I’m struggling to understand the concept of working out the relevant cost of an asset. My BPP book simply shows a “higher of, lower of” diagram, without explaining how it works. I’ll give the question I’m stuck on.
A machine cost $14,000 ten years ago. It is expected that the machine will generate future revenues of $10,000. Alternatively, the machine could be scrapped for $8,000. An equivalent machine in the same condition would cost $9,000 to buy now. What is the deprival value of the machine?
I understand that the $14,000 is a sunk cost, and is irrelevant. Therefore, if the machine was kept, would the cost be – $10,000 + $8,000 = – $2000? However, in that case, would it not be possible to still sell it as scrap afterwards?
The alternative would be to buy a new one. In that case, am I right in saying the cost would be $9,000 – $8,000 = $1,000?
The answer given in my book says “the deprival value of the machine is the lower of the replacement cost and £10,000. The deprival value is therefore $9,000. I’m afraid I can’t draw the diagram here, but it is on page 351 of the BPP book if you have it.
I would be very grateful if someone could explain how this works please, and also how the diagram works.
Thanks a lot.
I meant to post this in the F2 forum, but feel free to reply if you can help me!
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