Question

The Terme Corporation is contemplating the purchase of new equipment, which may potentially increase revenues by 25%. Currently, sales are $850,000 per year and cost of sales are 60% of sales. The equipment is expected to last for 6 years with no residual value. The cash outflow expected at the beginning of the year is $435,000. Ignoring income taxes, what is the estimated annual net operating income increase/decrease?

Answer 1

To estimate the annual net operating income change, increased revenues from the new equipment are calculated, additional costs of sales are factored in, and the annual equipment cost is subtracted, yielding an estimated annual net operating income increase of $12,500.

Step-by-step explanation:

The question asks for the estimated annual net operating income increase/decrease for the Terme Corporation upon the purchase of new equipment. We start by determining the expected increase in sales, which would be 25% of the current $850,000, resulting in increased revenues of $212,500. The cost of sales is 60% of the sales, so we must first calculate the current cost of sales ($850,000 x 60% = $510,000) and then determine the additional cost of sales from the increased revenue ($212,500 x 60% = $127,500). The new equipment costs $435,000 and will last for 6 years without any residual value. The annual cost of the equipment is the equipment cost divided by its useful life, which is $435,000 / 6 = $72,500. So, the estimated annual net operating income increase is calculated as the increased revenues minus the increased costs of sales and the annual cost of the equipment ($212,500 - $127,500 - $72,500 = $12,500).