Download Lecture 13: Replacement Decisions Introduction

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Replacement Decisions
• How should an asset be replaced?
• If an asset can be overhauled and
used a little longer, should those
funds be invested in the overhaul
or should we buy a new machine?
• Over a given study period, when
should I replace an asset?
Reasons for Replacement
Inadequacy – Doesn’t meet needs,
increased demand. May buy a duplicate
or replace with a larger asset.
Obsolescence – Technological changes,
better equipment is available (e.g.,
Economic Life – An asset at the end of its
economic life.
Deterioration – there is just not enough duct
tape in the world to keep it going longer.
The question is: when to replace the asset?
Asset Life Terminology
Economic Service Life – For on-going need.
How long an asset is used to minimize
equivalent annual cost.
Physical Life – How long an asset can be
kept alive (performing services).
Ownership Life – How long an asset is
actually kept before selling / disposing.
Accounting Life – For tax purposes, mostly.
Defined by law, GAAP. May not
correspond to physical, ownership, or
economic service life.
Asset Value Terminology
Market Value – What can I sell the
asset for at a point in time?
Salvage Costs – Expenses to prepare
an asset for sale.
Trade-In Value – What a vendor will
offer for the old asset, if you buy
their product. This is frequently
more than the market value.
Book Value – For tax purposes, mostly.
Book Value = Original Cost – Sum of Depreciation.
Basics of Replacement
1. Relevant costs ONLY. Do not include costs
that are common to all of the alternatives.
They just clutter the analysis.
Example: Paper for a copier
2. Sunk costs are NOT included. It only
matters what an asset is worth today.
What you originally paid for it is immaterial
(except for tax purposes).
• Defender – The existing asset
• Challenger(s) – Currently
available replacement
We will create cash flow
diagrams for both the
Defender and the Challenger
Outsider’s Perspective
We take the perspective of an outsider.
In order to use the defender, the
outsider would have to purchase it.
Thus, the best estimate of the current
value of the existing equipment will be
used as a “fair market value” for the
Opportunity Cost Approach
The fair market value of the defender will be
treated as a cost to retain the defender
(this is the opportunity cost that is foregone by
retaining the defender)
n = Lifetime
Overhaul Cost
Operating Cost
Fair Mkt. Value
Overhaul Cost
Maintenance Cost
Valuing the Defender
Biggest problem in reality!
Priority Order:
(& information sources)
1. Market Value
• Independent Audit
• Want Ads in paper/trade magazine
• Selling/Asking price at auction
2. Trade-In Value
• Must subtract difference with MV from
Challenger 1st cost if trade-in is excessive
• Can shop around to different vendors
• “Blue Book” price
• Bank / Savings & Loan estimate
3. Book Value
• Prefer Book depreciation to MACRS value
Example 1
ACME Company purchased a new piece of equipment three
years ago for $25,000. The machine was expected to last six
years and have no salvage value. Book value is now $12,000.
Operational costs associated with the equipment total $8,000
Demand for ACME’s product has now doubled and the
purchase of an additional machine is contemplated. A machine
similar to the existing machine (same capacity) and with a fiveyear economic life would now cost $35,000 and have operating
costs of $7,000 annually with no salvage value. The existing
equipment could be overhauled now at a cost of $20,000 which
would extend its life for an additional 2 years with no change in
operating costs.
Klinker Mfg. has offered ACME $15,000 for the existing
machine toward the purchase of a $65,000 unit with double the
current capacity. The new equipment would have annual
operating costs of $14,000 and an expected salvage value of
$10,000 at the end of five years. Using an interest rate of 18%
per year, compounded annually, determine what ACME should
do to meet their increased capacity needs.
Opportunity Cost Approach
What is the EAC of the challenger and
defender, and which system is the better
Example 2
A small retail business is housed in a structure built 10
years ago and heated by a central gas furnace. Current
heating costs average $500 per month and the furnace is in
need of an overhaul, including replacement of the fan motor
and filter system. Cost of this work, which is expected to be
$1,600, will improve the efficiency by approximately 10%.
The furnace could also be replaced by either of two units.
The first is a modified version of the current system, which
would cost $4,200 and is expected to reduce energy costs by
25%. The second is a pulsejet system costing $7,000 and
providing a 35% savings.
All three systems would be expected to last 10 years with
no maintenance costs other than routine cleaning and filter
replacement. At the end of that time, the current system
would have no salvage value and either new system would
probably be worth about 20% of the purchase price.
The current system has a market value of $500. Interest
runs 12%, compounded annually.
Opportunity Cost Approach
Which is the best of the challenger systems?
Opportunity Cost Approach
What is the EAC of the defender, and which
system is the better choice?