Now we will study the very important application of relevant costs. Namely, its in their influence on the decision of keeping or replacing the equipment. Now here we openly deal with the idea of sunk costs. And as you remember, from corporate finance and also from the discussion in this course, that sunk costs they occur in the past and you can not change them. So clearly sunk costs are always irrelevant. Because remember, relevance, this is the concept that deals with future alternatives, and does not deal with what happened in the past. Now I prepared, again, this table for you, so you can see that we are studying the following choice. So we have a machine that is still up and running, and this is the existing machine. So it was acquired some time ago, and we can see that actually that happened 3 years ago, it's current age. And it's useful life is 5 years, so it has 2 years to go. Now we use straight-line depreciation, so by over 3 years it has accumulated a depreciation of $720,000, all numbers here are in thousands. And therefore the book value, 480. And it can be sold right now at a small price of just 48,000 but well, it's better than nothing. And the whole idea of replacing stems from the fact that we see that annual operating costs for this machine is $960,000, which is quite high. Now we have an option to get rid of this machine and replace it with the other one. That has the cost of 720, so it's cheaper. It has an annual cost of just $550, almost half of what we have right now. The only problem is that this machine has a useful life of just 2 years. So after two years, we'll have to throw it away. So this is the set of inputs for the analysis of these machines. So we can see here these numbers for useful life, 5, 2. But the horizon of useful life remaining is the same, 2 years and 2 years. Here we have some numbers on our balance sheet. And the new machine are not yet acquired, so we do not have either book value or disposable price or whatever. Now if we sold the old machine right now, we would have an accounting loss of 432, why? Because the book value of the machine is 480, this is the original cost less accumulated depreciation. And we would sell it only at one-tenth of the price. So one sort of human idea here is that if you sold the machine, you would incur a loss over this year, and a significant loss. And no one is happy in showing losses. But now I would like to approach this, keeping in mind the idea of what is relevant and what is irrelevant. And here we have to analyze some important components. And those will be, first of all, book value of old machine. Then I'll put current disposal price. So this is 48, this is 480. Then 3, this is gain loss. So this is the notorious 432. And then, obviously, the cost of new machine. So, this is 720. Now let's analyze what is relevant and what is not. Well, let's start with relevant costs. Well, clearly current disposal, this a cash inflow, but this is relevant. Because in one case, if we don't sell the machine, we have nothing. If we do sell the old machine, we have $48,000 in cash. By the same token, if we buy a new machine, this outflow of 720 is also relevant. Because if we don't replace, we don't have to pay this amount. If we do, then we pay. However, the remaining two, they're irrelevant. Because book value of the old machine, why it's irrelevant? Because the machine was bought before. We cannot change this amount. By the same token, this gain and loss is also irrelevant because it's a combination of something irrelevant and something relevant. And unfortunately, you cannot make irrelevant things from one relevant and the other irrelevant. So strictly speaking, we can see that our analysis of relevant cost, we have to be more careful. And in order to do so, we will proceed, and we proceed to the following prepared table. We will analyze the choice over 2 years. Remember, 2 years is the useful life of both machines. It's the remaining useful life of the old one or the total useful life of the new one. And here we have two options, keep and replace, and then in red as always we put the difference. Now sales, this 2,700,000, I put just for reference because one thing is that regardless of which machine we use, we have the same sales. That's an assumption, but in this assumption, we just have a sort of built-in assumption that the capacity of both machines is enough to meet all the market demands for our products. So let's see what we have here. This line is important. This is cash operating cost. That that is 960 for two years and this is 550 for two years. Again, here for simplicity, we ignore discounting, because some of these costs they occur later, we ignore that altogether. Now comes the interesting part. So this is the old machine, it has a book value of 480. It can be either depreciated over 2 years if we keep it, or written off as a lump sum if we sell it. And the key story is that in this case, we depreciated and there's no lump sum write-off. If we replace, there is no depreciation, and lump sum write-off. So you can see that the combination of that has no difference. We don't care whether we write it off right now or in two installments of depreciation charges. Again, discounting is ignored here for simplicity. Now current disposal, like I said, this is occurs only in case of replacement. And contributes here and new machine, again, it's new machine if it's purchased. Yeah, this is a 720, and then it will be just depreciated over this period of time. So we can see how this goes. Now the key finding is that this situation is irrelevant. So you can see that our operating income is 300, indicates that we keep the old machine. And 448 indicates we replace that with a new machine. And the key story is that we save on cash operating costs. You can see that this is a huge saving of 820. So you can see that we save this amount. We also collect 48, and then the only outflow we have, this is for the new machine. So all other items are irrelevant. And the contribution of that is 148. So the decision based on relevant costs is to replace. Now here, this is summarized in this table. So we have keep, replace, and difference. And I put all of these relevant costs that I analyzed in the previous table, so you can see that the ones that I just mentioned. So we can see that there is only one relevant cost in the analysis of keeping the old machine. And three components in the analysis of buying the new ones. And the combined result is that we save $148 on these costs. So you can see now that it is the analysis of these relevant costs that completely ignores things like quoted losses or this we still have some book value equipment. This is not relevant to this choice. And therefore, we can see a close link to what we have in corporate finance. We can see that in making investment decisions, we have to keep in mind these relevant costs at the close link to the ideal that opportunity costs, that is key in validation. And at this time, we've found some additional support to that for the analysis of relevant costs in the way it is done in managerial accounting. While I'm wrapping up this week, it's also been quite long. Actually, all weeks in this course are quite long because we have to put together quite a few ideas and concepts. And we do not have that much ability to stretch this out. But for now, we are stopping here and I wish you all good luck with your assignments for this week. And I'll see you next week, which is the final for this course.
