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7-Replacement Analysis

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7-Replacement Analysis

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REPLACEMENT

ANALYSIS
INTRODUCTION

• Mass production has found to be the most


economical method of satisfying human wants.

• 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
KEY POINTS

• Additional expenses incurred for the installation of a


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

• When a 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 $20,000 book value 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
IN THIS CHAPTER…

1. Outsider’s point of view

2. Cash flow approach- for equal life

3. Economic life of an asset


OUTSIDER’S POINT OF VIEW
Problem 1:

A company purchased machine X 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 Y for Rs.11500 which has estimated
life of 5 years, salvage value of Rs.1500 and an operation cost of only Rs.5500/year
due to improvement. The salesman offers Rs.3500 for machine X, if machine Y is
purchased.

This appears low to the company but the best offer received elsewhere is only
Rs.3000

Assume an interest rate of 8% and determine the best course of action by taking
outsider’s point of view?
OUTSIDERS POINT OF VIEW
1,500
1,000
M/C X M/C Y
0 1 5 0 1 5

YOU
5,500
8,000
11,500

Outsider
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 for 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


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 X by m/c Y considering the


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

• By cash flow approach there is a reduction of Rs.659.5/year


(sometimes decision may be reverted)

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


annualized over a period of 10 years. Actually it is to be annualized for
5 years since its life is 5 years.

HENCE CASH FLOW APPROACH CANNOT BE USED WHEN THE DEFENDER


AND CHALLENGER HAS UNEQUAL LIVES. ONLY OUTSIDER’S POINT OF VIEW
IS TO BE USED.
POLICY OF USING SUNK COST

In spite of the fact that sunk cost cannot be reversed, charging the
sunk cost of the defender to the cost of its contemplated
replacement, can lead to erroneous conclusion. This is illustrated
in example given below,

Consider Problem 2 extension of Problem 1


In problem 1, if the present book value of m/c X is Rs.7250 and if
the company decides to recover the sunk cost it has incurred in
m/c X by m/c Y, what error in equivalent annual costs will result in
making the comparison of financial desirability of the 2 machines?
CAPITAL RECOVERY COST
Let, P= first cost of the asset, F= estimated salvage value,

n= estimated service life in years, CR(i)= capital

recovery with return.

CR(i)= P(A/P, i, n) – F(A/F, i, n)

But since, (A/F, i, n)=(A/P, i, n) – i

CR(i)= P(A/P, i, n) – F[(A/P, i, n) – i]

CR(i)= (P-F) (A/P, i, n) + F.i


ECONOMIC LIFE OF AN ASSET

• Minimum cost life- optimum time for replacement


• Here the annual cost can be,

✓Constant

✓Constant Increasing

✓Sporadic
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

1 53000 25000 78000

2 36810 25952 62762

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

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