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CHAPTER 9 REPLACEMENT ANALYSIS The evaluation of changes in economics of assets associated with their use in an operating environment. Considers asset.

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Presentation on theme: "CHAPTER 9 REPLACEMENT ANALYSIS The evaluation of changes in economics of assets associated with their use in an operating environment. Considers asset."— Presentation transcript:

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2 CHAPTER 9 REPLACEMENT ANALYSIS

3 The evaluation of changes in economics of assets associated with their use in an operating environment. Considers asset replacementreplacement retirementretirement augmentationaugmentation

4 REASONS FOR REPLACEMENT ANALYSIS PhysicalPhysical Impairment (Deterioration) AlteredAltered Requirements TechnologyTechnology FinancingFinancing

5 PHYSICAL IMPAIRMENT (DETERIORATION) EfficiencyEfficiency loss resulting from continued use -- aging IncreasedIncreased routine and corrective maintenance costs GreaterGreater energy requirements IncreasedIncreased need for operator intervention UnanticipatedUnanticipated problems leading to equipment deterioration

6 ALTERED REQUIREMENTS Significant change in demand for related products or servicesSignificant change in demand for related products or services Significant change in the composition or design of associated products or servicesSignificant change in the composition or design of associated products or services May be considered a form of obsolescenceMay be considered a form of obsolescence

7 TECHNOLOGY Impact of technological change varies with associated industryImpact of technological change varies with associated industry Technological changes typically reduce cost per unit and improve quality of outputTechnological changes typically reduce cost per unit and improve quality of output Results in earlier replacement of existing assets with improved assetsResults in earlier replacement of existing assets with improved assets May be considered a form of obsolescenceMay be considered a form of obsolescence

8 FINANCING Considers economic opportunity changes external to the physical operation or use of the asset(s)Considers economic opportunity changes external to the physical operation or use of the asset(s) May involve income tax considerations (depreciation and after-tax analysis)May involve income tax considerations (depreciation and after-tax analysis) –EG: rental of assets may become more attractive than ownership May be considered a form of obsolescenceMay be considered a form of obsolescence

9 ECONOMIC LIFE The period of time (years) that results in the minimum Equivalent Uniform Annual Cost (EUAC) of owning and operating an assetThe period of time (years) that results in the minimum Equivalent Uniform Annual Cost (EUAC) of owning and operating an asset EUAC is a term sometimes used to identify the annual worth of a primarily cost cash flow patternEUAC is a term sometimes used to identify the annual worth of a primarily cost cash flow pattern Assuming good asset management, economic life should coincide with time from date of acquisition to date of abandonment, demotion in use, or replacement from primary intended serviceAssuming good asset management, economic life should coincide with time from date of acquisition to date of abandonment, demotion in use, or replacement from primary intended service

10 ECONOMIC LIFE Sometimes called minimum-cost life or optimum replacement intervalSometimes called minimum-cost life or optimum replacement interval For a new asset, economic life can be computed if capital investment, annual expenses, and year-by-year market values are known or can be estimatedFor a new asset, economic life can be computed if capital investment, annual expenses, and year-by-year market values are known or can be estimated

11 OWNERSHIP LIFE Period between date of acquisition and date of disposal by a specific ownerPeriod between date of acquisition and date of disposal by a specific owner A given asset may have different categories of use during this periodA given asset may have different categories of use during this period

12 PHYSICAL LIFE Period of time between original acquisition and final disposal of an asset over its succession of ownersPeriod of time between original acquisition and final disposal of an asset over its succession of owners

13 USEFUL LIFE The time period in years that an asset is kept in productive service either in primary or backup modeThe time period in years that an asset is kept in productive service either in primary or backup mode An estimate of how long an asset is expected to be used in a trade or business to produce incomeAn estimate of how long an asset is expected to be used in a trade or business to produce income

14 REPLACEMENT STUDY CONSIDERATIONS 1.Recognition and acceptance of past errors 2. Sunk costs 3. Existing asset value and the outsider viewpoint 4. Income tax considerations 5. Economic life of the proposed replacement (Challenger) 6. Remaining (economic) life of the old asset (defender)

15 PAST ESTIMATION ERRORS Past estimation errors are irrelevant unless there are income tax implicationsPast estimation errors are irrelevant unless there are income tax implications i.e., when BV > current MV, frequently attributed to estimation error, while may be due to inadequate capacity or higher than expected maintenance costs Must focus on valid estimation of future replacement, without consideration of loss which may have occurred in pastMust focus on valid estimation of future replacement, without consideration of loss which may have occurred in past

16 THE SUNK COST TRAP Only present and future cash flows should be considered in replacement studiesOnly present and future cash flows should be considered in replacement studies Unamortized values of existing asset considered for replacement are the result of past decisions -- (Sunk costs = BV - MV)Unamortized values of existing asset considered for replacement are the result of past decisions -- (Sunk costs = BV - MV) Sunk costs are irrelevant to replacement decisions, except to extent they affect income taxesSunk costs are irrelevant to replacement decisions, except to extent they affect income taxes When tax considerations are involved, sunk costs must be included in studyWhen tax considerations are involved, sunk costs must be included in study

17 EXISTING ASSET INVESTMENT VALUE -- AN OUSIDER VIEWPOINT Perspective of impartial third party in establishing fair market value (MV) of your used assetPerspective of impartial third party in establishing fair market value (MV) of your used asset Present realizable MV modified by appropriate income tax effects defines correct investment amount for asset in replacement studiesPresent realizable MV modified by appropriate income tax effects defines correct investment amount for asset in replacement studies Consider the opportunity cost of retaining the asset -- the defenderConsider the opportunity cost of retaining the asset -- the defender

18 THE OUTSIDER VIEWPOINT The total investment in the defender is the opportunity cost of not selling the existing asset for its current MV, plus the cost of upgrading to be competitive with best available challenger

19 INCOME TAX CONSEQUENCES ReplacementReplacement of assets often result in gains or losses from sale of land or depreciable property StudiesStudies must be made on an after-tax basis ProspectiveProspective gain from asset disposal can be reduced by as much as 40% or 50% as a result of taxes

20 ECONOMIC LIFE OF THE CHALLENGER EconomicEconomic life of an asset minimizes equivalent uniform annual cost of owning and operating an asset life is often shorter than useful or physical life data regarding challengers are periodically (often annually) updated ReplacementReplacement studies then repeated to ensure most up-to-date evaluation

21 ECONOMIC LIFE OF DEFENDER OftenOften one year BecauseBecause different lives are involved, care should be taken when comparing defender with challenger DefenderDefender should be kept longer than apparent economic life as long as its marginal cost < minimum equivalent uniform annual cost of challenger over its economic life

22 USEFUL LIFE(S) OF DEFENDER AND / OR CHALLENGER INESTIMABLE When useful life of defender or challenger is unknown and cant be reasonably estimated, must rely on: economiceconomic life minimumminimum EUAC totaltotal year-by-year marginal costs for defender and best alternative challenger

23 BEFORE-TAX ANALYSIS Determining Present worth of total costs PW k ( i%) = I - MV k (P / F, i%,k) + k Ej (P / F, i%, j) j=1 Sum of PW of initial capital investments occurring after time 0PW of initial capital investments occurring after time 0 PW of MV at end of year kPW of MV at end of year k PW of annual expenses through year kPW of annual expenses through year k

24 BEFORE-TAX ANALYSIS Determining Present Worth of Marginal Costs Marginal cost is the difference in present worth of total cost for year k minus the present worth of total cost for year k - 1Marginal cost is the difference in present worth of total cost for year k minus the present worth of total cost for year k - 1 Total amount of this marginal cost is found by:Total amount of this marginal cost is found by: TC k (i%) = (PW k - PW k-1 ) (F / P, i%,k)

25 BEFORE-TAX ANALYSIS Determining Present Worth of Marginal Costs Simplification of Total calculation of marginal costSimplification of Total calculation of marginal cost TC k (i%) = MV k-1 - MV k + iMV k-1 + E k This is the sum of: the loss in MV during year of extended service the loss in MV during year of extended service the opportunity cost of capital invested in the asset at the beginning of year kthe opportunity cost of capital invested in the asset at the beginning of year k the annual expenses incurred in year kthe annual expenses incurred in year k

26 BEFORE-TAX ANALYSIS TheThe total marginal (Year-by-year) costs are used to find the EAUC through each year K minimum EAUC k EAUC k value during the useful life of the asset, determines its before-tax economic life Before-taxBefore-tax economic life = N*

27 AFTER-TAX ANALYSIS Extending the Before-Tax Analysis equation to account for income tax effects:Extending the Before-Tax Analysis equation to account for income tax effects: PW k (i%) = I + k [ ( 1 - t ) E j - td j ] ( P / F, i%, j ) - j=1 [ ( 1 - t )MVk + t ( BVk ) ] ( P / F, i%, k) Equation finds PW of ATCF through year k by: adding initial capital investment and sum of after-tax PW of annual expenses through year k, including adjustments for annual depreciation amountsadding initial capital investment and sum of after-tax PW of annual expenses through year k, including adjustments for annual depreciation amounts adjusting the total after-tax PW of costs by the after-tax consequences of gain or loss on disposal of asset at end of year kadjusting the total after-tax PW of costs by the after-tax consequences of gain or loss on disposal of asset at end of year k

28 AFTER-TAX ANALYSIS Determining Present Worth of Marginal Costs Total amount of this after-tax marginal cost: TC k = ( PW k - PW k-1 ) ( F / P, i%, k ) Simplifying TC k (i%) = (1 - t)(MV k-1 - MV k + iMV k-1 + E k ) + i (t)(BV k-1 ) The economic life of the asset on an after-tax basis is N* AT

29 DETERMINING THE ECONOMIC LIFE OF A DEFENDER WhenWhen major outlay for alteration or overhaul is required, the life that will yield least EUAC is likely time to next alteration or overhaul defender MV is 0 and operating expenses expected to increase annually, the remaining life that will yield least EAUC will be 1 year MVs are greater than 0 and expected to decline from year to year, calculate remaining economic life in same manner as for before-tax analysis ByBy using outsider viewpoint, the present realizable MV is considered its investment value

30 RETENTION OF THE DEFENDER The defender should be kept longer than the apparent economic life of the defender as long as its marginal cost (total cost for an additional year of service) is less than the minimum EUAC for the best alternative challenger

31 COMPARING DEFENDERS AND CHALLENGERS WITH DIFFERENT USEFUL LIVES COMPARING DEFENDERS AND CHALLENGERS WITH DIFFERENT USEFUL LIVES Requires use of the repeatability or coterminated assumptionsRequires use of the repeatability or coterminated assumptions Normally, the second stipulation of the repeatability assumption can not be met for the (older and used) defenderNormally, the second stipulation of the repeatability assumption can not be met for the (older and used) defender Failure to meet this stipulation may be circumvented if period of needed service is indefinitely long and purpose of analysis is simply to determine timing of defender replacementFailure to meet this stipulation may be circumvented if period of needed service is indefinitely long and purpose of analysis is simply to determine timing of defender replacement

32 PROJECT RETIREMENT WITHOUT REPLACEMENT -- ABANDONMENT Two assumptions apply: OnceOnce capital investment made, firm desires to postpone project abandonment as long as its present equivalent value (PW) is not decreasing TheThe project will be terminated at the best abandonment time and will not be replaced by the firm


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