Equipment upgrade versus replacement. (A. Spero, adapted) The Pacifica Corporation makes steel table lamps. It is considering either upgrading its existing production line or replac¬

ing it. The production equipment was purchased two years ago for $660,000. It has an expected useful life of five years, a terminal disposal price of $0, and is amortized on a straight-line basis at the rate of $132,000 per year. It has a current book value of $396,000 and a current disposal price of $99,000. The following table presents expected costs under the upgrade and replace alternatives:

Upgrade Replace 456 Expected one-time-only capital costs Variable manufacturing costs per unit Expected production and sales per year Selling price per unit

$330,000

$ 13.20 60,000 units

$ 27.50

$825,000

$ 9.90 60,000 units

$ 27.50 The expected useful life after the machine is upgraded or replaced is three years, and the expected terminal disposal price is $0. If the machine is upgraded, the $330,000 would be added to the current book value of $396,000 and amortized on a straight-line basis. The new equipment, if purchased, would also be amortized on a straight-line basis.

For simplicity, ignore income taxes, interest, and present value considerations.

Required 1. Should Pacifica upgrade its production line or replace it?

2.

(a) Now' suppose the capital expenditure needed to replace the production line is not known. All other data are as given previously. What is the maximum price that Pacifica would be willing to pay for the new line to prefer replacing the existing line over upgrading it?

(b) Assume that the capital expenditure needed to replace the production line is $825,000. Now' suppose the expected production and sales quantity' is not known.

For what production and sales quantity would Pacifica prefer to (i) replace the line,

(ii) upgrade the line?

3. Consider again the basic information given in this exercise. Suppose John Azinger, the man¬

ager of the Pacifica Corporation, is evaluated on operating income. The upcoming year’s operating income is crucial to Azinger’s bonus. What alternative would Azinger choose?