CE 22 Case Study

Abi Afunay
Group 5- Singko
Jay-ar Fernandez
November 15, 2014
Patrick Gan
Mark Charles Tarroza

The Problem:
A contract manufacturer purchased equipment for its new product line 9 years ago at a
cost of $47,000. The asset has a market value of $22,700, if it were sold now. The current asset
is expected to provide adequate services for another 3 years, given that the annual maintenance
costs of $12,250 is provided. It is estimated that, if the current asset is continued in service, its
final market value will be $14,600 three years from now. However, due to changing customer
needs, a new piece of machinery is being considered for the product line. The company can
purchase the new equipment at a cost of $56,000 and a $5,540 salvage value at the end of 15year economic life. The new equipment has annual maintenance costs of $10,250. The SL
method with a 15-years life and zero market value is used to write off both assets. Determine
whether replacement now is economical based on an after-tax annual worth analysis with an
effective tax rate of 36% and an after-tax MARR of 3% per year.
The Approach:
We are comparing two alternatives for this problem. The first (Option 1) is to keep using
the old equipment which is the defender for another three years until it is sold at a final market
value of $12,250. The other(Option 2) is to sell the said equipment for $22,700 and buy a new
equipment for $56,000 which we will assume to be utilized for its entire life span of 15 years and
sold for $5,540 after that. Since taxes and depreciation are present and the life span of the two
alternatives are different, we should compare their after-tax annual operation cost to find out
which option is better.

Before Tax Cash Flow Diagram for Option 1

Computation Table for Option 1

The investment cost for option 1 is the opportunity lost for keeping the old
equipment which is its currrent market value of $22,700. The anual operating cost
for option 1 is $12,250 which is slightly higher than that of option 2. Since SL
Depreciation of zero market value at the end is used for both option, the annual
depreciation for option 1 is:
Dk = ($47,000-0)/15 = $3133.33
To determine the taxable amount when the equipment is sold at the end of
year 3, we need to determine the book value and the gain for selling at that time.
Book Value = $47,000-($3133.33*(9+3)) =
$9,400
Gain = Salvage Value Book Value = $14,600 $9,400 = $5,200
The ATCF is computed in the spreadsheet using the studied table process
and the after tax annual cost yielded is $10,619.24.

Before Tax Cash Flow Diagram for Option 2

Computation Table for Option 2

Assuming that the new equipment will be used until the end of its
economic life of 15 years before it will be raplaced by another equipment, the
projected before tax cash flows for its entire life span was tabulated on a
spreadsheet. The ATCF was computed using a spreadsheet with the net present
worth and from that the after tax annual worth was derived.
The annual depreciation is:
Dk = ($56,000-0)/15 = $3733.33
Since the 15 year life span was to be fully realized, the book value will
become zero at the end. But the equipment can still be sold for a market value of
S5,540 which is the taxable gain.
The ATCF is computed in the spreadsheet using the studied table process
and the after tax annual cost yielded is $9,716.29.

Conclusion:
Option 1 which is choosing to keep the old equipment for another 3
years has an after tax annual operating cost of $10,619.24 while option 2 which is
buying a new equipment to replace the old one has an after tax annual operating
cost of $9,716.29. The difference is moderate but this will add up throughout the
life span of the equipment with interest rate. It is advisable to replace the old
equipment now based on the performed analysis. In addition to that, the new
equipment will allow the manufacturer to better adapt to the ever changing
customer needs. This could bring new posssibilities for greater stability or even
expansion of the manufacturing company bacause of the added range of capability
brought by the new equipment.