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 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.
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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