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Cases Case 27-1 Sinclair Company* A. EQUIPMENT REPLACEMENT Sinclair Company is considering the purchase of new equipment to perform operations currently being per- formed on different, less efficient equipment. The pur- chase price is $250,000, delivered and installed. A Sinclair production engineer estimates that the new equipment will produce savings of $72,000 in labor and other direct costs annually, as compared with the present equipment. She estimates the proposed Copyright by Professor Robert N. Anthony Accounting: Text and Cases, 13th Edition 877 Chapter 27 Longer-Run Decisions: Capital Budgeting 863 because good equipment, bought only two years previously, is being scrapped. How did this mistake come about? equipment's economic life at five years, with zero sal- vage value. The present equipment is in good working order and will last, physically, for at least five more years. The company can borrow money at 9 percent, al- though it would not plan to negotiate a loan specifically for the purchase of this equipment. The company re- quires a return of at least 15 percent before taxes on an investment of this type. Taxes are to be disregarded. Questions C. EFFECT OF INCOME TAXES Assume that Sinclair Company expects to pay income taxes of 40 percent and that a loss on the sale or dis- posal of equipment is treated as a capital loss resulting in a tax saving of 28 percent of the loss. Sinclair uses an 8 percent discount rate for analyses performed on an aftertax basis. Depreciation of the new equipment for tax purposes is computed using the accelerated cost re- covery system (ACRS) allowances; assume that these allowances were 35, 26, 15, 12, and 12 percent for years 1 to 5, respectively. The new equipment qualifies for a 5 percent investment tax credit, which will not re- duce the cost basis of the asset for calculating ACRS depreciation for tax purposes. 1. Assuming the present equipment has zero book value and zero salvage value, should the company buy the proposed equipment? 2. Assuming the present equipment is being depreci- ated at a straight-line rate of 10 percent, that it has a book value of $135,000 (cost, $225,000; accu- mulated depreciation, $90,000), and has zero net salvage value today, should the company buy the proposed equipment? 3. Assuming the present equipment has a book value of $135,000 and a salvage value today of $75,000 and that if retained for 5 more years its salvage value will be zero, should the company buy the pro- posed equipment? 4. Assume the new equipment will save only $37,500 a year, but that its economic life is expected to be 10 years. If other conditions are as described in (1) above, should the company buy the proposed equipment? Questions 1. Should the company buy the equipment if the facts are otherwise the same as those described in Part A (1)? 2. If the facts are otherwise the same as those de- scribed in Part A (2)? 3. If the facts are otherwise the same as those de- scribed in Part B? D. CHANGE IN EARNINGS PATTERN Assume that the savings are expected to be $79,500 in each of the first three years and $60,750 in each of the next two years, other conditions remaining as de- scribed in Part A (1). B. REPLACEMENT FOLLOWING EARLIER REPLACEMENT Sinclair Company decided to purchase the equipment described in Part A (hereafter called "model A" equip- ment). Two years later, even better equipment (called "model B") comes on the market and makes the other equipment completely obsolete, with no resale value. The model B equipment costs $500,000 delivered and installed, but it is expected to result in annual savings of $160,000 over the cost of operating the model A equipment. The economic life of model B is estimated to be 5 years. Taxes are to be disregarded. Questions Questions 1. What action should the company take? 2. Why is the result here different from that in Part A (1)? 3. What effect would the inclusion of income taxes, as in Part C, have on your recommendation? (You are not expected to perform any more calculations in answering this question.) 1. What action should the company take? 2. If the company decides to purchase the model B equipment, a mistake has been made somewhere, D. CHANGE IN EARNINGS PATTERN Assume that the savings are expected to be $79,500 in each of the first three years and $60,750 in each of the next two years, other conditions remaining as de- scribed in Part A (1) Questions 1. What action should the company take? 2. Why is the result here different from that in Part A (1)? 3. What effect would the inclusion of income taxes, as in Part C, have on your recommendation? (You are not expected to perform any more calculations in answering this question.)
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