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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 4 %. The weighted-average cost of capital is 10%. When comparing the two options, the $50,000 trade-in allowance would be considered.