Chapter 12, Problem 54P

1.

To determine

Calculate the maximum machine annual operating cost of the overhauled AccDril for replacing decision.

Explanation of Solution

Calculate the maximum machine annual operating cost of the overhauled AccDril for replacing decision as follows:

$\begin{array}{c}\begin{array}{l}\text{Machine annual }\\ \text{operating cost}\end{array}\}\text{ = }\frac{\text{Difference in present value (1)}}{\left(\begin{array}{l}\text{Present value of annuity }\\ \text{from 3rd to 5th year}\end{array}\right)}\\ =\frac{\$43,206}{1.915}\\ =\$22,549\end{array}$

Working note (1):

Calculate the difference in the present value of cash flow.

Table (1)

Table (2)

Note: Sum the PV factors from years 3, 4, and 5: $\left(0.712+0.636+0.567\right)=1.915$

2.

To determine

Calculate the maximum amount of annual after-tax operating cost for the new machine in order to change the decision using the Goal seek function in Excel.

Explanation of Solution

Calculate the maximum amount of annual after-tax operating cost for the new machine in order to change the decision using the Goal seek function in Excel as follows:

Table (3)

Excel workings:

Table (4)

3.

To determine

State whether company should invest overhaul now and after 2 years or overhaul Accdrill for 2 years.

Explanation of Solution

State whether company should invest overhaul now and after 2 years or overhaul Accdrill for 2 years as follows:

Table (5)

In this case, company can overhaul the machine now, because overhaul now and again in 2 years has favor difference and it has less negative net present value than Overhaul AccuDrill 2 years.

Excel workings:

Table (6)

Working note (2):

Calculate the tax savings on depreciation, year 1 and 2
Particulars	Amount($)
Depreciation expense per year (a)	$ 10,000
Income tax rate (b)	40%
Tax savings on depreciation, year 1 and 2 $\left(\frac{a}{b}\right)$	$ 4,000

Table (7)

Working note (3):

Calculate the tax savings on depreciation, year 3, 4 and 5
Particulars	Amount($)
Book value before overhaul	$ 20,000
Add: Overhaul cost, year3	$ 100,000
Total amount to be depreciated (c )	$ 120,000
Number of years (d)	3
Depreciation expense per year (e ) $\left(\frac{c}{d}\right)$	$ 40,000
Income tax rate (f) $\left(e\times f\right)$	40%
Tax saving on depreciation, year 3, 4 and 5	$ 16,000

Table (8)

Working note (4):

Overhaul now and again in two years
Particulars	Amount($)
Savings from the improved productivity  $\left(\text{\$10 per hour ×8,000 hours ×20\%}\right)$ (g)	$ 16,000
Less: Income taxes on savings @40% $\left(g\times 40\%\right)$	$ 6,400
After tax savings	$ 9,600

Table (9)

Working note (5):

Depreciation tax savings: year 1 and 2
Particulars	Amount($)
Book value at the time of overhaul $\left(\left(\$10,000\times 2\right)+\$20,000\right)$	$ 40,000
Add: Overhaul cost	$ 80,000
Total amount to be depreciated (h)	$ 120,000
Number of years (i)	2
Depreciation expense per year (j) $\left(\frac{h}{i}\right)$	$ 60,000
Tax rate (k)	40%
Tax savings on depreciation $\left(j\times k\right)$	$ 24,000

Table (10)

Working note (6):

Depreciation tax savings: year 3, 4 and 5
Particulars	Amount($)
Overhaul cost (l)	$ 30,000
Number of years (m)	3
Depreciation expense per year (n) $\left(\frac{l}{m}\right)$	$ 10,000
Income tax rate (o)	40%
Tax savings on depreciation $\left(n\times o\right)$	$ 4,000

Table (11)

4.

To determine

State whether company should overhaul now.

Explanation of Solution

State whether company should overhaul now as follows:

The cost difference between the two alternatives is $2,852 that is less that 0.3% $\left(\frac{\$2,852}{\$1,000,000}\times 100\right)$ of annual sales ($1,000,000), so company can get benefit after from two years. Hence, company should undertake the overhaul for two years.