Question

C7.61  

Castle Company is considering the purchase of a new machine. The invoice price of the machine is $150,000, freight charges are estimated to be $6,000, and installation costs are expected to be $4,000. The salvage value of the new equipment is expected to be zero after a useful life of four years. The company could retain the existing equipment and use it for an additional four years if it doesn't purchase the new machine. At that time, the equipment's salvage value would be zero. If Castle purchases the new machine now, it would have to scrap the existing machine. Castle's accountant, Shaida Fang, has accumulated the following data for annual sales and expenses, with and without the new machine:

• 1.Without the new machine, Castle can sell 15,000 units of product annually at a per-unit selling price of $120. If it purchases the new machine, the number of units produced and sold would increase by 20%, and the selling price would remain the same.
• 2.The new machine is faster than the old machine, and it is more efficient in its use of materials. With the old machine, the gross profit rate is 20% of sales, whereas the rate will be 25% of sales with the new machine.
• 3.Annual selling expenses are $180,000 with the current machine. Because the new machine would produce a greater number of units to be sold, annual selling expenses are expected to increase by 10% if it is purchased.
• 4.Annual administrative expenses are expected to be $100,000 with the old machine, and $90,000 with the new machine.
• 5.The current book value of the existing machine is $40,000. Castle uses straight-line depreciation.

Instructions:

A) Prepare an incremental analysis for the four years that shows whether Castle should retain the existing machine or buy the new one. (Ignore income tax effects.)
B) Explain your reasoning
C) Explain how each qualitative factor which you identify could influence the company’s decision to …... [Provide and address at least 5 qualitative factors]

Answer 1

a) Prepare an incremental analysis for the four years that shows whether Castle should retain the existing machine or buy the new one. (Ignore income tax effects.)
	Retain old Machine	Purchase New Machine	Net Income Increase (Decrease)
Sales (15000 X $120 X 4 years) ;(10,000 X $100 X 4 years x 120%)	$ 7,200,000.00	$ 8,640,000.00	$ 1,440,000.00
Costs and expenses
Cost of goods sold ($7,200,000 X (100% – 20%); $8,640,000 X (100% – 25%)	$ 5,760,000.00	$ 6,480,000.00	$  (720,000.00)
Selling expenses (180,000 x 4 years), 180,000 x 4yrs x 1.10)	$    720,000.00	$    792,000.00	$    (72,000.00)
Admin. Expenses(100000 x 4) ; (90000 x 4)	$    400,000.00	$    360,000.00	$      40,000.00
Depreciation	$      40,000.00	$    160,000.00	$  (120,000.00)
Total costs and expenses	$ 6,920,000.00	$ 7,792,000.00	$  (872,000.00)
Net Income	$    280,000.00	$    848,000.00	$    568,000.00
b)
The new machine should be purchased. The incremental analysis shows that net income will increase from $280,000 to $848,000 over the four years with the new machine.
c)
The qualitative factors which influence the company's decision to purchase machine or not are as follows:
1) Opportunity Cost - A company has to  forfeited  or lost revenues  when one alternative is chosen over another.
2) To focus their resources on their core competencies
3)  Impact on sales to regular customers, its potential to lead the company into new sales areas, and the customer’s ability to maintain an ongoing relationship
4) How to manage competition, economic conditions and social issues
5) Product and service Quality

a) Prepare an incremental analysis for the four years that shows whether Castle should retain the existing 12 machine or buy the new one. (Ignore income tax effects.) Retain old Machine Purchase New Machine Net Income Increase (Decrease) = 15000*120*4 =15000*120*4*120% =C14-B14 14 Sales (15000 X $120 X 4 years): (10,000 X $100 X 4 years x 120%) 15 Costs and expenses 16 Cost of goods sold ($7,200,000 X (100% - 20%); $8,640,000 X (100% - 25%) =B14*80% =C14*75% =B16-C16 17 Selling expenses (180,000 x 4 years), 180,000 x 4yrs x 1.10) Admin. Expenses(100000 x 4); (90000 x 4) Depreciation 20 Total costs and expenses 21 Net Income 19 =180000*4 =100000*4 40000 =SUM(B16:319) =B14-B20 =180000*4*110% =90000*4 =150000+6000+4000 =SUM(C16:019) =C14-C20 =B17-C17 =B18-C18 =B19-C19 =SUM(D16:019) =D14+D20