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MANAGEMENT AND ACCOUNTING WEB |
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Moving Baseline Examples From Sinason* Summaries by James R. Martin |
Sinason provides two examples to illustrate the moving baseline concept.
Example 1: Equipment Replacement
|
Data for Existing Equipment |
Year X0 (Present) | Year X1 | Year X2 | Year X3 |
| Estimated average units production per hour | 90 | 87 | 84 | 83 |
| Required production to meet demand | 81 | 84 | 87 | 93 |
| Machine age in years | 2 | 3 | 4 | 5 |
| Class estimated by engineering | 3 | 3 | 4 | 5 |
| Maintenance costs estimated | $1,500 | $1,500 | $2,000 | $3,000 |
| Overtime required per week to meet demand = (Production requirements ÷ Estimated production)(40 hours) |
0 | 0 | 1.43 | 4.82 |
| Overtime cost based on ($50 per hour)(Hours per week)(52 weeks) |
0 | 0 | $3,718 | $12,532 |
| Incremental cost, i.e., cost in addition to current operating costs for maintenance and overtime. | $1,500 | $1,500 | $5,718 | $15,532 |
| Data for New Equipment | Year X0 (Present) | Year X1 | Year X2 | Year X3 |
| Estimated incremental cash flows, i.e., savings compared to old equipment. | $5,000 | $10,000 | $15,000 | $25,000 |
| Cost of new equipment | $60,000 | |||
| Salvage value of old equipment | 0 | |||
| Cost of non-investment, i.e., or cost avoided if the new equipment is purchased. | $1,500 | $1,500 | $5,718 | $15,532 |
| Combined cash flow | (53,500) | 11,500 | 20,718 | 40,532 |
| Conventional Present Value Analysis | |||
|
Year |
Cash Flow | Discount Factor (8% Cost of Capital) |
Discounted Cash Flow |
|
0 |
$(55,000) | 1.000 | $(55,000) |
| 1 | 10,000 | .9259 | 9,259 |
| 2 | 15,000 | .8573 | 12,859 |
| 3 | 25,000 | .7938 | 19,845 |
| NPV | $(13,037) | ||
Conclusion based on conventional analysis: Do not invest in the new equipment since the cost of non-investment is not recognized.
| Moving Baseline Present Value Analysis | |||
|
Year |
Cash Flow | Discount Factor | Discounted Cash Flow |
|
0 |
$(53,500) | 1.000 | $(53,500) |
| 1 | 11,500 | .9259 | 10,648 |
| 2 | 20,718 | .8573 | 17,761 |
| 3 | 40,532 | .7938 | 32,174 |
| NPV | $7,083 | ||
Conclusion based on moving baseline analysis: Invest in the new equipment. The difference results from recognizing the cost of non-investment.
Example 2: Investment in New Technology
| Data | Year X0 (Present) | Year X1 | Year X2 | Year X3 |
| Present market share projections
without the investment in the new technology. |
20% | 19.9% | 19.5% | 19.0% |
| Revenue projections without the investment in the new technology. |
$1,000,000 | $995,000 | $975,000 | $950,000 |
| Decrease in cash flow from declining market share if investment is not made. |
0 | $5,000 | $25,000 | $50,000 |
| Cash flow from investment. | $(250,000) | $(20,000) | $80,000 | $190,000 |
| Combined cash flow. | $(250,000) | $(15,000) | $105,000 | $240,000 |
| Conventional Present Value Analysis | |||
|
Year |
Cash Flow | Discount Factor (8% Cost of Capital) |
Discounted Cash Flow |
|
0 |
$(250,000) | 1.000 | $(250,000) |
| 1 | (20,000) | .9259 | (18,518) |
| 2 | 80,000 | .8573 | 68,534 |
| 3 | 190,000 | .7938 | 150,822 |
| NPV | $(49,162) | ||
Conclusion based on conventional analysis: Do not invest in the new technology since the decreases in cash flows caused by the declining market share are not recognized.
| Moving Baseline Present Value Analysis | |||
|
Year |
Cash Flow | Discount Factor (8% Cost of Capital) |
Discounted Cash Flow |
|
0 |
$(250,000) | 1.000 | $(250,000) |
| 1 | (15,000) | .9259 | (13,888) |
| 2 | 105,000 | .8573 | 90,017 |
| 3 | 240,000 | .7938 | 190,512 |
| NPV | $16,641 | ||
Conclusion based on moving baseline analysis: Invest in the new technology after recognizing the decreases in cash flows caused by the declining market share if the investment is not made.
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* Sinason, D. H. 1991. A dynamic model for present value capital expenditure analysis. Journal of Cost Management (Spring): 40-45. (Summary).
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