Question: The Consolidated Logging Company Ltd. Early in 1 987, the financial manager of Consolidated Logging Company (CLC) was investigating the possibility of either replacing one of the company's 7 logloaders with a new model or substantially refitting the existing machine. The company is engaged in supplying timber-loading services to a large lumber concern in British Columbia. CLC has been in business for approximately 12 years and has built up a reputation for dependability and quality service. Initially, the financial manager decided to look at replacing or refitting just one machine. Based on the outcome of that analysis, he felt that he would be in a better position to decide on the other loaders. The following information, on a per-annum, before-tax basis, indicates the approximate current costs of operating each loader:
Maintenance and repair $ 25,000
Wages of two operators 79,750
Gasoline 20,500
Storage 12,000
Miscellaneous servicing 14,000
Total operating costs $151,250
Although the "average" loader appears in the asset class at approximately $ 100,000, a market price of only $50,000 could be obtained if it were to be sold today. If refitting were undertaken, the financial manager estimated that the machine could be run for another 10 years. The cost of each refitting was estimated at $21 2,500, and would be capitalized and added to the book value of the asset class. Alternatively, CLC could acquire a new, more powerful loader at a cost of $375,000 from a local manufacturer. In addition, special tires and parts would have to be purchased at a price of $37,500 and would last the useful life of the basic machine. The new machine was essentially equivalent to the older one as it could perform the same functions. This model had not been previously produced, however, and it was a "first off the production line' ', but it promised lower operating costs primarily in the form of reduced labour expense (only one highly trained "engineer" was needed to operate the machine) and lower maintenance and repair costs. Pre-tax, annual operating costs are estimated as follows:
Maintenance and repair $ 16,250
Wages of two operators 48,750
Diesel fuel 22,250
Garage facilities 15,000
Miscellaneous servicing 10,000
Total operating costs $112,250
The financial manager thought that the new machine would last at least 10 years without any major refitting or overhaul. Beyond this, no one could estimate with reasonable accuracy what was going to happen. Given the rapid technological advances within this industry, the loader's salvage value was estimated to be only $6,000 or approximately one half of its undepreciated capital cost at that time. Other considerations that would affect the decision on whether to replace or refit included the current general decline in the lumber industry, labour unrest, and the opportunity costs associated with tying up funds in either project. Concerning the general decline in the lumber industry, just how long the downturn would last remained to be seen, but at the time, the effects of it were starting to be felt in industries associated with lumber production. CLC's revenues were slightly lower than last year. Furthermore, the manufacturer of the new machines had experienced considerable labour unrest at his plant over the past 2 or 3 months. As a result, customers were not getting delivery of much-needed equipment on time, and one large purchaser had cancelled his order at the last moment. Another factor that the financial manager had to consider was the opportunity cost associated with tying up scarce funds in either the purchase of the new loaders or the refitting of the older ones. It was estimated that in order to invest in any project of this nature, after-tax annual returns of 12 percent had to be achieved for the project to be attractive. The financial manager believed this to be a reasonable figure given the risks associated with this particular investment. All of these loaders belonged to the Class 10 pool of assets that always had a substantial balance, and were depreciable at the maximum rate of 30 percent per year. CLC's overall tax rate was 40 percent. As the financial manager, you are to submit to the president a written analysis concerning the advisability of either refitting the existing loader or acquiring a new one. Your report should separate the qualitative and quantitative considerations.