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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Differential analysis involving opportunity costs

On July 1, Coastal Distribution Company is considering leasing a building and buying the necessary equipment to operate a public warehouse. Alternatively, the company could use the funds to invest in $740,000 of 5% U.S. Treasury bonds that mature in 14 years. The bonds could be purchased at face value. The following data have been assembled:

Cost of equipment $740,000
Life of equipment 14 years
Estimated residual value of equipment $75,000
Yearly costs to operate the warehouse, excluding depreciation of equipment $ 175,000
Yearly expected revenues—years 1 -7 $280,000
Yearly expected revenues—years 8-14 $240,000

Instructions

1.    Prepare a differential analysis as of July 1 presenting the proposed operation of the warehouse for the 14 years (Alternative 1) as compared with investing in U.S. Treasury bonds (Alternative 2).

2.    Based on the results disclosed by the differential analysis, should the proposal be accepted?

3.    If the proposal is accepted, what is the total estimated income from operations of the warehouse for the 14 years?

a)

To determine

Opportunity Cost: Opportunity cost refers to the forgone revenue which could have been generated through an alternative use of the assets.

Differential Analysis: Differential analysis refers to the analysis of differential revenue that could be gained or differential cost that could be incurred from the available alternative options of business

To Prepare: The differential analysis of Company CD as on July 1, for given alternatives.

Explanation

The differential analysis of Company CD as on July 1, for given alternatives is shown below.

Differential Analysis of Company CD
Operate Warehouse  (Alt. 1) or Invest in Bonds (Alt. 2)
July 1
Operate Warehouse     (Alternative 1) Invest in Bonds  (Alternative 2) Differential effect on income
Revenues (1)  $3,640,000 (2)  $518,000 (-)  $3,122,000
Costs
   Cost to operate the warehouse (3)  (-)  $2,450,000 $0 $2,450,000

   Cost of equipment less              

   residual value

(4)  (-)  $665,000 $0 $665,000
Income (loss) $525,000 $518,000 (-)  $7,000

Table (1)

Differential analysis of Company CD as on July 1, shows that operating a warehouse yeilds a greater income of $7,000 over the period of 14 years than the investment in bonds.

Working Notes:

Calculate the revenues from operating the warehouse for 14 years.

Revenues from operatingthe warehouse}=($280,000×7)+($240,000×7)=$1,960,000+$1,680,000=$3,640,000

(1)

Calculate the revenues from investing in bonds for 14 years

b)

To determine

To Deicide: The proposal to be accepted on the basis of differential analysis.

c)

To determine

To Calculate: The total estimated income from the operation of warehouse for 14 years.

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