On January 2, 2006, the S. H. Park company
installed a brand new $87,000 special moulding machine for producing a new
product. The product and the machine have an expected life of three years. The
machine’s expected disposal value at the end of three years is zero.
On January 3, 2006, Kimiyo Lee, a star salesperson for a machine tool manufacturer,
tells Mr. Park: “I wish I had known earlier of your purchase plans. I
can supply you with a technically superior machine for $99,000. The machine
you just purchased can be sold for $16,000. I guarantee that our machine will
save $35,000 per year in cash operating costs, although it too will have no disposal
value at the end of three years.”
Park examines some technical data. Although he has confidence in Lee’s
claims, Park contends: “I’m locked in now. My alternatives are clear: (a) disposal
will result in a loss, (b) keeping and using the ‘old’ equipment avoids such a loss,
I have brains enough to avoid a loss when my other alternative is recognizing a
loss. We’ve got to use that equipment until we get our money out of it.”
The annual operating costs of the old machine are expected to be $60,000,
exclusive of amortization. Sales, all in cash, will be $910,000 per year. Other
annual cash expenses will be $810,000 regardless of this decision. Assume that
the equipment in question is the company’s only fixed asset.
Ignore income taxes and the time value of money.
1. Prepare statements of cash receipts and disbursements as they would
appear in each of the next three years under both alternatives. What is
the total cumulative increase or decrease in cash for the three years?
2. Prepare income statements as they would appear in each of the next three
years under both alternatives. Assume straight-line amortization. What is
the cumulative increase or decrease in net income for the three years?
3. Assume that the cost of the “old” equipment was $1 million rather
than $87,000. Would the net difference computed in requirements 1
and 2 change? Explain.
4. As Kimiyo Lee, reply to Mr. Park’s contentions.
5. What are the irrelevant items in each of your presentations for requirements
1 and 2? Why are they irrelevant?