Question

Gertrude's Bakery is thinking about replacing the convection oven with new, more energy-efficient model. Information related to the old and new oven follows:

mework: Chapter 11 7 of 9 (0 complete) Data Table Old Oven New Oven Original cost 26,000 $ 41,000 Accumulated depreciation 7,000 Not acquired yet Book value 20,000 Not acquired yet Current disposal value 16,000 Not acquired yet Installation cost Not applicable $ 2,600 Annual operating cost 10.000 $ 4,000 Useful life 9 years 7 years Current age 2 years O years Remaining useful life 7 years 7 years Terminal disposal value (in 7 years) 0 $ Ignore the effect of income taxes and the time value of money. $ Print Done Print Done Clear All

Begin by determining whether each item is relevant or irrelevant for this decision. If an item is irrelevant, select why it is irrelevant (dont differ, sunk cost)

1. Which of the costs and benefits above are relevant to the decision to replace the oven?
2. What information is irrelevant? Why is it irrelevant?
3. Should Gertrude's Bakery purchase the new oven? Provide support for your answer.
4. Is there any conflict between the decision model and the incentives of the manager who has purchased the "old" oven and is considering replacing it only two years layer?
5. At what purchase price would Hertrud's Bakery be indifferent between purchasing the new oven and continuing to use the old oven?

Answer 1

	Old Oven	New oven	Why irrelevant
Orginial cost	Irrelevant	Relevant	Orginal cost of old oven is not relevant since the old oven cost is already paid. Hence it’s a sunk cost
Accumulated depeciation	Irrelevant	Irrelevant	It’s a past year cost which was already accounted. Hence it wont affect decision making.
Book Value	Irrelevant	Irrelevant	book value of an existing equipment is irrelevant. It’s a sunk cost. Similarly For new equipment, purchase value is relevant.
Current disposal value	Relevant	Irrelevant	Current disposal value is relevant for the existing equipment. It affects decision making. Disposal value of new equipment is not really relevant sine its not bought.
Installation Cost	Irrelevant	Relevant	Installation of old oven is already done. Hence it’s a sunk cost.
Annual operating cost	Relevant	Relevant	It incurs every year. Its an important element in decision making.
Terminal disposal value	Relevant	Relevant	It is important since it helps to calculate the depreciation. And It’s the value the company expects to receive at the end of the useful life.

(1)Which of the costs and benefits above are relevant to the decision to replace the oven?

	Old Oven	New oven	Whether relevant to the decision to replace the oven
Orginial cost	Irrelevant	Relevant	Original cost of new oven is relevant
Accumulated depeciation	Irrelevant	Irrelevant	Not relevant for decision making
Book Value	Irrelevant	Irrelevant	Not relevant for decision making
Current disposal value	Relevant	Irrelevant	Current disposal value of old oven is relevant
Installation Cost	Irrelevant	Relevant	Installation cost of new oven is relevant
Annual operating cost	Relevant	Relevant	This operating cost is relevant for decision making
Terminal disposal value	Relevant	Relevant	Relevant for decision making

(2)What information is irrelevant? Why is it irrelevant?

	Old Oven	New oven	Whether irrelevant to the decision to replace the oven
Orginial cost	Irrelevant	Relevant	Orginal cost of old oven is not relevant since the old oven cost is already paid. Hence it’s a sunk cost
Accumulated depeciation	Irrelevant	Irrelevant	It’s a past year cost which was already accounted. Hence it wont affect decision making.
Book Value	Irrelevant	Irrelevant	book value of an existing equipment is irrelevant. It’s a sunk cost.
Current disposal value	Relevant	Irrelevant	Disposal value of new equipment is not really relevant sine its not bought.
Installation Cost	Irrelevant	Relevant	Installation of old oven is already done. Hence it’s a sunk cost.
Annual operating cost	Relevant	Relevant	These cost are relevant for decision making
Terminal disposal value	Relevant	Relevant	These cost are relevant for decision making

3. Should Gertrude's Bakery purchase the new oven? Provide support for your answer.

Year	Particulars	Old oven	new oven
1	New oven cost		41000
1	Disposal value of old oven		-16000
1	installation cost		2600
1	Annual operating cost	10000	4000
2	Annual operating cost	10000	4000
3	Annual operating cost	10000	4000
4	Annual operating cost	10000	4000
5	Annual operating cost	10000	4000
6	Annual operating cost	10000	4000
7	Annual operating cost	10000	4000
	Total expenses	70000	55600

As per our working, expenses is low for new oven in the 7 years period. Hence its a more profitable option.

For old oven, Operating expense is Rs 70000 while new oven cost only Rs 55600. So there is a saving of Rs 14400 with new oven.

Decison:Purchase new oven.

(4) Is there any conflict between the decision model and the incentives of the manager who has purchased the "old" oven and is considering replacing it only two years layer?

We cant make conclusion without knowing cirumstances of 2 years(when old oven purchased). For example, any technological developments, whether new model available at that time, financial strength of the company etc.

However, at present situation, we could note that the value of old oven is overrated.

the book value is 20000, while the market value is only $16000. Carried value of oven after deducting depreciation is also only $ 19000. Hence the manager has overrated the value of equipment.

(5)At what purchase price would Hertrud's Bakery be indifferent between purchasing the new oven and continuing to use the old oven?

With the purchase of new oven , there is a profit of $ 14400. So if the purchasing value of new oven is lower by $14400, then it will be indifferent between purchasing the new oven and continuing to use the old oven.

Required purchase price = 41000-14400 = $ 26600