Question - Bob Marsden manages the Victorian plant of George Manufacturing. He has been approached by a representative of Garfield Engineering regarding the possible replacement of a large piece of manufacturing equipment that George uses in its process with a more efficient model. While the representative made some compelling arguments in favour of replacing the 3-year-old equipment, Bob is hesitant. He is hoping to be promoted next year to manager of the larger New South Wales plant, and he knows that the accrual-basis net operating income of the Victorian plant will be evaluated closely as part of the promotion decision. The following information is available concerning the equipment replacement decision:
The historical cost of the old machine is $300,000. It has a current carrying amount of $120,000, two remaining years of useful life and a market value of $72,000. Annual depreciation expense is $60,000. It is expected to have a salvage value of $0 at the end of its useful life.
The new equipment will cost $180,000. It will have a two-year useful life and a $0 salvage value. George uses straight-line depreciation on all equipment. The new equipment will reduce electricity costs by $35,000 per year and will reduce direct manufacturing labour costs by $30,000 per year.
For simplicity, ignore income taxes and the time value of money.
Required:
1. Assume that Bob Marsden's priority is to receive the promotion, and he makes the equipment replacement decision based on next year's accrual-based net operating income. Which alternative would he 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 two years? Show your calculations.
3. At what cost of the new equipment would Bob Marsden be willing to purchase it? Explain.