Dear Ozge,
Thanks for posting this question.
Option one: Total initial investment is = Investment - trade in allowance = $1,000,000 - $50,000 = $950,000/- only.
Also note, this is the amount that will be used for depreciation i.e.. $950,000 / 5 years = $190,000/- per year for NPV workings.
So, $50,000 reduces our cash outflow and it is relevant.
Option two: does not have trade in allowance and there is no cash outflow reduction.
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Ganesan Sivalingam
Accountant
Sharqiyah Desalination Co SAOG
Muscat
Oman
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Original Message:
Sent: 05-04-2014 08:10 AM
From: Ozge Yagcioglu
Subject: question part 2
I could not understand waht the question is?
Could you please help me?
Thnanks,
Özge
| Verla Industries is trying to decide which one of the following two options to pursue. Either option will take effect on January 1st of the next year. Option One -- Acquire a New Finishing Machine The cost of the machine is $1,000,000 and will have a useful life of 5 years. Net pre-tax cash flows arising from savings in labor costs will amount to $100,000 per year for 5 years. Depreciation expense will be calculated using the straight-line method for both financial and tax reporting purposes. As an incentive to purchase, Verla will receive a trade-in allowance of $50,000 on its current fully depreciated finishing machine. Option Two -- Outsource the Finishing Work Verla can outsource the work to LM, Inc., at a cost of $200,000 per year for 5 years. If it outsources, Verla will scrap its current fully depreciated finishing machine. Verla's effective income tax rate is 40%. The weighted-average cost of capital is 10%. When comparing the two options, the $50,000 trade-in allowance would be considered. |
| | | | | | | | Answer (C) is correct.
To be relevant to a decision, an inflow or outflow must (1) take place in the future (i.e., not be a sunk cost) and (2) vary between alternatives. Since the trade-in allowance will be received in the future and since it is only associated with Option One, it is relevant to the decision. | | | |