Question: Equipment replacement decisions and performance evaluation. Susan Smith manages the Wexford plant of Sanchez Manufacturing. A representative of Darnell Engineering approaches Smith about replacing a large piece of manufacturing equipment that Sanchez uses in its process with a more efficientmodel. While the representative made some compelling arguments in favor of replacing the 3-year-old equipment, Smith is hesitant. Smith is hoping to be promoted next year to manager of the larger Detroit plant, and she knows that the accrual-basis net operating income of the Wexford plant will be evaluated closely as part of the promotion decision. The following information is available concerning the equipmentreplacement decision:
Old Machine New Machine
Original cost $900,000 %540,000
Useful life 5 years 2 years
Current age 3 years 0 years
Remaining useful life 2 years 2 years
Accumulated depreciation $540,000 Not acquired yet
Book value $360,000 Not acquired yet
Current disposal value(in cash) $216,000 Not acquired yet
Terminal disposal value(in cash 2 years from now) $0 $0
Annual operating costs(maintenance, energy, repairs, coolants, $995,000 $800,000
and so on)
Sanchez uses straight-line depreciation on all equipment. Annual depreciation expense for the old machine is $180,000 and will be $270,000 on the new machine if it is acquired. For simplicity, ignore income taxes and the time value of money.
1. Assume that Smith's priority is to receive the promotion and she makes the equipment-replacement decision based on the next one year's accrual-based net operating income. Which alternative would she choose? Show your calculations.
2. What are the relevant factors in the decision? Which alternative is in the best interest of the company over the next 2 years? Show your calculations.
3. At what cost would Smith be willing to purchase the new equipment? Explain.