REPLACEMENT

ANALYSIS
 INTRODUCTION

• Failure to continuously upgrading these assets can

result in serious loss of operating efficiency.

• A sound replacement analysis can ultimately effect

the financial success of an enterprise.
 GENERAL NATURE
Two important terms here in this analysis are,

• The existing old asset being considered

as the asset to be replaced
Defender
• The asset proposed to be the
replacement
Challenger
 FEATURES

• The economic characteristics of the two alternatives

are usually dissimilar.

• Duration of cash flows for both assets will be different.

• Also, the remaining life of an asset being considered

for replacement is usually short and its future can be
estimated with relative certainty.
BASIC REASONS FOR REPLACEMENT

Reduced
Performance

REPLACEMENT

FUNCTIONAL
OBSOLESCENCE

ECONOMICAL
 KEY POINTS

• The economy of scrapping an efficient old machines

lies in the conservation of effort, energy, material and
time.

• Additional expenses incurred for the installation of a

new machine before operation should be considered
as part of initial cost.

• When an old machine is replaced its removal may

entail expenses which must be deducted from the
amount received to arrive at net salvage value.
 TERMINOLOGIES

• Sunk cost
For example, suppose a machine acquired for $50,000 three years
ago has a book value of $20,000. The $30,000 is a sunk cost that
does not affect a future decision involving its replacement.

Present book value – Present market value

• Economic life – Estimating economic life in any organization is very
useful.

• Unused value
 METHODS

1. Outsider’s point of view

2. Cash flow approach- for equal life

3. Policy of including sunk cost in Replacement

Analysis

4. Economic life of an asset

 OUTSIDER’S POINT OF VIEW

1. A company purchased machine A a year ago for Rs.8500 with the following

characteristics,
Estimated life- 6 years
Salvage value- Rs.1000
Operating expenses- Rs.8000/year

At the end of 1st year a salesman offers machine B for Rs.11500 which has estimated life

of 5 years, salvage value of Rs.1500 and an operation cost of Rs.5500/year due to

improvement. The salesman offers Rs.3500 for machine A, if machine B is purchased.

This appears low to the company, but it is the best offer received elsewhere. Assume an

interest rate of 8% and determine the best course of action by taking outsider’s point of

view?
OUTSIDER’S POINT OF VIEW
 CASH FLOW APPROACH- FOR EQUAL
LIFE
• This approach is based on the fact that-

• If the challenger is selected, the defender’s present market

value is a cash inflow to the challenger.

• Alternatively, if the defender is selected there is no actual

expenditure of cash to the organization.

• Hence defender’s first cost is taken as zero and the market

value of the defender is subtracted from the challenger’s first
cost.

SOLVING THE SAME PREVIOUS PROBLEM

 CASH FLOW APPROACH (INSIDER POINT OF VIEW)

A company purchased machine A a year ago for Rs.8500 with the following
characteristics,
Estimated life- 6 years
Salvage value- Rs.1000
Operating expenses- Rs.8000/year

At the end of 1st year a salesman offers machine B for Rs.11500 which has
estimated life of 5 years, salvage value of Rs.1500 and an operation cost of
Rs.5500/year due to improvement. The salesman offers Rs.3500 for machine
A, if machine B is purchased.

This appears low to the company but it is the best offer received elsewhere.
Assume an interest rate of 8% and determine the best course of action by
taking insider point of view?
CASH FLOW APPROACH
 CASH FLOW APPROACH- FOR EQUAL
LIFE

CONCLUSION

• The annual saving of replacing m/c A by m/c B

considering the outsider’s point of view is

Rs.581.55/year.

• By cash flow approach is Rs.581.55/year

 WHAT HAPPENS FOR UNEQUAL LIFE?

IN THE ABOVE PROBLEM IF THE CHALLENGER HAS A LIFE OF 10

YEARS.

CONCLUSION

• The annual saving of replacing m/c A by m/c B considering

the outsider’s point of view is Rs.1595.85/year.

• By cash flow approach, AW is Rs.1240.84/year (sometimes

decision may be reverted)

• The error is due to the market value of m/c A is Rs.3500,

which is annualized over a period of 10 years.
 CONCLUSION

Savings when Savings when

Approach alternatives have alternatives have
equal lives unequal lives
Outsider’s
approach Rs. 581.55 Rs. 1595.85

Cash flow
approach Rs. 581.55 Rs. 1240.84

Hence cash flow approach can be used when the defender and challenger

has equal lives. Outsider’s point of view is to be used when defender and

challenger has unequal lives.

 PROBLEM

• The outsider will consider the following information for the

two trucks at the interest rate of 10%.
Old machines New machines
Present value 7500 11000
Salvage value 2000 2000
Annual operating cost 3000 1800
Life (Year) 3 10

Identify the best course of action considering outsiders point

of view.
 ECONOMIC LIFE OF AN ASSET

• Minimum cost life- optimum time for replacement

• EUAC or total cost = Capital Recovery + AOC with interest
• EUAC or total cost = [{(P-F) * (A/P, i, n)} + Fi]+AOCwith interest
 EXAMPLE
An asset purchased 3 years ago is now challenged
by a new piece of equipment. The present market
value of the defender is Rs.130000. anticipated
salvage values and Annual Operating Costs (AOC)
for the next 5 years are given in the table. What is the
minimum cost life to be used while comparing this
defender with a challenger if a 10% year return is
required. Life (in years) Salvage value AOC
1 Rs 90,000 Rs 25,000
2 Rs 80,000 Rs 27,000
3 Rs 60,000 Rs 30,000
4 Rs 20,000 Rs 35,000
5 Rs 0.00 Rs 45,000
 SOLUTION
CR(i) = (P-F) (A/P, i, n) + Fi
Finding for n=1, 2, 3, 4, 5
n=1, 1.10
CR(i) = (1,30,000-90,000) (A/P, 10,1) + 90000 x 0.1= 53000
n=2, 0.5762
CR= (1,30,000-80,000) (A/P, 10,2) + 80000 x 0.1 = 36810

n=3, 0.4021
CR= (1,30,000-60,000) (A/P, 10,3) + 60000 x 0.1 = 34147
n=4, 0.3155

CR= (1,30,000-20,000) (A/P, 10,4) + 20000 x 0.1 = 36705

n=5, 0.2638
CR= (1,30,000-0) (A/P, 10,5) + 0 = 34294
Equivalent Annual Operating Costs for n= 1,2,3,4,5
n= 1, A= 25,000
n=2,
A= [25000 (P/F,10,1) + 27000 (P/F,10,2)] x (A/P, 10,2)
= 25952
n=3,
A= [25000 (P/F,10,1) + 27000 (P/F,10,2) + 30000 (P/F, 10,3)] x (A/P, 10,3)
= 27174
n=4,
[25000 (P/F,10,1) +27000 (P/F,10,2) +30000 (P/F,10,3) +35000 (P/F, 10,4)] x (A/P, 10,4)
= 28861
n=5
A= [25000 (P/F,10,1) + 27000(P/F,10,2) + 30000 (P/F,10,3) + 35000 (P/F, 10,4) +

45000 (P/F,10,5)] x (A/P, 10,5)

= 31504
TABULATIONS
Year CR (i) AOC EUAC (Total
Cost)
1 53000 25000 78000

2 36810 25952 62322

3 34148 27174 61322

4 36702 28861 65563

5 34294 31504 65798

Minimum total EUAC occur at year 3.

Hence economic life of the asset is 3 years
 REPLACEMENT ANALYSIS USING
ECONOMIC LIFE
• Three years ago a chemical processing plant installed a system at
a cost of $ 20,000 to remove pollutants from waste water that is
discharged into a nearby river. The present system has no present
salvage value and will cost $14500 to operate next year, with the
operating cost expected to increase at the rate of $500 per year
thereafter.
• A new system has been designed to replace the existing system at
a cost of $10000. The new system is expected to have first year
operating of $9000 with these costs increasing at the rate of $1000
per year. The new system is estimated to have a useful life of
12years. The salvage values of both the system at any future time
are expected to be zero. If the interest rate is 12% conduct
replacement analysis based on the economic life of the asset.
 SOLUTION
The equation for finding the total equivalent annual cost
(EUAC) for the existing system can be written as,

EUAC= CR (i) + Equivalent Annual Operating Costs (Eq. AOC)

Since the present system has no salvage value at present or in future, P=F=0
Therefore, EUAC= 14500 + 500 (A/G, i, n)

For n=1,
EUAC= 14500 + 500 (A/G, i, n) → EUAC= 14500 + 500 (A/G, 12, 1)
=14500/- $/yr

For n=2,
EUAC= 14500 + 500 (A/G, i, n) → EUAC= 14500 + 500 (A/G, 12, 2)
=14736/- $/yr
For n=3,
EUAC= 14500 + 500 (A/G, i, n) → EUAC= 14500 + 500 (A/G, 12, 3)
=14962/- $/yr

• It can be seen that since the present system has no

present and future salvage value its equivalent annual
costs consists of only Eq. AOC.
• Hence the EUAC will increasing every year.
• Therefore the economic life of this is ONE year with
EUAC = 14500
The equation for finding the total equivalent annual cost
(EUAC) for the new system can be written as,

EUAC= CR (i) + Equivalent Annual Operating Costs (Eq. AOC)

Therefore, EUAC= (P-F) (A/P, i, n) + Fi + 9000 + 1000 (A/G, i, n)

P= 10,000; F= 0; i= 12%

For n=1,
EUAC= 10,000 (A/P, 12, 1) +9000 + 1000 (A/G, 12, 1)
=20,200/- $/yr

For n=2,
EUAC= 10,000 (A/P, 12, 2) +9000 + 1000 (A/G, 12, 2)
=15,389/- $/yr
For n=3,
EUAC= 10,000 (A/P, 12, 3) +9000 + 1000 (A/G, 12, 3)
=14,089/- $/yr
For n=4,
EUAC= 10,000 (A/P, 12, 4) +9000 + 1000 (A/G, 12, 4)
=13,651/- $/yr
For n=5,
EUAC= 10,000 (A/P, 12, 5) +9000 + 1000 (A/G, 12, 5)
=13,549/- $/yr

For n=6,
EUAC= 10,000 (A/P, 12, 6) +9000 + 1000 (A/G, 12, 6)
=13,604/- $/yr

For n=7,
EUAC= 10,000 (A/P, 12, 7) +9000 + 1000 (A/G, 12, 7)
=13,742/- $/yr
 The economic life of the new system is FIVE years with EUAC = 13549

The Results can be tabulated as follows

Present System New system

Economic Life n=1 n= 5
EUAC 14500 13549

Conclusion: From the economic life and EUAC the existing

system should be replaced by new system