Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Replacement Analysis with Tax Consideration Lecture No. 48 Chapter 14 Contemporary Engineering Economics Copyright © 2016

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Replacement Analysis with Tax Consideration When computing the net proceeds from sale of the old asset, any gains or losses must be identified to determine the correct amount of the opportunity cost. (Example 14.6) Whenever possible, replacement decisions should be based on the cash flows after taxes. (Example 14.7) All basic replacement decision rules including the way of computing economic service life remain unchanged. (Examples 14.8 and 14.9)

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 14.6: Net Proceeds from the Disposal of an Old Machine  Given: Depreciation schedule, tax rate = 40%, and market value = $10,000  Find: Market value to be used in replacement analysis

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 14.7: Replacement Analysis Using the Opportunity Cost Approach  Given: o Depreciation schedule o Tax rate = 40% o Discount rate = 10% o All other financial information as given in Example 14.2  Find: Whether or not to replace the defender now AEC D = $7,524 AEC C = $6,723

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Excel Worksheet (Example 14.7) DefenderChallenger

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 14.8: Economic Service Life of a Lift Truck on After-Tax Basis  Given: Financial data as given in Example 14.3, depreciation schedule, tax rate = 40%, and discount rate = 9%  Find: Economic service life  Forecasted Operating Costs and Net Proceeds from Sale as a Function of Holding Period

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Economic Service Life Based on After-Tax Cash Flows

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Economic Service Life

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 14.9: Replacement Analysis under the Infinite Planning Horizon DefenderChallenger

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Summary of Economic Service Lives  Defender: o N D* = 2 years o AEC D* = $3,030  Challenger: o N C* = 5 years o AEC C* = $3,541

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Equivalent Annual Cash Flow Streams  PW for an infinite cash flow stream when the Defender is Kept for n Years followed by Infinitely Repeated Purchases of the Challenger Every 4 Years

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Summary o In replacement analysis, the defender is an existing asset; the challenger is the best available replacement candidate. o The current market value is the value to use in preparing a defender’s economic analysis. Sunk costs—past costs that cannot be changed by any future investment decision—should not be considered in a defender’s economic analysis.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved o The opportunity cost approach views the net proceeds from sale of the defender as an opportunity cost of keeping the defender. This approach works in all situations of replacement problems. o Economic service life is the remaining useful life of a defender, or a challenger, that results in the minimum equivalent annual cost or maximum annual equivalent revenue. o We should use the respective economic service lives of the defender and the challenger when conducting a replacement analysis.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved o Ultimately, in replacement analysis, the question is not whether to replace the defender, but when to do so. o The AEC method provides a marginal basis on which to make a year-by-year decision about the best time to replace the defender. o As a general decision criterion, the PW method provides a more direct solution to a variety of replacement problems, with either an infinite or a finite planning horizon, or a technological change in a future challenger. o The role of technological change in asset improvement should be weighed in making long-term replacement plans. o Whenever possible, all replacement decisions should be based on the cash flows after taxes.