Report on Sinclair Company: 27-1

Sinclair Company is considering the purchase of new equipment to perform operations currently being
performed in different, less efficient equipment. A Sinclair production engineer estimates that the new
equipment will produce savings. She estimates the proposed the equipments economic life at five (5)
years, with zero salvage value. The present equipment is in good working order and will last, physically,
for at least five more years. The company can borrow money at 9%, although it would not plan to
negotiate a loan specifically for the purchase of this equipment. The company requires a return of at
least 15% before taxes on an investment of this type. TAXES ARE TO BE DISREGARDED.
Purchase value :

$ 250,000 (delivered and installed)

Estimated Savings:

$ 72,000 (annually in labor and other direct cost as compared
with present equip)

Proposed Equipment ECO-LIFE:

5 years

Present Equipment life:

5 years

Can borrow money

9% (although it would not plan to negotiate a loan specifically
for the purchase of this equipment.)

Return requirement

15% (before taxes on an investment of this type)

PART A. EQUIPMENT REPLACEMENT
Q1 and 2: Assuming the present equipment has zero book value and zero salvage value, should the
company buy the proposed equipment?
Assuming the present equipment is being depreciated at a straight-line rate of 10%, that it
has a book value of $135,000 *cost, $225,000; accumulated depreciation, $90,000), and has zero net
salvage value today, should the company buy the proposed equipment?
1.

2.

PART A
Investment .......................................................................................................................................................................
$250,000
Annual savings ................................................................................................................................................................
72,000
Present value of $1 a year, 5 years, 15 percent ................................................................................................................
3.352
Total present value of savings .........................................................................................................................................
241,344
Decision: Net present value = -$8,656; therefore ............................................................................................................
Do not purchase
Same as question 1.

Moral: Book value makes no difference. The figures and decision are the same as in 1. Nevertheless, a
profit center manager may not view the $135,000 write-off as irrelevant, even though it does represent a
sunk cost.yt

............................................................................................ gross ............. Investment ................000 Annual earnings .........................................344 Decision: Net present value = $66......................................................000 * 3..................................... 175...................................................019 .......500 * 5.................000 and that if retained for 5 more years its salvage value will be zero (0).................................... 37................................................000 Net investment ....344. Do not purchase Moral: Although total earnings are approximately the same as in question 1 ($375......................................................000 Less salvage on old ..................... If other conditions are as described in (1) above......... should the company buy the proposed equipment? 4.... $250.......................787................. therefore ......................000)..............213 Decision: Net present value = -$61..................................... the present value is considerably different...................................................... 72....... therefore ..... It is the pattern of earnings through time that counts...........................................................000 and a salvage value today of $75...................500 a year...... not the total “amount..................................................................... but that its economic life is expected to be 10 years.........................................................................000 Annual earnings ..................................................... $250.................................................................. 188......... Investment................................ 75........................................ 241...................................................... should the company buy the proposed equipment? 3..........000 versus $360...........................” .Q 3: Assuming that the present equipment has a book value of $135....................... 15%: $37......................................000 Present value: $72.............................. Q 4: Assume the new equipment will save only $37....500 Present value.................................................................... Purchase Moral: The resale value of the superseded machine reduces the amount of new funds required which (in this case) changed the decision...................... 10 years.............................352 ..........................

................. bought only two years previously........... $500.... because good equipment......320.. a mistake has been made somewhere...PART B....... consequently. Purchase (If Model A has resale value..............000 * 3...... Moral: Don’t let past mistakes prevent you from making wise decisions now (i.................................. Purchase value : $ 500..... TAXES ARE TO BE DISREGARDED.............. Two years later...........320 Decision: Net present value = $36. with no resale value.................... Model A should not have been bought (although this is known only from hindsight).................e.... sunk costs are irrelevant).................. the return would be even higher......................................... but it is expected to result in annual saving of $ 160.................................................................... 160......000 over the cost of operating the model A equipment............................... It turns out that its economic life was only two years...... REPLACEMENT FOLLOWING EARLIER REPLACEMENT Sinclair Company decided to purchase the equipment described in PART A (hereafter called “model A” equipment)....000 (delivered and installed) Estimated Savings: $ 160........................... How did this mistake come about? PART B 1............... The error arose when Model A was purchased.......... therefore ......... Investment ........ ..000 Present value: $160...........................000 delivered and installed................... is being scrapped..................... even better equipment (called “model B”) comes on the market and makes the other equipment completely obsolete.... Assuming the situation in A(3). The economic life of model B is estimated to be 5 years...........................352 . The model B equipment costs $500......................) 2... Model A has an acceptable return if its economic life is 5 years........000 Annual earnings ......... 536....................000 (annually in labor and other direct cost as compared with present equip) Proposed Equipment ECO-LIFE: 5 years Q 1&2: What action should the company take? If the company decides to purchase the model B equipment.......................

..860 $417... 15%.. 26...........000 * .. because of the erratic “depreciation” (officially... ACRS Allowance Year PV factor ratio 1 175.050 2 130..........12 and 12% for years 1 to 5....516 Deduct: PV of depreciation shield from old machine sacrificed ($50......000 × .. Q 1: Should the company buy the equipment if the facts are otherwise the same as those described in PART A(1)? Q 2: If the facts are otherwise the same as tbhose described in PART A (2)? Q 3: If the facts are otherwise the same as those described in PART B? The 1981 Tax Act (and subsequent acts) with ACRS provisions usually makes this kind of a computational nightmare for students.. 15........... the decision is to purchase.. 12% for 5-year assets.....................000/yr..993 ............. Sinclair uses an 8% discount rate for analyses performed on an aftertax basis.550 4 60................... “cost recovery”) amounts in years 1-5.......857 $111.... for 3 more years) = $50.577 (Table B) ...... Depreciation of the new equipment for tax purposes is computed using the accelerated cost recovery system (ACRS) allowances..000 × ..000 × ..100 5 60. $498.328 Add: PV of ACRS depreciation tax shield for $500.........976 Since $498........000/year for 5 years = $160..........000 × ....976 is more than the net investment of $433. 51.... and the absence of such amounts in later years...........970 .....000.......40............000 machine = $417..... The new equipment qualifies for a 5% investment tax credit.. 26%..... $383....000 * ....... is: PV of cash savings of $160..........540 Net present value of earnings ...... 167.... assume that theses allowances were 35... respectively...............735 $44..410 3 75......................40 * 2.970 * ...000 × ..188 550....... We have assumed that the ACRS allowances stay at 35%. 12%.........60 * 3.... expects to pay income taxes of 40% and that a loss on the sale or disposal of equipment is treated as a capital loss resulting in a tax saving of 28% of the loss..............681 $40.794 $59...PART C: EFFECT ON INCOME TAXES Assume that Sinclair Comp.....926 $162......................... The cash flow pattern.............. which will not reduce the cost basis of the asset for calculating ACRS depreciation for tax purposes............... including a 5% (assumed to be time zero) ITC.

..................441............985 * ............................................000 Present value of earnings Years 1-3: $79..................416 .........................................................283 (Table B) ........500 Present value of cash savings: Years 1-3: $79.................................................................................130 *3................................................. Q 1: What action should the company take? Q 2: Why is the result here different from that in PART A (1)? 1.................................993 (5 yrs..... *This is the difference between 3....................................... 64.....499 Years 4-5: $60...................................................................................................................... net of ITC............................tax rate) * 2.........613 Present value of ACRS depredation tax shield: $208...... other conditions remaining as described in PART A (1).... 51.................... $122..............500 ITC)..............................................577 (3 yrs......................500 in each of the first 3 years and $60...........441 Decision: Do not purchase..................................... $246.................................................. ....577 .......... PART D Investment ......500 * 2................. Investment.........) Moral: The combination of tax-shield benefits and a shift in earnings now makes the decision to purchase a good one (even without the $12............750 * 1............. $250............................................. $181................. 3.......750 in each of the next two years.......................................................................) – 2...40 ....... $258.... $237....................... shifting more of the earnings to the early years and less to the later years increases the present value from $241.....594 Total present value ...500 * ...............344 to $246....................750 * ..........$3......069*..........................................60 * l............559................60 (1 ................ since NPV = ....... 83..... Although the total earnings for the 5-year period are the same in Part D as in A(1)......................923 Years 4-5: $60.................352 and 2............283 2.......................................942 Total PV of earnings ..... Moral: The time pattern of earnings makes a difference..............................................PART D: CHANGES IN EARNING PATTERNS Assume that the savings are expected to be $79...................................