Asset Replacement Decision 10 / 11

Assets will need replacing but how often is best?

The different options open to us have different time scales so, in order to compare, we use an EAC (equivalent annual cost):

1

Steps:

  1. Calculate the PV of costs for all options

  2. Then the EAC for each option

  3. Then choose the option with the lowest EAC

Key Assumptions

  1. Although the operating revenues are deemed to be the same, using an older asset may not be as efficient

  2. The assets are replaced in perpetuity

  3. Tax & Inflation ignored

Illustration

  • Machine Cost 20,000

    Running costs
    Year 1 5,000
    Year 2 5,500

    Residual Value (if sold after..)
    Year 1 16,000
    Year 2 13,000

    Cost of capital = 10%

Solution

  • Replaced Every Year

 01
Machine(20,000) 
Running Costs (5,000)
Residual Value 16,000
 (20,000)11,000
Discount Factor10.909
Discounted Cashflows(20,000)9,999

NPV (10,001)

EAC = 10,001 / 0.909 = 11,002

  • Replacing Every 2 Years

 012
Machine(20,000)  
Running Costs (5,000)(5,500)
Residual Value  13,000
 (20,000)(5,000)7,500
Discount Factor10.9090.826
Discounted Cashflows(20,000)(4,545)6,195

NPV (18,350)
EAC = 18,350 / 1.736 = 10,570

Machine should be replaced every 2 years as this is cheaper

Limitations of replacement analysis

  • It ignores changes in the production plan

  • It ignores the fact that inflation changes the cost structure of equipment, therefore the optimal replacement cycle can vary over time

  • It ignores the fact that due to changing technology, machines become obsolete frequently

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