Solving for Unknown Costs The Mendoza Company discussed in the chapter is now considering replacing a piece of equipment that the company uses to monitor the integrity of metal pipes used for deep-sea drilling purposes. The company's pretax WACC is estimated as 12 percent. The follow- ing data are pertinent to the question you've been asked to analyze:
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Existing Asset
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Replacement
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Annual (pretax) variable operating expenses
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$200,000
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(?)
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Current purchase price
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N/A
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$500,000
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Current salvage value
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$ 40,000
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N/A
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Expected useful life (years)
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6
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6
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Expected salvage value, end of year 6
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$ 10,000
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$100,000
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Required:
1. What is the maximum amount of annual variable operating expenses, pretax, that would make this an attractive investment from a present-value standpoint?
2. Assume now that the company expects, over the coming six years, to be subject to a combined income- tax rate of 40 percent, including any gain/loss realized on the sale of the existing equipment. Assume that the current book value of the existing asset is $50,000 and that the after-tax WACC for Mendoza is 10 percent. Finally, assume that the company will use SL depreciation, with no salvage value, for income-tax purposes. In this situation, what is the maximum amount of variable operating costs that can be incurred in order to make the proposed purchase attractive in a present-value sense?
3. What strategic considerations might affect the decision whether to invest in this new equipment?