Chapter 7, Problem 7.1BYP

Decision-Making Across the Organization

Aurora Company is considering the purchase of a new machine. The invoice price of the machine a $140,000, freight charges are estimated to be $4,000, and installation costs are expected to be $6,000. Salvage value of the new equipment is expected to be zero after a useful life of 5 years. Existing equipment could be retained and used for an additional 5 years if the new machine is not purchased. At that time, the salvage value of the equipment would be zero. If the new machine is purchased now, the existing machine would have to be scrapped. Auroras accountant, Lisah Huang, has accumulated the following data regarding annual sales and expenses with and without the new machine.

1. Without the new machine. Aurora car sell 12,000 units of product annually at a per unit selling price of $100. If the new machine is purchased, the number of units produced and sold would increase by 10%, and the selling price would remain the same.

2. The new machine is faster than the old machine, and it is more efficient in its usage of materials. With the old machine the gross profit rate will be 25% of sales, whereas the rate will be 30% of sales with the new machine.

3. Annual selling expenses are $180,000 with the current equipment. Because the new equipment would produce a greater number of units to be sold, annual selling expenses are expected to increase by 10% if it is purchased.

4. Annual administrative expenses are expected to be $100,000 with the old machine, and $113,000 with the new machine.

5. The current book value of the existing machine is $36,000. Aurora uses straight-line depreciation.

Instructions

With the class divided into groups, prepare an incremental analysis for the 5 years showing whether Aurora should keep the existing machine or buy the new machine. (Ignore income tax effects.)