Brooke Russell, Executive Director of Yoland Research Institute, was contemplating a proposal submitted to her by Dr. Russ Roberts, the head of the Nutrition Studies Department. Dr. Roberts' request was for the purchase of new equipment to perform operations currently being performed on different, less efficient equipment. The purchase price was $150,000 delivered and installed.
Yoland Research Institute was a nonprofit, university-affiliated organization, specializing in research in a wide variety of fields. In large part, its activities were determined by a combination of the faculty affiliated with it and their research interests, although most of its projects tended to be of a basic, rather than applied, nature. As such, it was constantly involved in projects that were attempting to advance the state of the art in the particular field of investigation. One such area was nutrition, where much of the work required sophisticated equipment. Sometimes the purchase of this equipment was funded by a particular research grant or contract.
DR. ROBERTS’ REQUEST
Dr. Roberts had worked closely with the equipment manufacturer to determine the potential benefits of the new equipment, and estimated that it would result in annual savings to the Institute of $30,000 in labor and other direct costs, as compared with the present equipment. He also estimated that the proposed equipment's economic life was 10 years, with zero salvage value.
In the case of this request, no grant or contract funds were available, and hence Yoland would need to finance the cost of the new equipment itself. The Institute had recently borrowed long-term to finance some other projects, and Ms. Russell was certain that it could obtain additional funds at 12 percent, although she would not plan to negotiate a loan specifically for the purchase of this equipment. She did feel, however, that an investment of this type should have a return of at least 20 percent, even though the Institute paid no taxes.
There were several complications associated with Dr. Roberts’ request. The first was that, although the present equipment was in good working order and would probably last, physically, for at least 20 more years, it was being depreciated at a straight-line rate of 10 percent per year. As such, it had a book value of $72,000 (cost $120,000; accumulated depreciation, $48,000). It had no resale value, however. Dr. Roberts thought the Institute would be able to find someone to remove it at no charge, but that was about all.
The second complication was that Dr. Roberts’ proposal had arrived on the same day as a proposal from Dr. Sharon Kim in the Sanitary Engineering Department. Two years ago, the Institute had approved a proposal from Dr. Kim involving the same economic life and dollar amounts as Dr. Roberts’ proposal. Dr. Kim’s new proposal was for what she termed even better equipment . . .
- What is your response to the argument made by the board member concerning the appropriate discount rate to use? If not 5 percent, what figure would you use?
- Should the Institute buy the proposed equipment for Dr. Roberts? For Dr. Kim?
- If the Institute decides to purchase the new equipment for Dr. Kim, a mistake apparently has been made somewhere, because good equipment, bought only two years previously, is being scrapped. How did this mistake come about? What might be done to avoid similar mistakes in the future?