Chavez Company is considering purchasing new equipment or overhauling its existing equipment. The manager has gathered the following information: Current machinery: Original cost$50,000 Accumulated depreciation 40,000 Annual operating costs 5,000 Current market value 1,500 Salvage value at the end of five years - Cost of overhauling machinery: Cost of overhaul$12,000 Annual operating costs after overhauling 2,000 Salvage value at the end of five years - New machinery: Cost$56,000 Annual operating costs 1,000 Salvage value at the end of five years - Required:1) Identify the sunk costs associated with this decision. 2) Compute the increase or decrease in total income over the five-year period if the company chooses to buy the new equipment. 3)
Compute the increase or decrease in total income over the five-year period if the company chooses to overhaul its existing machinery. 4) What is your recommendation for this decision?
What will be an ideal response?
1) Sunk costs include the original cost and accumulated depreciation (i.e., book value) of the existing machinery.
2) Increase or decrease in income if new machine is purchased:
| Cost savings: ($5,000 ? $1,000) × 5 | $ | 20,000 | |
| Current market value | 1,500 | ||
| Cost of new equipment | (56,000 | ) | |
| Decrease in income | $ | (34,500 | ) |
3) Increase or decrease in income if machine is overhauled:
| Cost savings: ($5,000 ? $2,000) × 5 | $ | 15,000 | |
| Cost of overhaul | (12,000 | ) | |
| Increase in income | $ | 3,000 | |
4) The existing machine should be overhauled.
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