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REPLACEMENT1

The document discusses various methods for evaluating equipment replacement including: 1. Total Life Average Method - Compares total costs over lifetime to determine if proposed equipment has lower average annual cost. 2. Annual Cost Method - Calculates annual capital recovery cost and operating costs to compare annual costs of different equipment. 3. Present Worth Method - Discounts all cash flows to present value to compare net present costs of alternatives. 4. Rate of Return Method - Calculates rate of return based on net operating benefits to determine if return meets requirements. 5. MAPI Method - Developed by George Terborgh, it compares "adverse minimum" costs of defender and challenger equipment accounting for deterioration and obsole

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103 views51 pages

REPLACEMENT1

The document discusses various methods for evaluating equipment replacement including: 1. Total Life Average Method - Compares total costs over lifetime to determine if proposed equipment has lower average annual cost. 2. Annual Cost Method - Calculates annual capital recovery cost and operating costs to compare annual costs of different equipment. 3. Present Worth Method - Discounts all cash flows to present value to compare net present costs of alternatives. 4. Rate of Return Method - Calculates rate of return based on net operating benefits to determine if return meets requirements. 5. MAPI Method - Developed by George Terborgh, it compares "adverse minimum" costs of defender and challenger equipment accounting for deterioration and obsole

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Ramees Kp
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Module - II

Replacement
Module 2
• Replacement of equipments- Method of
providing for depreciation- Determination of
economic life - Simple problems
Replacement
ECONOMIC REALITY OF VEHICLE
REPLACEMENT

TOTAL
COST

OPERATING CAPITAL

*TIME/USAGE *
Reasons for replacement
• Deterioration
• Obsolescence
• Inadequacy
• Working conditions
FACTORS TO BE CONSIDERED
• Technical Factors and
• Financial Factors
Replacement – Technical Factors
Replacement – Technical Factors
Replacement – Financial Factors
Replacement – Analysis Methods
1. Total Life Average Method
1. Total Life Average Method
Interest calculated as follows
• Existing equipment depreciates @ Rs. 1000 /
year and hence interest is :

• Proposed equipment is costing Rs. 10,000 and


after 9 years its scrap value will be only Rs. 1000.
Hence the interest calculation as follows.

• First year

• Second year
• Third year
• Fourth year = 700
• Fifth year = 600
• Sixth year = 500
• Seventh year = 400
• Eigth year = 300
• Ninth year = 200
• Depreciation for 9 years = 1000 + 900 + 800 +
700 + 600 + 500 + 400 + 300 + 200 = Rs. 5400
• AVERAGE COST LESS FOR PROPOSED HENCE
GO FOR REPLACEMENT
• An existing piece of equipment has it
market value as Rs. 10,000/- maintenance
cost of Rs. 1000/- per year, a life of 10 years
and no scrap value. The proposed new
equipment for replacement has an installed
cost of Rs. 1,00,000/-, maintenance cost of
Rs. 800/- per year and a life of 50 years and
scrap value Rs. 16,000/. Suggest if the
proposed equipment should be purchased.
Item Existing New
Depreciation 10,000-0 = 10,000 1,00,000-16,000 =
84,000
Operating cost 1000 x 10 = 800 x 50 = 40,000
10,000
Total Life cost 20,000 124,000
Life 10 years 50 years
Average cost per 20,000÷10= 124,000÷50=
year 2000 2480

AVERAGE COST LESS FOR EXISTING HENCE NEED NOT GO FOR


REPLACEMENT
2. Annual Cost Method
•The equivalent annual cost (EAC) is the annual cost
of owning, operating and maintaining an asset over
its entire life. EAC is often used by firms for capital
budgeting decisions. The equivalent annual cost
methodology allows a company to compare the
cost effectiveness of various assets that have
unequal life-spans.
•Compares annual cost of obtaining service from
difference equipments
•Annual cost = Capital recovery + Operating costs
•The annual cost of capital recovery is calculated as
follows:
2. Annual Cost Method
CRF for 5% as an example
Given below is the data for two equipments. Find
out which alternative you will select.
Calculate for 8 years mistake hence 80 instead of 60
Calculate for 8 years mistake hence 112 instead of 84

Equipment 1 selected due to low annual cost


3. Present Worth Method
•In this method, the interest rate per interest
period is determined, which equates the
equivalent worth (either present worth,
future worth or annual worth) of cash outflows
(i.e. costs or expenditures) to that of cash
inflows (i.e. incomes or revenues) of an
alternative.
•Compares all alternatives by
•Reducing all receipts and expenditures for each
alternative equipment to the present worth basis
•Applicable for equal service only
Given below is the data for two equipments. Find
out which alternative you will select.
Present worth of equipment 1 is less than 2
equipment 1 should be selected.
3. Present Worth Method
•A concern has got an old equipment which if is
overhauled after every three years can give service
up to a total period of 9 years. Considering the data
given below, suggest whether new equipment
which also has a life of 9 years should be purchased
or not.
Present worth old<new hence new neednot purchased.
4. Rate of Return method
A rate of return is the gain or loss on an
investment over a specified time period,
expressed as a percentage of the investment’s
cost. Gains on investments are defined as
income received plus any capital gains realized
on the sale of the investment.
4. Rate of Return method
•Calculates rate of return then examined for
adequacy
•Unadjusted rate of return as interest rates not
taken into consideration
•Net monetary operating advantage=algebraic
sum of operation, maintenance and differences
in revenue
4. Rate of Return method

•If tax is also considered


4. Rate of Return method
e.g.: A new material handling system costs
Rs.25000 (installed) including the cost of re-
layout. This decreases the number of material
handling workers by five. After adding increased
maintenance and power costs, the net monetary
operating advantage is estimated as Rs. 12000
per year. If estimated economic life is 5 years,
calculate the rate of return before tax and after
tax. Assume a depreciating term of 10 years.
4. Rate of Return method

Assuming an income tax rate


of 50% , the incremental tax
due to project is
4. Rate of Return method
Rate of return thus by second relation is

Rate of return 56% or 18% is adequate or not, it can


be judged in relation to the risk involved in the
particular project and the returns possible through
uses of the capital
4. Rate of Return method
Whether a machine having following particulars
must be purchased or not:
5. MAPI method
•MAPI by Machinery and Allied Product Institute of
Washington D C
•developed by George Terborgh, the Director of
this institute.
• all the equipment’s are subjected to
deterioration and obsolescence in varying
de-gree with the passage of time.
•Thus with the passage of time operating
inferiority increases
•old machine has his operating inferiority high
and book value as low
5. MAPI method
•The exist-ing equipment which is to be replaced
is known as DEFENDER and
•The new which will replace the old one is known
as the CHALLENGER.
•The “adverse mini-mum” of the defender and
the challenger are found and compared.
•“Adverse minimum” of the defender or the
challenger is the lowest sum of the time adjusted
average of capital cost and operating inferiority
(expressed in terms of money) obtainable from a
machine. The calculations can easily be done
with the help of MAPI charts.
Refer MAPI chart No. 2A (Fig. 14.2). For 12
years of service life and 10% salvage ratio,
read percent value on vertical scale. It
comes out to be 87%.
Terborgh’s Short Cut (Approximate
MAPI Solution):
Two different short cuts, i.e., regarding CAM and
DAM will be discussed below:

(a) Short cut for determining the challenger’s


(economic life and) adverse minimum (CAM).

(b) Short cut for determining the defender’s


adverse minimum (DAM).
(a) Short cut for determining the challenger’s
(economic life and) adverse minimum (CAM).
Operating Inferiority:
•It indicates the amount by which the defender is
operationally inferior to its challenger.
•is the result of wear and tear.
•Inferiority gradient is the combined effect of
obsolescence and deterioration
•The inferiority gradient shows the increase per year
in operating cost and opportunity cost due to
deterioration and obsolescence.
•Opportunity cost includes interest on opening
salvage value and loss in salvage value during the
year.
•Assuming salvage value S to be zero, equation (1)
can be simplified as
Operating Inferiority:
Operating Inferiority:
(b) Short Cut: Defender:

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