Financial Accounting Question

The management of the company is planning to expand operations by replacing existing equipment (with EM and JB models) along with purchasing new machinery. (The Matz and Ebz)

The investment decision regarding the new machinery to be purchased involves a choice between two types of equipment which have the trade names ‘Matz’ and ‘Ebz’.  The initial outlays required for the two alternative proposals (given in Exhibit 1) are for a total of nine machines in each case.

The total cost of the ‘Matz’ machines under consideration is $332,000, whilst for the ‘Ebz’ machines the cost is $317,000. In addition to these machines, an expenditure of $108,000 and $133,000 respectively is required for auxiliary equipment.

EXHIBIT 1

Estimated cash-flows and other data

 

  Notes Matz Ebz

 

Initial Outlay a 440,000 450,000
Annual Sales Revenue   1,300,000 1,305,000
Annual Operating Costs b 1,052,000 1,044,000
Interest Charges   30,000 30,000
Annual Depreciation c 40,000 35,000
Estimated Scrap      
10 years   40,000 30,000
12 years      
Overhauls required      
Every 5 years d 60,000  
Every 6 years     80,000
Required increase in working capital   20,000 30,000
Expected Useful Life   10 years 12 years

Notes.

  1. An investment allowance of 10 per cent is claimable on these initial outlays for taxation purposes, for the year of the expenditure.(end of year)
  1. Annual operating costs include all direct costs of manufacture, together with factory, selling and administrative expenses, but exclude taxation, depreciation and interest.
  1. Depreciation for tax purposes is to be claimed at the rate of 20 percent per annum on a straight-line basis.
  1. Costs of overhauls are to be capitalised for accounting purposes, and amortised over :
  • five years if the ‘Ebz’ equipment is acquired, or
  • five years if the ‘Matz’ equipment is acquired.

It is expected, however, that this cost will be claimable as a tax deduction in the year of the expenditure.

The management is also considering two types of machines to replace the existing equipment.

These are:

  • The ‘EM’, which is a relatively small and inexpensive machine; and
  • The ‘JB’, a larger and more durable machine with a higher capacity.

The expected cash flows and other information relating to one of the old machines and the two types of replacement machines under consideration are given in Exhibit 2.

The existing equipment, which consists of four of the old type machine (an early model ‘JB’) originally cost $100,000 in total, six years ago, and has been fully depreciated for taxation purposes. Expected future sales volume is expected to absorb an overall production volume of 4,000 units per hour.

It is considered necessary to have only one type of machine in operation for three reasons:

  1. Existing material handling and packaging equipment will be used to full advantage.
  2. Inter-changeability of moulds and spare parts permits greater flexibility in production scheduling, and requires a smaller stock of spare parts.
  3. Regular maintenance and periodic overhauls will be more economical.

The installation of the ‘EM’ machines would require considerable modification to existing ancillary equipment. The additional cost of these modifications is incorporated in the cash flows given in Exhibit 2.

 

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