In 2 x 4 and 2 x 6 lumber production, significant amounts of wood are present in sideboards produced after the initial cutting of logs. Instead of processing the sideboards into wood chips for the paper mill, an "edger" is used to reclaim additional lumber, thus resulting in savings for the company. An edger is capable of reclaiming lumber by any of the following three methods: (1) removing rough edges, (2) splitting large sideboards, and (3) salvaging 2 x 4 lumber from low-quality 4 x 4 boards. Union Camp Company's engineers have discovered that a significant reduction in production costs could be achieved simply by replacing the original "edger" machine with a newer laser-controlled model.

Old Edger: The old edger was placed in service 12 years ago and is fully depreciated. Any machine scrap value would offset the removal cost of the equipment. No market exists for this obsolete equipment. The old edger needs two operators. During the cutting operation, the operator makes edger settings based on his/her own judgment. The operator has no means of determining exactly what dimension of lumber could be recovered from a given sideboard and must guess at the proper setting to recover the highest grade of lumber. Furthermore, the old edger is not capable of salvaging good-quality 2 x 4s from poor-quality 4 x 4s. The defender can continue in service for another 5 years with proper maintenance.

Current market value

$0

Current book value

0

Annual maintenance cost

$2,500 in year 1, increasing at a rate of 15% each year over the previous year's cost.

Annual operating costs

(labor and power)

$65,000

New Laser-Controlled Edger: The new edger has numerous advantages over its defender. These advantages include laser beams that indicate where cuts should be made to obtain the maximum yield by the edger. The new edger requires a single operator, and labor savings will be reflected in lower operating and maintenance costs of $35,000 a year.

Estimated Cost

Equipment

$35,700

Equipment Installation

21,500

Building

47,200

Conveyor modification

14,500

Electrical (wiring)

16,500

Sub total

$135,400

Engineering

7,000

Construction management

20,000

Contingency

16,200

Total

$178,600

Useful life of new edger

10 years

Salvage value

Building (tear down)

$0

Equipment

10% of the

original cost

Annual O&M costs

$35,000

Depreciation Methods

Building

39-year MACRS

Equipment and

installation

7-year MACRS

Twenty-five percent of total mill volume passed through the edger. A 12% yield improvement is expected to be realized on this production, which will result in an improvement of total mill volume of (0.25)(0.12)=3%, or an annual savings of $57,895.

(a) Should the defender be replaced now if the mill's MARR and marginal tax rate ar 15% and 40%, respectively?

(b) If the defender will eventually be replaced by the current challenger, when is the optimal time to replace?