Retirement/Replacement Decisions

Lecture 11
Retirement/Replacement Decisions
Reasons for retirement

A better alternative exists Needs have changed The equipment has deteriorated The equipment has been damaged
Retirement or replacement
An asset that is retired from one application may be used elsewhere
(Either sold to another business, or kept) Old equipment may be kept for other uses
Replacement may not mean retirement:
Complicating factors
Extending the life of an existing asset is different from replacing it Retirement and replacement may have implications for income taxes
(Will be addressed in more detail later)
The existing asset and the replacement may have different lifetimes
4
Example
Should we sell our old warehouse
And rent space? Purchased for:

Warehouse is 10 years old
$40,000 land $160,000 building
Is this relevant???
Assume i* = 20% (before income tax)

5
Example
Current annual expenses:

$14,000/year operations and maintenance $4,600/year property tax $1,500/year insurance on warehouse $3,000/year insurance on inventory $23,100/year total
(Ignore income tax for now)

6
Example
Plan was to sell 10 years from now:
For $250,000 For $350,000
Just received an offer today:
Example
New expenses if we rent space:

$65,000/year rent $5,200/year operations and maintenance $1,600/year insurance on inventory $71,800/year total
Example

Compare based on annual equivalent Annual equivalent of current option:

Annual expenses $23,100 $350,000 (A/P, 20%, 10) = $83,500

This is like a cost of keeping the warehouse You dont get it unless you sell!
-$250,000 (A/F, 20%, 10) = -$9,600 Total = $97,000

9
Example
Annual equivalent of renting:
Annual expenses Annual expenses Yes, its cheaper to rent!
$71,800 $97,000
Annual equivalent of current option:
Is renting better?
In practice, might want to do after-tax analysis with lower i*

10
Example

Compare based on IRR Keeping warehouse has higher first cost
Because we forego the current sale price Year 0 -$350,000 Years 1-10 ($71,800-$23,100)= $48,700 Year 10 salvage value $250,000
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Cost of renting - cost of owning:

Example
Year 0 1 2 3 4 5 6 7 8 9 10 10 Present worth Cash flow Discounted Discount rate -350.0 -350.00 0.2 48.7 40.58 48.7 33.82 48.7 28.18 48.7 23.49 48.7 19.57 48.7 16.31 48.7 13.59 48.7 11.33 48.7 9.44 48.7 7.87 250.0 40.38 -105.45
First try: discount rate i* = 20%

12
Example
Year 0 1 2 3 4 5 6 7 8 9 10 10 Present worth Cash flow Discounted Discount rate -350.0 -350.00 0.1 48.7 44.27 48.7 40.25 48.7 36.59 48.7 33.26 48.7 30.24 48.7 27.49 48.7 24.99 48.7 22.72 48.7 20.65 48.7 18.78 250.0 96.39 45.63
Second try: discount rate i* = 10%

13
Example
Year 0 1 2 3 4 5 6 7 8 9 10 10 Present worth Cash flow Discounted Discount rate -350.0 -350.00 0.123 48.7 43.37 48.7 38.62 48.7 34.39 48.7 30.62 48.7 27.27 48.7 24.28 48.7 21.62 48.7 19.25 48.7 17.14 48.7 15.27 250.0 78.37 0.19
Converged: discount rate i* = 12.3%

14
Example
Analysis is easy:
Because both options have the same lives
(10 years)
Keeping the old warehouse is like investing money at 12.3%:
Since our i* is 20%, this is not good!
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Judging proposed investments
In this example, we used annual equivalent and internal rate of return interchangeably
This is OK, because options had same life
With different lives:
Use annual equivalent!
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Decisions about life extension involve both present and future salvage values
Forego present value to get future one (opportunity cost!) Added to the life extension cost, or Subtracted from the replacement cost, But not both!
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Present salvage value can be either

When lifetimes are different,
Present salvage value must be added to the life extension cost! Or else it wont recur with right frequency! You dont actually get the salvage value unless you replace the equipment!
This seems unintuitive:
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Think of it as buying a used item of equipment from scratch:

You are choosing the best policy, Not making a one-time choice Assume that you will eventually replace it with a similar used item of equipment Take an outsiders viewpoint!
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If keeping your used equipment is best,
Another example
Wrong equipment bought:

Pump cost $3,600 one year ago Power cost = $2,000/year
Because of poor pump choice
Is this relevant??? (before income tax)
Assume i* = 18%
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Another example
New expenses if we replace pump:

$3,400 cost of new pump $1,100/year power cost $700 salvage value of old pump
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Another example

Should we replace the pump? Assume a 10-year remaining life
(For both new pump and existing pump)
22
Another example

Compare based on annual equivalent Annual equivalent of current pump:

Annual expenses $700 (A/P, 18%, 10)

$2,000/year = $156/year
This is like a cost of keeping the current pump, because you dont get it unless you sell!
Total
= $2,156/year
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Another example
Annual equivalent of replacing pump:

Annual expenses $3,400 (A/P, 18%, 10) Total
$1,100/year = $757/year = $1,857/year
Is it better to replace the pump?
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Note
Sunk cost
E.g., sell asset before its expected lifetime
Does this show that the past decision was bad?
25
Review
We learned how to choose between
Life extension
(Keeping old item of equipment)
Replacement Both options had same lifetime Optimal life for each option was known!
So far:

26
Dynamic example (study on your own?)
Should we replace leaking gas mains?

Gas costs New pipe costs Old pipe has
$5/thousand feet3 $40,000/mile $0 salvage value
New pipe has no leaks for 15 years,
Then increases by 100,000 feet3/mile/year
Assume i* = 10%
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Dynamic example
Annual equivalent of replacing pipe:

Need annual equivalent of gas losses This is complicated:

Non-equal (gradient) amounts by year Doesnt start for 15 years Convert gradient to annual (in several steps) Trial and error in spreadsheet
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Two ways to do this:

Dynamic example
Convert gradient to annual
Leaks in years 16-25 are equivalent to:
11-year gradient starting in year 15
(1st year of gradient is always 0)
Convert to present value in year 14 (before start of gradient) according to:
$5/thousand ft3 (100,000 ft3) (P14/G, 10%, 11)
= $500 (26.4) = $13,200
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Dynamic example
Convert gradient to annual
Can we convert present value in year 14 directly to annual amount over years 1-25?
No! Two different time periods involved:

P14 is 14 years into the future But we want to annualize it over 25 years! = $3475
Convert to year 0 by $13,200 (P/F, 10%, 14)
Annualize by $3475 (A/P, 10%, 25) = $383

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Year Losses Discounted Annual Discounted Discount rate 1 0 0.00 382.9 348.09 0.1 2 0 0.00 382.9 316.45 3 0 0.00 382.9 287.68 4 0 0.00 382.9 261.53 5 0 0.00 382.9 237.75 6 0 0.00 382.9 216.14 7 0 0.00 382.9 196.49 8 0 0.00 382.9 178.63 9 0 0.00 382.9 162.39 10 0 0.00 382.9 147.62 11 0 0.00 382.9 134.20 12 0 0.00 382.9 122.00 13 0 0.00 382.9 110.91 14 0 0.00 382.9 100.83 15 0 0.00 382.9 91.66 16 500 108.81 382.9 83.33 17 1000 197.84 382.9 75.75 18 1500 269.79 382.9 68.87 19 2000 327.02 382.9 62.61 20 2500 371.61 382.9 56.92 21 3000 405.39 382.9 51.74 22 3500 429.96 382.9 47.04 23 4000 446.71 382.9 42.76 24 4500 456.87 382.9 38.87 25 5000 461.48 382.9 35.34 Present worth 3475.48 3475.60
Converged: annual equivalent = 383
Dynamic example

Compare based on annual equivalent Annual equivalent of replacing pipe:

Annualized gas losses $383 $40,000 (A/P, 10%, 20) = $4,407
Annualized capital cost
Total
= $4,790
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Dynamic example

Replace current pipe if losses > $4,790 Assumptions:

Current losses are only going to grow Original cost of current pipe is a sunk cost! Current pipe has 0 salvage value,

So there is no opportunity cost of keeping it Only annualized losses (no capital cost)
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Lecture 11

Reasons for retirement

An asset that is retired from one application may be used elsewhere

Replacement may not mean retirement:

(Will be addressed in more detail later)

Should we sell our old warehouse

And rent space? Purchased for:

Warehouse is 10 years old

$40,000 land $160,000 building

Assume i* = 20% (before income tax)

Current annual expenses:

(Ignore income tax for now)

Plan was to sell 10 years from now:

For $250,000 For $350,000

Just received an offer today:

New expenses if we rent space:

Compare based on annual equivalent Annual equivalent of current option:

Annual expenses $23,100 $350,000 (A/P, 20%, 10) = $83,500

-$250,000 (A/F, 20%, 10) = -$9,600 Total = $97,000

Annual equivalent of renting:

Annual expenses Annual expenses Yes, its cheaper to rent!

Annual equivalent of current option:

In practice, might want to do after-tax analysis with lower i*

Compare based on IRR Keeping warehouse has higher first cost

Cost of renting - cost of owning:

First try: discount rate i* = 20%

Second try: discount rate i* = 10%

Converged: discount rate i* = 12.3%

Because both options have the same lives

Keeping the old warehouse is like investing money at 12.3%:

Since our i* is 20%, this is not good!

Judging proposed investments

This is OK, because options had same life

With different lives:

Use annual equivalent!

Judging proposed investments

Present salvage value can be either

Judging proposed investments

When lifetimes are different,

This seems unintuitive:

Judging proposed investments

Think of it as buying a used item of equipment from scratch:

If keeping your used equipment is best,

Wrong equipment bought:

Pump cost $3,600 one year ago Power cost = $2,000/year

Because of poor pump choice

Is this relevant??? (before income tax)

New expenses if we replace pump:

Should we replace the pump? Assume a 10-year remaining life

(For both new pump and existing pump)

Compare based on annual equivalent Annual equivalent of current pump:

Annual expenses $700 (A/P, 18%, 10)

Annual equivalent of replacing pump:

Annual expenses $3,400 (A/P, 18%, 10) Total

$1,100/year = $757/year = $1,857/year

Is it better to replace the pump?

E.g., sell asset before its expected lifetime

Does this show that the past decision was bad?

We learned how to choose between