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Chapter 4 CASE 4-1 Temecula Inc. began business on January 1, 2015 as a wholesale distributor of general merchandise to discount variety stores. Due to capital constraints, Temula purchased a used fleet of delivery trucks to deliver inventory to its customers when it began busi- ness. Recent events have caused Temecula's management to consider upgrading its delivery fleet. The firm initially invested $600,000 for its delivery trucks at the beginning of opera tions on January 1, 2015. Temecula placed them into service immediately. All of the trucks were the same age with approximately the same mileage. Consequently, Temecula decided to depreciate the trucks collectively as an asset entitled Delivery Equipment The head of Temecula's facilities management, Turk Wrench, estimated that the trucks had a useful service life of six years. He further commented, "All trucks will be totally worthless after we're through with them." Temecula's chief accountant decided to depreciate the delivery equipment on a straight-line basis. Andrea Accrual stated, "Straight-line depreciation best reflects the economic reality of the delivery equipment, and we can improve our bottom line by using that depreciation method. Temecula used and depreciated its delivery equipment through 2016. An internal audit of the firm's long-term assets in January 2017 revealed that the delivery equipment only had a value of $220,000. This d caused by excessive use and poor gas mileage relative to newer vehicles. Andrea Accrual immediately recognized the trucks as impaired and adjusted the book value and depre- ciation schedule according. value was By the beginning of 2018, Temecula became concerned that its inefficient delivery fleet placed the firm at a competitive disadvantage. The firm decided to secure debt financing from its bank to upgrade its trucks. Chief Financial Officer, Kesha Money, commented the firm's good credit standing would allow Temecula to borrow up to $1.2 million at 4%. The term loan would require Temecula to pay annual interest on the debt, and repay the principal upon maturity Bill Buyer, director of purchasing and acquisitions, identified a possible replace- ment fleet. One potential acquisition was a fleet of new diesel trucks. The cost would be $800,000 and the diesel vehicles promised savings of $160,000 annually in fuel costs due to greater fuel efficiency than the current gas guzzlers. The diesel trucks, however, would require an extra $20,000 in annual maintenance costs due to their sophisticated engineering. B.G. Shot, the Chief Executive Officer of Temecula, called the personnel involved to a meeting on January 2, 2018. B.G. said, "If we make the investment, I want to sell the fleet after three years because I want to maintain a highly efficient fleet, and I don't want to revisit an impaired asset situation." Bill Buyer, in consultation with Turk Wrench, said, "If that's the case, we could sell the trucks for $425,000 after three years of use." Kesha Money noted that a buyer existed who was willing to pay $100,000 for the old delivery trucks. She said, "Tm afraid it's the best price we can get for those dinosaurs." Andrea Accrual chimed in, "Just like the old trucks, we would depreciate the new fleet on a straight-line basis to maximize our profits if we buy the new trucks." 4{ up,.ll 84% 9:27 PM Schedule B (in thousands) All Relevant Factor Income Statements-Buy New Delivery Equipment 020 018 Income before depreciation, g/l, interest, and t uel 1,500 S500500 (Gain) loss on sale of d equipment Interest ex Net fuel expense Prelax incorre $976 $282 Assumed S500 anmially 99 Amount Finance(cnst minus sale of nld equipment) times 4 %- $ hecause they are $140 higher under the altemative Rememher to subtract expenses from Inonme to arive at pretax incnme. Income Statements -Reta in Old Deli Equipment 020 $500 2019 018 $500 Tncome hefore d ation ex nte and tuel S1,500 De Gain) loss on sale Interest expense Net fuel expense* Pretax iccarie Assumed $500 aually Fuel savings less maintenance Cash Flows-Buy New Del Total 2020 2019 2018 S 0 Brow(repay) cash Buy) new Sell new Pav) interest Fuel expense Cash flow Enclose dollar amounts with) when there is a cash outflow. ment ent 425 ($ 359) ($303 ) ! Cash Flows-Retain Old Delivery Equipment Sell old equipment cash (Buy) new equipmen Pav Fuel ex Cash flow Retaining old equipment results in no sale, and no purchase of new equipment, therefore, no interest expense incurred