Question

Marine Industrial Coatings, Inc. is considering replacing its existing computer system with a new computer system. The new system can offer considerable savings in computer processing and inventory management costs. Information about the existing system and the new system follow: | Existing Computer $10,000 $ 3,500 $ 6,000 New Computer $15,000 $ 2,000 Original cost Annual operating cost Accumulated depreciation Current salvage value of the existing system Remaining life in 5 years Salvage value in 5 years $ 4,000 5 years $ 0 0 Annual depreciation | $ 2,000 $3,000 Required: a. Which costs are sunk costs? b. Which costs are relevant to the decision? c. What are the changes in pretax operating income and in cash flow over the next 5 years assuming that Marine Industrial Coatings replaces the existing computer system with the new one? d. What do you recommend and what other factors should Marine Industrial Coatings consider when making this decision?

Answer 1

a) Sunk costs are the Procurement cost of existing computer ie. $10000.
b) Relevant costs to the decision are:
1)Procurement cost of new Computer i.e $15000
2) Annual operating cost
3) Salvage value of the existing system ie. $4000
4)Annual depreciation cost
c) Change in the Pre-tax Operating Income:
Decrease in operating cost	$1,500
less: Increase in Annual Depreciation	$1,000
Annual increase in Pretax OI:	$500
Total for 5 years	$2,500
Change in Cash flow over 5 years:
Purchase cost	($15,000)
Less:Salvage of existing computer	$4,000
Less:Total annual cash saving	$7,500
Net cash flow	($3,500)
d) No, we do not recommend to replace the existing computer
system because it will result in negative cash flow of $3500.
Other factors to consider are : i) Increase in revenue due to
improvement in productivity due to replacement.
ii) The tax effect, iii) expected increase in operating cost of
existing computer.