Equipment Replacement Decision: Columbia Enterprises Is Stud

5 Equipment Replacement Decisioncolumbia Enterprises Is Studying The

Columbia Enterprises is evaluating whether to replace its existing equipment or retain it for further use. The current equipment initially cost $74,000 and is expected to operate for six more years if major repairs costing $8,700 are made in two years. The equipment generates annual cash operating costs of $27,200. It can be sold now for $36,000, and its estimated residual value after six years is $5,000.

Alternative new equipment is available at a cost of $103,000, with a six-year service life and an estimated residual value of $13,000. The new equipment would reduce annual cash operating costs to $21,000. Sales are projected to be $430,000 annually regardless of the choice, and all equipment is depreciated on a straight-line basis. The company's minimum desired return is 12%.

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Decision-making regarding equipment replacement involves analyzing the costs, benefits, and the time value of money to determine the most economically advantageous choice. The net present value (NPV) method, which discounts future cash flows to their present value, offers a systematic approach to comparing the retention of existing equipment versus purchasing new equipment. This analysis considers initial investment, operating costs, residual values, and the required rate of return to facilitate a rational decision aligned with the company's financial goals.

Analysis of Equipment Replacement Using Net Present Value

To determine whether Columbia should retain its current equipment or invest in new equipment, we employ the net present value (NPV) method. This technique involves calculating the present value of all cash inflows and outflows associated with each alternative over the relevant time horizon, which is six years in this case. The decision favors the option with the higher positive NPV.

1. Retaining Existing Equipment

The current equipment's salvage value if sold now is $36,000, and over six years, the residual value is estimated at $5,000. Operating costs are $27,200 annually, and ignoring taxes, the cash flows can be summarized as follows:

• Initial cash inflow (sale now): $36,000
• Annual operating costs: $27,200 (outflows)
• Additional major repair cost in Year 2: $8,700 (outflow)
• Residual value after six years: $5,000 (cash inflow at the end)

Considering the repair costs in Year 2 and the residual value, the total cash outflows over six years include the annual costs and the major repair, with the salvage value of the equipment at the end. The present value of these cash flows, discounted at 12%, is computed to compare against the alternative.

2. Purchasing New Equipment

The new equipment costs $103,000, with an estimated residual value of $13,000 after six years. Annual operating costs would be reduced to $21,000. The cash flows related to this option include:

• Initial investment: $103,000
• Residual value at end of year 6: $13,000
• Annual operating costs: $21,000

To calculate the NPV, all cash outflows occur at the start, and inflows include the residual value and the savings from reduced operating costs over the six years. Discounting these cash flows at the company's minimum desired return of 12% allows a comparison of the net benefit or cost associated with purchasing the new equipment versus keeping the existing equipment.

Calculations and Results

Applying the NPV formula:

NPV = (Present value of cash inflows) - (Present value of cash outflows)

For the existing equipment, the net cash flows are primarily operating costs and salvage value, while for the new equipment, the investment cost and savings are considered. The calculations involve discounting the respective cash flows using the present value factors for 12% over six years, which are obtained from standard present value tables (see Appendix).

Based on the calculations, if the NPV of retaining the existing equipment is higher than that of purchasing new equipment, Columbia should keep its current asset. Conversely, if the NPV of the new equipment is favorable, then replacement is justified.

Preliminary computation indicates that the initial costs and operational savings favor purchasing the new equipment, especially considering the lower annual operating costs and residual value benefits. However, precise calculations must be completed to confirm this conclusion, which typically show a positive NPV for the new equipment, supporting replacement.

Rationale for Including Time Value of Money in Long-term Decisions

Management's emphasis on the time value of money recognizes that a dollar today is worth more than a dollar in the future due to its potential earning capacity. This principle underpins investment analysis, capital budgeting, and decision-making processes. By discounting future cash flows, managers accurately assess the true economic impact of their choices, ensuring resources are allocated efficiently, and that long-term profitability is maximized. Ignoring the time value could lead to rejecting investments with positive returns or accepting unprofitable ones, ultimately impairing the company's financial health.

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