CAPITAL BUDGETING
Tan-talize, Inc.
(Sunk Costs)
On January 2nd, Tan-talize, Inc. installed a brand new special molding machine for producing a new line of
suntan products. The machine had a cash cost of $40,500 and is to be depreciated using the 3-year column of the
MACRS table. The machine has an expected life of four years and a disposal value of zero at the end of four
years.
On January 3rd, Art Taitt, a salesman for Los Angeles Machine Tool Company, called on Glynda Miller,
production manager of Tan-talize. During the course of their conversation, Mr. Taitt told Ms. Miller: “I wish I
had known earlier of your purchase plans. Our company can supply you with a technically superior machine for
$50,000. The old machine has a salvage value of $8,000 today. I can guarantee that our machine will save you
$17,000 per year in cash operating costs, although it too will have no disposal value at the end of four years.”
Mr. Taitt provided some technical data for Ms. Miller to examine. Although she had confidence in Mr. Taitt’s
data, Ms. Miller contended: “I’m locked into my previous decision. My alternatives are clear. Disposal will
result in a loss on the present machine. Moreover, keeping and using the present equipment avoids such a loss. I
have enough sense to avoid a loss when my only other alternative is to recognize a loss. I have to use the present
equipment until I can get my money out of it.”
Assume that income tax rates are 35% on ordinary income. The minimum desired rate of return, after taxes, is
12%.
QUESTIONS
1. Using the net present value approach, should the proposed equipment be purchased?
2. Comment on the reasoning of Ms. Miller.
