrow money

9% (although it would not plan to negotiate a loan specifically


for the purchase of this equipment.)

Return requirement

15% (before taxes on an investment of this type)

PART A. EQUIPMENT REPLACEMENT


Q1 and 2: Assuming the present equipment has zero book value and zero salvage value, should the
company buy the proposed equipment?
Assuming the present equipment is being depreciated at a straight-line rate of 10%, that it
has a book value of $135,000 *cost, $225,000; accumulated depreciation, $90,000), and has zero net
salvage value today, should the company buy the proposed equipment?
1.

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.

Investment, gross .............................................................................................................................................................


$250,000
Less salvage on old ......................................................................................................................................................
75,000
Net investment ..........................................................................................................................................................
175,000
Annual earnings ...............................................................................................................................................................
72,000
Present value: $72,000 * 3.352 ........................................................................................................................................
241,344
Decision: Net present value = $66,344; therefore ...........................................................................................................
Purchase

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.

PART 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 saving 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.
Purchase value :

$ 500,000 (delivered and installed)

Estimated Savings:

$ 160,000 (annually in labor and other direct cost as compared


with present equip)

Proposed Equipment ECO-LIFE:

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).

PART C: EFFECT ON INCOME TAXES


Assume that Sinclair Comp. expects to pay income taxes of 40% and that a loss on the sale or disposal of
equipment is treated as a capital loss resulting in a tax saving of 28% of the loss. Sinclair uses an 8%
discount rate for analyses performed on an aftertax basis. Depreciation of the new equipment for tax
purposes is computed using the accelerated cost recovery system (ACRS) allowances; assume that
theses allowances were 35, 26, 15,12 and 12% for years 1 to 5, respectively. The new equipment
qualifies for a 5% investment tax credit, which will not reduce the cost basis of the asset for calculating
ACRS depreciation for tax purposes.

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 of cash savings of $160,000/year for 5 years = $160,000 * .60 * 3.993 ....................................................................


$383,328
Add: PV of ACRS depreciation tax shield for $500,000 machine = $417,970 * .40.......................................................
167,188
550,516
Deduct: PV of depreciation shield from old machine sacrificed
($50,000/yr. for 3 more years) = $50,000 * .40 * 2.577 (Table B) ..................................................................................
51,540
Net present value of earnings ...........................................................................................................................................
$498,976
Since $498,976 is more than the net investment of $433,000, the decision is to purchase.
ACRS Allowance
Year

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: CHANGES IN EARNING PATTERNS


Assume that the savings are expected to be $79,500 in each of the first 3 years and $60,750 in each of
the next two years, other conditions remaining as described in PART A (1).

Q 1: What action should the company take?


Q 2: Why is the result here different from that in PART A (1)?
1.

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.

Investment, net of ITC......................................................................................................................................................


$237,500
Present value of cash savings:
Years 1-3: $79,500 * .60 (1 - tax rate) * 2.577 ...........................................................................................................
$122,923
Years 4-5: $60,750 * .60 * l.416 .................................................................................................................................
51,613
Present value of ACRS depredation tax shield:
$208,985 * .40 .............................................................................................................................................................
83,594
Total present value ...........................................................................................................................................................
$258,130
*3.993 (5 yrs.) 2.577 (3 yrs.)

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).

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