Question

Hancock Company is trying to make a decision as to whether it should purchase of a new piece of equipment. The invoice price of the equipment is $140,000 with an estimate of $4,000 in freight charges and installation costs are expected to be $6,000.   The Company expects that the salvage value of the new equipment will be zero after a useful life of 5 years.

If the new machine is not purchased, the Company’s existing equipment could be retained and used for an additional 5 years.   At that time, the salvage value of the existing equipment would be zero.   If the new machine is purchased now, the existing machine would have to be scrapped.

The following is data regarding annual sales and expenses with and without the new machine:

• Without the new machine, Hancock can sell 12,000 units of product annually at a per unit selling price of $100. If the new machine is purchased, the number of units produced and sold would increase by 10%, and the selling price would remain the same.
• The new machine is faster than the old machine, and it is more efficient in its usage of materials. With the old machine the gross profit rate will be 25% of sales, whereas the rate will be 30% of sales with the new machine.
• Annual selling expenses are $180,000 with the current equipment. Because the new equipment would produce a greater number of units to be sold, annual selling expenses are expected to increase by 10% if it is purchased.
• Annual administrative expenses are expected to be $100,000 with the old machine, and $113,000 with the new machine.
• The current book value of the existing machine is $36,000. Aurora uses straight-line depreciation.

Required: Prepare an incremental analysis for the 5 years showing whether Hancock should keep the existing machine or buy the new machine.

Answer 1

Step 1:
Calculation of Initial cashoutflow
Particulars	Year 0
Value of the equipment	140000
Freight Charges	4000
Installation costs	6000
Total value of Equipment	150000
Step 2:
Calculation of Net operating Cashflows of Existing machine
Particulars	Year (n)
1	2	3	4	5
Revenue	1200000	1200000	1200000	1200000	1200000
Gross Profit (25% of sales)	300000	300000	300000	300000	300000
Less: Annual Selling expenses	-180000	-180000	-180000	-180000	-180000
Less: Administrative expenses	-100000	-100000	-100000	-100000	-100000
Less: Depreciation (36000 / 5 years)	-7200	-7200	-7200	-7200	-7200
Net profit	12800	12800	12800	12800	12800
Addback Depreciation	7200	7200	7200	7200	7200
Net Operating Cashflows	20000	20000	20000	20000	20000
Step 3:
Calculation of Net operating Cashflows of New machine
Particulars	Year (n)
1	2	3	4	5
Revenue	1320000	1320000	1320000	1320000	1320000
Gross Profit (30% of sales)	396000	396000	396000	396000	396000
Less: Annual Selling expenses	-198000	-198000	-198000	-198000	-198000
Less: Administrative expenses	-113000	-113000	-113000	-113000	-113000
Less: Depreciation (150000 / 5 years)	-30000	-30000	-30000	-30000	-30000
Net profit	55000	55000	55000	55000	55000
Addback Depreciation	30000	30000	30000	30000	30000
Net Operating Cashflows	85000	85000	85000	85000	85000

Year	New Piece of Equipment	Old Piece of Equipment	Incremental Cashflows
0	-150000	0	-150000
1	85000	20000	65000
2	85000	20000	65000
3	85000	20000	65000
4	85000	20000	65000
5	85000	20000	65000
IRR	33%

Required Rate of Return is not mentioned in the problem.

If Required Rate of Return is less than IRR then Project should be accepted

If Required Rate of Return is higher than IRR then Project should be rejected