AAA Company produces and sells 6,000 desks per year at a selling price of $500 each. Its current production equipment, purchased for $1,500,000 and with a five-year useful life, is only two years old. It has a terminal disposal value of $0 and is depreciated on a straight line basis. The equipment has a current disposal price of $600,000. However, the emergence of a new technology has led AAA to consider either upgrading or replacing the production equipment. The following table presents data for the two alternatives:
One-time equipment costs $2,700,000(Upgrade) $4,200,000 (Replace)
Variable manufacturing cost per desk $140 (Upgrade) $80 (Replace)
Remaining useful life of equipment (years) 3 (Upgrade) 3 (Replace)
Terminal disposal value of equipment $0 (Upgrade) $0 (Replace)
All equipment costs will continue to be depreciated on a straight-line basis. For simplicity, ignore income taxes and the time value of money.
1. Should AAA upgrade its production line or replace it? Show your calculations.
2. Now suppose the one-time equipment cost to replace the production equipment is somewhat negotiable. All other data are as given previously. What is the maximum one-time equipment cost that AAA would be willing to pay to replace the old equipment rather than upgrade it?
3. Assume that the capital expenditures to replace and upgrade the production equipment are as given in the original exercise, but that the production and sales quantity is not known. For what production and sales quantity would AAA (i) upgrade the equipment or (ii) replace the equipment?
4. Assume that all data are as given in the original exercise and AAA manager's bonus is based on operating income. Because he is likely to relocate after about a year, his current bonus is his primary concern. Which alternative would the manager choose? Explain.