CIMA P2 Syllabus B. Capital Investment Decision Making - Asset Replacement Decision - Notes 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):
Steps:
Calculate the PV of costs for all options
Then the EAC for each option
Then choose the option with the lowest EAC
Key Assumptions
Although the operating revenues are deemed to be the same, using an older asset may not be as efficient
The assets are replaced in perpetuity
Tax & Inflation ignored
Illustration
Machine Cost 20,000
Running costs
Year 1 5,000
Year 2 5,500Residual Value (if sold after..)
Year 1 16,000
Year 2 13,000Cost of capital = 10%
Solution
Replaced Every Year
0 | 1 | |
---|---|---|
Machine | (20,000) | |
Running Costs | (5,000) | |
Residual Value | 16,000 | |
(20,000) | 11,000 | |
Discount Factor | 1 | 0.909 |
Discounted Cashflows | (20,000) | 9,999 |
NPV (10,001)
EAC = 10,001 / 0.909 = 11,002
Replacing Every 2 Years
0 | 1 | 2 | |
---|---|---|---|
Machine | (20,000) | ||
Running Costs | (5,000) | (5,500) | |
Residual Value | 13,000 | ||
(20,000) | (5,000) | 7,500 | |
Discount Factor | 1 | 0.909 | 0.826 |
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