Chapter 13

Ibrahim Asafi, the general manager of the Coronado Company, is contemplating replacing the existing assembly-line equipment in the Assembly Department with automated assembly equipment. Production output and revenues will be unaffected by the replacement decision. Transactions related to the capital investment are cash transactions that would occur today.

	Existing Assembly Equipment	New Automated Assembly Equipment
Original cost	$1,100,000	$1,200,000
Useful life	11 years	5 years
Current age	6 years	0 years
Useful life remaining	5 years	5 years
Accumulated amortization	$600,000	$0
Book value	$500,000	Not acquired yet
Current disposal price (in cash)	$200,000	Not acquired yet
Terminal disposal price (in cash, in 5 years)	$0	$0
Average working capital needed	$120,000	$70,000

Current annual Assembly Department costs are as follow:
Direct materials	$600,000
Direct manufacturing labour	400,000
Amortization	100,000
Maintenance and repairs	150,000
Other operating costs	50,000
Supervision (allocated as 10% of direct manufacturing labour costs)	40,000
Allocated rent (based on space used)	40,000
Allocate corporate overhead (based on direct manufacturing labour costs)	120,000
Total	$1,500,000

Additional Information

• Coronado uses straight-line amortization calculated on the difference between the initial equipment investment and the terminal disposal price of the equipment.
• The new equipment will produce output more swiftly. Therefore, the average working capital investment, if the new equipment is purchased, will decrease.
• Of the total direct materials costs, $120,000 is waste and scrap. The new equipment is expected to reduce scrap costs to $20,000
• The new equipment is expected to reduce direct manufacturing labour costs by $150,000 each year.
• Maintenance and repairs on the old equipment have been excessive. If the new equipment is acquired, maintenance and repair costs are expected to decrease to $100,000.
• Coronado collects all supervision costs for all manufacturing departments in the plant into one cost pool. These costs are ten allocated to departments on the basis of direct manufacturing labour costs. The Assembly Department has only one supervisor currently. The supervisor will continue in her current position if the new equipment is purchased.
• The new equipment will reduce the space required for assembly operation by 20%, reducing allocated rent by $8,000. The Coronado Company has no alternative uses for this extra space.
• Corporate overhead costs are allocated to each department at 30% of direct manufacturing labour costs of each department.

Coronado estimates a required rate of return of 12% for this project.

Required:

• On the basis of the net present value method, should Asafi replace the existing assembly equipment?
• Suppose that next year is the last year Coronado will offer the attractive bonus plan currently in place. Asafis bonus hinges on short-run accrual accounting income for that year. Will Asafi be inclined to replace the Assembly Department equipment? Provide quantitative support for our answer.