Asset depreciation range, Financial Management

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Work out and submit the comprehensive problem below.

  1. Halstrom Corporation purchased a piece of equipment three years ago for $230,000. It has an asset depreciation range (ADR) midpoint of eight years. This equipment can be sold now for $90,000.

A new piece of equipment can be purchased for $320,000 that would replace the existing equipment. It also has an ADR of eight years.

The new equipment, if purchased, will have a useful life of six years, with no salvage value at the end of that time. If the old equipment is kept, it will be operated for six more years in addition to the three years it has already been operated. It also will have no salvage value at the end of that time.

The old and new equipment would provide the following operating gains or losses (earnings before depreciation, interest, and taxes) over the next six years, beginning with the coming year.

Table 2

Year

New Equipment

Old Equipment

1 (1st year of new equip., 4th year of old equip.)

$80,000

$25,000

2

76,000

16,000

3

70,000

9,000

4

60,000

8,000

5

50,000

6,000

6

45,000

(7,000)

The firm has a 36 percent tax rate and a 9 percent cost of capital. Do the calculations to determine if the new equipment should be purchased to replace the old equipment. Should the new equipment be purchased or should the old equipment be kept in operation?

Be careful here. This problem involves an investment that is supposed to increase profits, whereas the problem in Part 1 involved investing in a machine that would result in a cost savings. While the cash benefit resulting from the purchase of new equipment can come either in the form of a cost savings or an increase in profit, in this case be careful to work with the increase in cash flows resulting from the purchase of the new machine, not merely the profit from the new machine. The fact that the new machine will earn some profit is not sufficient reason to invest in it. It must increase profits enough to justify its purchase. This is easily seen if we consider a case where the new machine will in fact earn a profit, but the profit will actually be less than the existing machine is presently earning. Clearly, one would not purchase such a machine to replace the existing one. It is the increase in cash flows that counts.


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