Frank Moran manages the cutting department of Greene Timber Company. He purchased a tree-cutting machine on January 1, year 2, for $200,000. The machine had an estimated useful life of five years and zero salvage value, and the cost to operate it is $45,000 per year. T

Frank Moran manages the cutting department of Greene Timber Company. He purchased a tree-cutting machine on January 1, year 2, for $200,000. The machine had an estimated useful life of five years and zero salvage value, and the cost to operate it is $45,000 per year. Technological developments resulted in the development of a more advanced machine available for purchase on January 1, year 3, that would allow a 25 percent reduction in operating costs. The new machine would cost $120,000 and have a four-year useful life and zero salvage value. The current market value of the old machine on January 1, year 3, is $100,000, and its book value is $160,000 on that date. Straight-line depreciation is used for both machines. The company expects to generate $112,000 of revenue per year from the use of either machine.

Required

1. Recommend whether to replace the old machine on January 1, year 3.
   
2. Prepare income statements for four years (year 3 through year 6) assuming that the old machine is retained.
   
3. Prepare income statements for four years (year 3 through year 6) assuming that the old machine is replaced.
   

Explanation

a.
The historical cost of the old machine is a sunk cost and therefore is irrelevant. The relevant (avoidable) costs for each alternative are shown below:

Decision	Keep Old			Replace With New
Opportunity cost of old machine	$	100,000
Purchase price of the new machine				$	120,000
Operating expense		180,000			135,000
Total avoidable costs	$	280,000		$	255,000

Operating expense of old $45,000 × 4 years = $180,000.
Operating expense of new $180,000 × 0.75 = $135,000.

The analysis suggests that the old machine should be replaced because Greene Timber Company would minimize avoidable cost with this decision.

c.
*$100,000 Market value − $160,000 Book value = $60,000 Loss

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