CM2 is considering a significant equipment replacement. Conner and Martin believe that the best time for this equipment replacement is at the end of 2018. However, they are concerned about the effect this replacement might have on their financial statements. Conner, Martin, Knepp, and Lopez tell you that they have thought of two options regarding the old equipment. They could (a) overhaul the old equipment or (b) purchase new equipment.

Action

Review options (a) and (b) to determine which option is best for CM2 financially to proceed with what should be done with the old depreciated equipment and then complete requirements 1 and 2 below.

Option (a): Overhaul the existing equipment.
The following expenses are anticipated under this approach:

1. The normal annual cost for lubrication and replacement of minor parts to maintain the integrity of the exterior body would be $27,000.
2. The cost of re-wiring interior components in an overhaul would be $125,000.
3. Replacing old worn components would cost $82,000 with associated labor costs of $210,000 for installation. The overhaul is estimated to extend the useful life of the equipment another four years past the present useful life was eight years, starting January 1, 2011.

Option (b): Purchase new equipment.
Purchase new equipment by giving a non-interest-bearing note with five payments of $164,000 to the supplier (starting on the first day of note’s term and each year thereafter) and selling the old equipment for $60,000 cash. The first $164,000 payment would be made in late December 2018. The prevailing interest rate for obligations of this nature is 10%. (Remember this option uses a present value factor of (4.16986) to calculate the Present Value of Asset) (I=10% n=5) =, as the purchase price is not supplied, but requires calculation.

Requirements:

(1) Prepare a spreadsheet calculating the equipment cost for both Options (a) and (b). What are the short-term and long-term obligations?

(2) Prepare a memorandum explaining the best option for the company.