Question

As the senior accountant at Jackson Quality Sportswear (JQS), which manufactures sport attire for men, women, youth, and children, you are often asked to prepare various financial analysis necessary for decision making. Jacob Reynolds, the controller, asked you to evaluate whether a piece of factory equipment should be replaced or kept. The old piece of factory equipment was purchased four years ago for $850,000. Over the last four years, JQS has allocated depreciation based on the straight-line method. The expected salvage value is $25,000. The current book value of the factory equipment is $520,000. The operating expenses total approximately $40,000 a year. It is estimated that the residual value (market value) of the old machine is $300,000. The controller is contemplating whether to replace the piece of factory equipment. The replacement factory equipment would consist of a purchase price of $400,000, a useful life of eight years, salvage value of 20,000, and annual operating costs of $25,000.

Please show work.

Answer 1

The data of JQS is given below:

Particulars	Old Machine	New Machine
Cost	8,50,000	4,00,000
Salvage Value	25,000	20,000
Life (Years)	10	8
Book Value	5,20,000
Operating Exp	40,000	25,000
Market Value	3,00,000
Depreciation-SLM	82,500	47,500

The life of the old machine is calculated using reverse calculation method wherein the salvage value, cost, book value and depreciation method is known.

Assumption: The question does not specify the additional increase in useful life (2years, since current machine is only having 6 years balance life) which the new machine would bring and thus it is assumed that an excess cost would have to be incurred to increase the life of the old machine at the end of its life to have 2 more years of life.

From the above data, the following conclusion is drawn

JQS may opt for replacement of the current machinery with the new one based on the following points:

Particulars	Amount
Investment (Less Sale Value of old machine)	-1,00,000
Reduction in operating cost	1,20,000
Reduction in depreciation	2,80,000
Loss on sale of Machine	-2,20,000
Total Profit	80,000

Reduction in operating cost and depreciation is considered for 8 years, further the cost of improvement to be incurred on old machinery is not considered in the answer as mentioned in the assumption. However the result would be to opt for the new machine as the cost of improvement would have to be reduced from the investment in new machine.

The loss on sale of old machine is difference between the book value and current market cost, even though it is a sunk cost it has been considered as it doesn't effect the decision. The loss on sale may not be considered based on the company's policy and appropriate assumption.