Replacement Decisions

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., computers) 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 Analysis • 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 • 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).

Terminology • Defender – The existing asset • Challenger(s) – Currently available replacement alternatives • 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 defender.

DEFENDER DIAGRAM: Salvage 1 2 3 n = Lifetime 0 Overhaul Cost Operating Cost Fair Mkt. Value Overhaul Cost Maintenance Cost 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)

Valuing the Defender • Biggest problem in reality! • Priority Order: (& information sources) • Market Value • Independent Audit • Want Ads in paper/trade magazine • Selling/Asking price at auction • 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 • 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 annually. 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 five-year 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 choice?

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?

Replacement Decisions