Question

A company is considering replacing an old piece of machinery, which cost $598,600 and has $348,500 of accumulated depreciation to date, with a new machine that has a purchase price of $484,200. The old machine could be sold for $64,900. The annual variable production costs associated with the old machine are estimated to be $156,400 per year for eight years. The annual variable production costs for the new machine are estimated to be $99,000 per year for eight years.

Required:

A. Prepare a differential analysis dated September 13 to determine whether to continue with (Alternative 1) or replace (Alternative 2) the old machine.
B. Determine whether the company should continue with (Alternative 1) or replace (Alternative 2) the old machine.
C. What is the sunk cost in this situation?

Answer 1

A & B

* Alternative 1: Continue with the old machine, the net cash flow will be unchanged, variable production cost per year will be remained at $156,400 =>Cost through 8 years is -156,400 x 8 = $1,251,200

* Alternative 2: Replace the old machine with the new one:

Y0: Cash inflow from selling the old - Cash outflow from buying the new = 64,900 - 484,200 = -$419,300

Y1 - Y8: Variable production cost = -99,000 x 8 = - 792,000

=> Cost through 8 years is -792,000 - 419,300 = $1,211,300

Differential in income of Alternative A and B = 1,251,200 - 1,211,300 = $39,900. Thus, Alternative B resulted in a higher income throughout 8 years.

=> Alternative 2 should be take.

C.

Sunk cost in this situation = Initial cost of old machine - its accumulated depreciation = 598,600 - 348,500 = $250,100

Step-by-step explanation:

Explanation is given in Answer part.