CHAPTER 9
REPLACEMENT
ANALYSIS
REPLACEMENT ANALYSIS
The evaluation of changes in
economics of assets associated with
their use in an operating
environment.
Considers asset
• replacement
• retirement
• augmentation
REASONS FOR
REPLACEMENT ANALYSIS
•
•
•
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Physical Impairment (Deterioration)
Altered Requirements
Technology
Financing
PHYSICAL IMPAIRMENT
(DETERIORATION)
• Efficiency loss resulting from continued
use -- aging
• Increased routine and corrective
maintenance costs
• Greater energy requirements
• Increased need for operator intervention
• Unanticipated problems leading to
equipment deterioration
ALTERED REQUIREMENTS
• Significant change in demand for
related products or services
• Significant change in the
composition or design of associated
products or services
• May be considered a form of
obsolescence
TECHNOLOGY
• Impact of technological change
varies with associated industry
• Technological changes typically
reduce cost per unit and improve
quality of output
• Results in earlier replacement of
existing assets with improved assets
• May be considered a form of
obsolescence
FINANCING
• Considers economic opportunity
changes external to the physical
operation or use of the asset(s)
• May involve income tax
considerations (depreciation and
after-tax analysis)
– EG: rental of assets may become more
attractive than ownership
• May be considered a form of
obsolescence
ECONOMIC LIFE
• The period of time (years) that results in the
minimum Equivalent Uniform Annual Cost
(EUAC) of owning and operating an asset
• EUAC is a term sometimes used to identify the
annual worth of a primarily cost cash flow
pattern
• Assuming good asset management, economic
life should coincide with time from date of
acquisition to date of abandonment, demotion
in use, or replacement from primary intended
service
ECONOMIC LIFE
• Sometimes called minimum-cost life
or optimum replacement interval
• For a new asset, economic life can
be computed if capital investment,
annual expenses, and year-by-year
market values are known or can be
estimated
OWNERSHIP LIFE
• Period between date of acquisition
and date of disposal by a specific
owner
• A given asset may have different
categories of use during this period
PHYSICAL LIFE
• Period of time between
original acquisition and final
disposal of an asset over its
succession of owners
USEFUL LIFE
• The time period in years that an
asset is kept in productive service
either in primary or backup mode
• An estimate of how long an asset is
expected to be used in a trade or
business to produce income
REPLACEMENT STUDY
CONSIDERATIONS
1. Recognition and acceptance of past errors
2. Sunk costs
3. Existing asset value and the outsider viewpoint
4. Income tax considerations
5. Economic life of the proposed replacement
(Challenger)
6. Remaining (economic) life of the old asset
(defender)
PAST ESTIMATION ERRORS
• Past estimation errors are irrelevant
unless there are income tax implications
i.e., when BV > current MV, frequently
attributed to estimation error, while may
be due to inadequate capacity or higher
than expected maintenance costs
• Must focus on valid estimation of future
replacement, without consideration of
loss which may have occurred in past
THE SUNK COST TRAP
• Only present and future cash flows should be
considered in replacement studies
• Unamortized values of existing asset
considered for replacement are the result of
past decisions -- (Sunk costs = BV - MV)
• Sunk costs are irrelevant to replacement
decisions, except to extent they affect income
taxes
• When tax considerations are involved, sunk
costs must be included in study
EXISTING ASSET INVESTMENT
VALUE -- AN OUSIDER VIEWPOINT
• Perspective of impartial third party in
establishing fair market value (MV) of
your used asset
• Present realizable MV modified by
appropriate income tax effects defines
correct investment amount for asset in
replacement studies
• Consider the opportunity cost of
retaining the asset -- the defender
THE OUTSIDER VIEWPOINT
The total investment in the
defender is the opportunity cost
of not selling the existing asset
for its current MV, plus the cost
of upgrading to be competitive
with best available challenger
INCOME TAX CONSEQUENCES
• Replacement of assets often result in
gains or losses from sale of land or
depreciable property
• Studies must be made on an after-tax
basis
• Prospective gain from asset disposal
can be reduced by as much as 40% or
50% as a result of taxes
ECONOMIC LIFE OF THE CHALLENGER
• Economic life of an asset minimizes
equivalent uniform annual cost of owning
and operating an asset
• Economic life is often shorter than useful
or physical life
• Economic data regarding challengers are
periodically (often annually) updated
• Replacement studies then repeated to
ensure most up-to-date evaluation
ECONOMIC LIFE OF DEFENDER
• Often one year
• Because different lives are involved, care
should be taken when comparing
defender with challenger
• Defender should be kept longer than
apparent economic life as long as its
marginal cost < minimum equivalent
uniform annual cost of challenger over
its economic life
USEFUL LIFE(S) OF DEFENDER AND /
OR CHALLENGER INESTIMABLE
When useful life of defender or
challenger is unknown and can’t be
reasonably estimated, must rely on:
• economic life
• minimum EUAC
• total year-by-year marginal costs
for defender and best alternative
challenger
BEFORE-TAX ANALYSIS
Determining Present worth of total costs
PWk ( i%) = I - MVk (P / F, i%,k) + Sk Ej (P / F, i%, j)
j=1
Sum of
• PW of initial capital investments occurring after
time 0
• PW of MV at end of year k
• PW of annual expenses through year k
BEFORE-TAX ANALYSIS
Determining Present Worth of Marginal
Costs
• Marginal cost is the difference in present
worth of total cost for year ‘k’ minus the
present worth of total cost for year ‘k - 1’
• Total amount of this marginal cost is
found by:
TCk(i%) = (PWk - PWk-1) (F / P, i%,k)
BEFORE-TAX ANALYSIS
Determining Present Worth of Marginal Costs
• Simplification of Total calculation of marginal
cost
TCk(i%) = MVk-1 - MVk + iMVk-1 + Ek
This is the sum of:
• the loss in MV during year of extended service
• the opportunity cost of capital invested in the
asset at the beginning of year ‘k’
• the annual expenses incurred in year ‘k’
BEFORE-TAX ANALYSIS
• The total marginal (Year-by-year) costs
are used to find the EUAC through
each year ‘K’
• The minimum EUACk value during the
useful life of the asset, determines its
before-tax economic life
• Before-tax economic life = N*
AFTER-TAX ANALYSIS
• Extending the Before-Tax Analysis equation to
account for income tax effects:
PWk(i%) = I + Sk [ ( 1 - t ) Ej - tdj ] ( P / F, i%, j ) j=1
[ ( 1 - t )MVk + t ( BVk ) ] ( P / F, i%, k)
Equation finds PW of ATCF through year k by:
• adding initial capital investment and sum of
after-tax PW of annual expenses through year
k, including adjustments for annual
depreciation amounts
• adjusting the total after-tax PW of costs by the
after-tax consequences of gain or loss on
disposal of asset at end of year k
AFTER-TAX ANALYSIS
Determining Present Worth of Marginal Costs
Total amount of this after-tax marginal cost:
TCk = ( PWk - PWk-1 ) ( F / P, i%, k )
Simplifying
TCk (i%) = (1 - t)(MVk-1 - MVk + iMVk-1 + Ek) + i (t)(BVk-1)
The economic life of the asset on an after-tax basis
is N*AT
DETERMINING THE ECONOMIC
LIFE OF A DEFENDER
• When major outlay for alteration or overhaul is
required, the life that will yield least EUAC is
likely time to next alteration or overhaul
• When defender MV is 0 and operating expenses
expected to increase annually, the remaining life
that will yield least EUAC will be 1 year
• When MVs are greater than 0 and expected to
decline from year to year, calculate remaining
economic life in same manner as for before-tax
analysis
• By using outsider viewpoint, the present
realizable MV is considered its investment value
RETENTION OF THE
DEFENDER
The defender should be kept longer
than the apparent economic life of
the defender as long as its marginal
cost (total cost for an additional year
of service) is less than the minimum
EUAC for the best alternative
challenger
COMPARING DEFENDERS AND
CHALLENGERS WITH DIFFERENT
USEFUL LIVES
• Requires use of the repeatability or
coterminated assumptions
• Normally, the second stipulation of the
repeatability assumption can not be met for
the (older and used) defender
• Failure to meet this stipulation may be
circumvented if period of needed service is
indefinitely long and purpose of analysis is
simply to determine timing of defender
replacement
PROJECT RETIREMENT WITHOUT
REPLACEMENT -- ABANDONMENT
Two assumptions apply:
• Once capital investment made, firm desires to
postpone project abandonment as long as its
present equivalent value (PW) is not
decreasing
• The project will be terminated at the best
abandonment time and will not be replaced by
the firm