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ACCA Applied Skills · Financial Management · Specific investment decisions (lease or buy, asset replacement, capital rationing)

Harlow Co has an existing machine that could be kept for one more year, with running costs of $14,000 payable at the end of the year. It could be sold now for $6,000 or for $4,000 at the end of the year. A new machine has an EAC of $18,000. The cost of capital is 10%. Expressed as a cost at the end of the year, which decision is correct, and what is the cost of keeping the old machine for the year?

Keep the old machine, because retaining it for another year costs $16,600, which is less than the new machine's EAC of $18,000. That cost is the running cost plus the forgone sale proceeds with interest, $6,600, less the later $4,000 sale value.

  1. AKeep the old machine; cost $16,600Correct
  2. BReplace now; cost $20,000
  3. CKeep the old machine; cost $14,000
  4. DReplace now; cost $24,600

Explanation

Keeping the old machine costs the $14,000 running cost plus the forgone sale proceeds of $6,000 compounded at 10% ($6,600), less the $4,000 later sale value: 14,000 + 6,600 − 4,000 = $16,600. This is below the new machine's EAC of $18,000, so keep the old machine for now. Ignoring the opportunity cost of the sale proceeds gives $14,000, which is wrong.

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