Definition of Replacement Analysis
Replacement analysis is one of the crucial analysis in capital budgeting. An asset life may be reduced due to physical impairment, changes in economic requirements and rapid changes in technology that may obsolete an assets prior to expectation. The replacement of assets offer economic opportunity for the firm. In replacement analysis there is two alternatives:
- The assets that are currently using : The defender
- The assets that we have to buy to replace current assets : The challenger
Factors to be Considered
- Sunk costs to be ignored
- Existing asset value need not be considered
- Income tax to be avoided
- The optimal replacement cycle is one which has lowest equivalent annual cost
- The replacement decision will apply indefinitely.
- Economic life of the challenger and the defender should not consider
Worked Example
A machine costs CU 20,000 and it can be replaced every year or every two years. Delaying the replacement causes the running costs to increase and the scrap proceeds to decrease as follows:
| Year | Running Costs | Sales Proceeds |
| 1 | 5,000 | 16,000 |
| 2 | 5,500 | 13,000 |
Company’s cost of capital is 10%
Requirement: Should the machine be replaced every one or two years?
Solution:
Replacement after two years:
| Time | Narrative | Cash Flows | DCF @ 10% | Present Value |
| 0 | Purchase | (20,000) | 1.00 | (20,000) |
| 1 | Running Costs | (5,000) | .909 | (4,545) |
| 2 | Running Costs | (5,500) | .826 | (4,543) |
| 2 | Scrap Proceeds | 13,000 | .826 | 10,738 |
| Net Present Value | (18,350) |
Annual Equivalent Cost (EAC) = 18,350/1.736 (.909+.826) = CU 10,570
Replace after one years:
| Time | Narrative | Cash Flow | DCF @ 10% | Present Value |
| 0 | Purchase | (20,000) | 1.000 | (20,000) |
| 1 | Running Costs | (5,000) | .909 | (4,545) |
| 1 | Scrap Proceeds | 16,000 | .909 | 14,544 |
| NPV | (10,001) |
Annual Equivalent Cost (EAC) = 10,001/.909 = 11,002
Summary of Above two options are as follows:
| EAC (Annual Equivalent Costs after one Year) | $ 11,002 | |
| EAC (Annual Equivalent Cost after two Year) | $ 10,570 | Lowest One |
Hence, the Machine to be replaced after two years because it has lowest EAC.
Limitations of Replacement Analysis
This method assumes that a firm is continually replacing , and therefore determines a once- and-for-all optimal replacement cycle. In practice this is unlikely to be valid due to:
- Changing technology, which can quickly make machines obsolete and shorten replacement cycles. This means that one asset is not being replaced by one exactly similar
- Inflation, which by altering the cost structure of assets means that the optimal replacement cycle can vary over time
- If inflation affects all variables equally it is best excluded from the analysis by discounting real cash flows at a real interest rate – the optimal replacement cycle will remain valid
- Differential inflation rates mean that the optimal replacement cycle varies over time
- The effects of taxation (ignored in the analysis but they could be incorporated)
- The fact that production is unlikely to continue in perpetuity
Conclusions
A business needs to know how often to replace such assets. Replacing after a long time means not replacing as often, so delaying the cost of a new replacement machine. However this invariably means keeping an asset whose value is declining and which costs more to maintain. These costs and benefits need to be balanced