LESSON 5

ASSET REPLACEMENT
ICE BREAKER
 LESSON 6-LEARNING OUTCOMES

At the end of this lesson you should be able to:

• evaluate whether a currently owned asset should be
kept in service or immediately replaced
 QUICK QUIZ

What to do with an existing asset?

Keep it
Abandon it (do not replace)
Replace it, but keep it for backup purposes
Increase the capacity of the asset
Dispose of it, and replace it with another
 REASONS TO CONSIDER A CHANGE

• Physical impairment (deterioration)

• Altered requirements
• New and improved technology is now available.
 ASSET REPLACEMENT

• As well as assisting with decisions between particular

assets, DCF techniques combined with annualised
equivalents can be used to assess when and how
frequently an asset should be replaced.
 IDENTICAL REPLACEMENT

• As the asset gets older, it may cost more to maintain and operate,
its residual value will decrease, and it may loose some
productivity/operating capability.
• When an asset is to be replaced by an identical asset, the
problem is to decide the optimum interval between replacements.
• When an asset is being replaced with an identical asset, the
Equivalent Annual Cost (EAC) can be used.
 EQUIVALENT ANNUAL COSTS (EAC)
• At some stage you have probably bought an asset such as a car, a washing machine or a
computer and you may have considered how long you should keep that asset prior to
replacing it.
• If the asset is kept for a longer period, its initial cost, less any residual value, is spread
over more years which is likely to reduce your cost per year of ownership.
• However, as the asset ages it is likely to require more and more maintenance and may
operate less effectively which will increase your costs per year.
• Determining the optimal time to replace the asset (the optimal replacement cycle) is
difficult.
 EQUIVALENT ANNUAL COSTS (EAC)
• As a general rule, individuals do not worry too much about this. Most of us
will make a decision based on our ‘gut feel’ and other factors such as image for
example. We tend to keep our cars until such time that we have lost confidence
in their ability to get us from point A to B or it has deteriorated so much that
we no longer want to be seen in it.
• Companies also face exactly the same asset replacement decisions. However as
the amounts involved can often be very significant, making decisions based on
‘gut feel’ is not really accurate enough. The calculation of equivalent annual
costs is a tool that can be used to assist in this decision-making process.
 EAC STEPS
• Step 1 – Calculate the net present value (NPV) of cost for each
potential replacement cycle.
• Step 2 – For each potential replacement cycle an equivalent annual
cost is calculated.
• The decision – The replacement cycle with the lowest equivalent
annual cost may then be chosen, although other factors may also have
to be considered.
• Equivalent annual cost =
 EXAMPLE
A machine costs $20,000.

The following information is also available:

Running costs (payable at the end of the year):

Calculate the optimal replacement cycle if the cost of capital is 10%.

 EXAMPLE - FEEDBACK

• One year replacement cycle

 EXAMPLE - FEEDBACK

• Two year replacement cycle

 EXERCISE 1
• A machine has a cost of N$3 500. The annual maintenance costs of the
machine are forecast to be N$900 in the first year, N$1 000 in the
second year and N$1 200 in the third year of ownership.
• The residual value of the machine is expected to be N$2 100 after two
years and N$1 600 after three years.
• The cost of capital of the company is 11% per year.
• Required: Calculate the optimal replacement cycle for the
machine.
 EXERCISE 1 - FEEDBACK

Step 1 – Calculate the NPV of cost for each potential

replacement cycle.
• As we have not been given the residual value after one year of
ownership, we cannot calculate an NPV of cost for a one-year
replacement cycle. Hence, our decision here will be between a
two- or three-year replacement cycle.
 NPV OF COST – 2-YEAR REPLACEMENT CYCLE:

• Here we evaluate all the cash flows associated with buying and
keeping the asset for two years.
Time 0 1 2
Initial cost (3,500)
Maintenance (900) (1,000)
Residual value 2,100
Net Cash Flows (3,500) (900) 1,100
DF 11% 1 0.9009 0.8116
PV (3,500) (811) 893
NPV (3,418)
 NPV OF COST – 3-YEAR REPLACEMENT CYCLE:

• Here we evaluate all the cash flows associated with buying and
keeping the asset for three years.
Time 0 1 2 3
Initial cost (3,500)
Maintenance (900) (1,000) (1,200)
Residual value 1,600
Net Cash Flows (3,500) (900) (1,000) 400
DF 11% 1 0.9009 0.8116 0.7312
PV (3,500) (811) (812) 292
NPV (4,830)
STEP 2 – FOR EACH POTENTIAL REPLACEMENT CYCLE
AN EQUIVALENT ANNUAL COST IS CALCULATED.

2-year cycle:
• EAC = N$3,418/1.713 = N$1,995 per year
• 3-year cycle:
• EAC = N$4,831/2.444 = N$1,977 per year
The decision:
As an annual cost of N$1,977 is less than an annual cost of N$1,995, the
three-year replacement cycle is said to be the optimal replacement cycle.
 EXERCISE 2
• James operates a machine which costs N$25 000 to buy and has the following costs and
resale values over its four year life. The organisation’s cost of capital is 10%

Required: Assess how frequently the asset should be replaced.

 EXERCISE 2 - FEEDBACK
Year Replacement every year Replacement every 2 years Replacement every 3 years Replacement every 4 years
Cash
flow DF PV Cash flow DF PV Cash flow DF PV Cash flow DF PV

0 (25,000) 1 (25,000) (25,000) 1 (25,000) (25,000) 1 (25,000) (25,000) 1 (25,000)

1 7,500 0.9091 6,818 (7,500) 0.9091 (6,818) (7,500) 0.9091 (6,818) (7,500) 0.9091 (6,818)

2 - 0.8264 - (10,000) 0.8264 (8,264) (10,000) 0.8264 (8,264)

3 (5,000) 0.7513 (3,757) (12,500) 0.7513 (9,391)

4 (12,500) 0.6830 (8,538)

PV of cost over
one replacement
cycle (18,182) (31,818) (43,839) (58,012)
Cummulative PV
factor 0.909 1.7355 2.4869 3.1699
Annualiased
equivalent cost (20,000) (18,333) (17,628) (18,301)
 WEAKNESSES OF EAC
• Ignores the impact of taxation. Both buying an asset and incurring a maintenance cost
will cause tax cash flows. While these cash flows could be included they would add to the
complexity of the calculation. EAC excludes the impact of taxation on the cash flows.
• Assumes that you can replace like with like. EAC assumes that the asset can be
replaced by exactly the same asset in perpetuity. In reality, this will not be possible as
assets are constantly developing. Even if you replace your car with exactly the same
model after a number of years the new car will undoubtedly have improvements and
other differences to the old one.
 WEAKNESSES OF EAC
• Assumes that you will want to replace like with like. Additionally EAC assumes that we will want to
replace the asset with the same asset in perpetuity. In reality, business needs develop and when it becomes
time to replace an asset a company may want to acquire a different asset with different functionality. For
instance, a company may want an asset with greater capacity due to growth in their business. We also face
exactly the same issue. Over your lifetime you have had a variety of different cars as your need has
developed – your two-seater sports car proved less than useful when your first child was born!
• Ignores inflation. Different cash flows may suffer from different specific inflation rates and as a result your
analysis may not be correct. For instance, the initial cost of assets often inflates quite slowly as manufacturers
find more efficient ways of production. However, maintenance costs often inflate much more quickly as
maintenance is often labour-intensive and labour costs often grow quickly. This differential between the
inflation rates of different cash flows means that an alternative method,should be used. If all the cash flows
inflate at one rate then the EAC method can be used with real cash flows and a real cost of capital.
 NON IDENTICAL REPLACEMENT
• When an asset is being replaced with a non-identical asset, the decision
is when to replace the asset rather than how frequently.
• The best time to replace the existing machine will be the option which
gives the lower NPV of cost in perpetuity, for both the existing machine
and the machine which eventually replaces it. The present value of an
annuity in perpetuity must be calculated.
• Present value of an annuity in perpetuity
= Equivalent Annual Cost/Cost of Capital
 NON IDENTICAL REPLACEMENT
• This formula is used to calculate the PV of cost in perpetuity of the new machine. In our
exercise 2, PV of cost = N$17 628/0.1 = N$176 280.
• The new machine will have a PV of cost in perpetuity of N$176 280 from the start of the
year when it is eventually purchased.
• The present value relates to the beginning of the year when the first annual cash flow
occurs, so that if replacement occurs now, the first annuity is in year 1, and the PV of cost
relates to year 0 values.
• If replacement occurs at the end of year 1 the first annuity is year 2, and the PV of cost
relates to year 1, and so on.
 NON IDENTICAL REPLACEMENT

• The total cash flow of the replacement decision may now be

presented as follows:
• The cash flows shows the:
PV of cost in perpetuity of the new machine,
the running costs of the existing machine, and
the resale value of the existing machine, at the end of year 0, 1, 2,
or 3 as appropriate.
 EXAMPLE

• Suppose that James’ machine (in exercise 2) is a new machine

and will be introduced to replace a non-identical existing
machine which is nearing the end of its life and has a maximum
remaining life of only three years.
• James wishes to decide when the best time to replace an old
machine is, and estimates of relevant costs have been drawn up
as follows:
 EXAMPLE

• Required: Calculate the best time to replace the existing

machine
 EXAMPLE FEEDBACK
Year Replace now Replace in 1 year Replace in 2 years Replace in 3 years
0 -176 280
8 500
1 -176 280
-9 000 -9 000 -9 000
5 000
2 -176 280
-12 000 -12 000
2 500

3 -176 280
-15 000
 EXAMPLE FEEDBACK
The PV of each
replacement option Year Cash flow DCF Present value Present value
Replace Now 0 -176 280
8 500
-167 750 1 -167 750 -167 750
Replace in one year 1 -176 280
-9 000
5 000
-180 250 0.909 -163 847 -163 847

Replace in two years 2 -9 000 0.909 -8 181

-176 280 0.826 -145 583
-12 000 0.826 -9 912
2 500 0.826 2 065 -161 611
Replace in 3 years 3 -9 000 0.909 -8 181
-12 000 0.826 -9 912
-176 280 0.751 -132 364
-15 000 0.751 -11 265 -161 722