EG Capital, Inc. acquired equipment 4 years ago at a cost of $4,000,000. At the time the old equipment was acquired the company estimated a residual value equal to 7% of the acquisition cost and a useful life of 6 years. The equipment has been depreciated using the straight-line method and its current fair value is $1,200,000.
The current equipment is operating at a capacity of producing 100,000 units annually which is 20,000 units less than what marketing represents they are capable of selling. An analysis of current operations provides the following:
Current Per Unit Selling Price - $30.00
Variable operating cost ratio – 40%
Operating Leverage – 1.5
At the end of year 4 the manager of the manufacturing facility is recommending that the old equipment be replaced with new equipment as of January 1 for the following reasons:
- The new equipment will be able to increase production by 10%.
- The new equipment is more efficient than the old equipment thus reducing variable operating cost by 5% (reducing labor, material cost and variable overhead cost)
- The new equipment will produce a better product which will allow the company to increase the price of the products by 4% initially and then 2% annually as demand for the higher quality product increases. Marketing has concurred with the manager’s conclusion regarding the “new and improved” product and concurs that price increases will be accepted by customers without impacting demand.
The cost of the new equipment is $5,000,000. The equipment will be depreciated using the straight-line method of a useful life of 5 years with an estimated a 10% residual value. However, the company expects that it will be able to sell equipment at the end of its useful life for $600,000. The fixed manufacturing cost will increase by 7% as a result of increases in property taxes, insurance and maintenance. This would be a one-time increase when the new equipment is placed in service.
The manager has also indicated that the new equipment will require an expenditure of $500,000 in year 3 for repairs and engine overhaul and the project will require an initial working capital of $250,000.
The company has a required rate of return of 14% and effective tac rate of 40%.
Required: Use the format on the following page.
- Prepare an analysis of the proposal by compute the following:
- Net Present Value
- Internal Rate of Return
- Payback Period
- Accounting Rate of Return for Year One
Summary: This question belongs to management accounting and discusses about a company’s equipment replacement and to determine net present value and internal rate of return and payback period.
Total word count: 236
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