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Unformatted text preview: CHAPTER 9 CHAPTER REPLACEMENT REPLACEMENT ANALYSIS ANALYSIS REPLACEMENT ANALYSIS REPLACEMENT The evaluation of changes in The economics of assets associated with their use in an operating environment. environment. Considers asset • replacement • retirement • augmentation REASONS FOR REPLACEMENT ANALYSIS REPLACEMENT • • • • Physical Impairment (Deterioration) Altered Requirements Technology Financing PHYSICAL IMPAIRMENT (DETERIORATION) (DETERIORATION) • Efficiency loss resulting from continued Efficiency use -- aging use • Increased routine and corrective Increased maintenance costs maintenance • Greater energy requirements • Increased need for operator intervention • Unanticipated problems leading to Unanticipated equipment deterioration equipment ALTERED REQUIREMENTS ALTERED • Significant change in demand for Significant related products or services related • Significant change in the Significant composition or design of associated products or services • May be considered a form of May obsolescence obsolescence TECHNOLOGY TECHNOLOGY • Impact of technological change Impact varies with associated industry varies • Technological changes typically Technological reduce cost per unit and improve quality of output quality • Results in earlier replacement of Results existing assets with improved assets existing • May be considered a form of May obsolescence obsolescence FINANCING FINANCING • Considers economic opportunity Considers changes external to the physical operation or use of the asset(s) operation • May involve income tax May considerations (depreciation and after-tax analysis) after-tax – EG: rental of assets may become more EG: attractive than ownership attractive • May be considered a form of May obsolescence obsolescence ECONOMIC LIFE ECONOMIC • The period of time (years) that results in the The minimum Equivalent Uniform Annual Cost Equivalent (EUAC) of owning and operating an asset (EUAC) • EUAC is a term sometimes used to identify the EUAC annual worth of a primarily cost cash flow pattern • Assuming good asset management, economic Assuming life should coincide with time from date of acquisition to date of abandonment, demotion in use, or replacement from primary intended service service ECONOMIC LIFE ECONOMIC • Sometimes called minimum-cost life Sometimes or optimum replacement interval or • For a new asset, economic life can For be computed if capital investment, annual expenses, and year-by-year market values are known or can be estimated estimated OWNERSHIP LIFE OWNERSHIP • Period between date of acquisition Period and date of disposal by a specific owner owner • A given asset may have different given categories of use during this period categories PHYSICAL LIFE PHYSICAL • Period of time between Period original acquisition and final disposal of an asset over its succession of owners succession USEFUL LIFE USEFUL • The time period in years that an The asset is kept in productive service either in primary or backup mode either • An estimate of how long an asset is An expected to be used in a trade or business to produce income business REPLACEMENT STUDY CONSIDERATIONS CONSIDERATIONS 1. Recognition and acceptance of past errors 2. Sunk costs 3. Existing asset value and the outsider viewpoint 3. outsider 4. Income tax considerations 5. Economic life of the proposed replacement 5. (Challenger) (Challenger) 6. Remaining (economic) life of the old asset 6. (defender) (defender) PAST ESTIMATION ERRORS PAST • Past estimation errors are irrelevant Past irrelevant unless there are income tax implications unless i.e., when BV > current MV, frequently i.e., attributed to estimation error, while may be due to inadequate capacity or higher than expected maintenance costs • Must focus on valid estimation of future Must replacement, without consideration of loss which may have occurred in past loss THE SUNK COST TRAP THE • Only present and future cash flows should be Only considered in replacement studies considered • Unamortized values of existing asset Unamortized considered for replacement are the result of past decisions -- (Sunk costs = BV - MV) past • Sunk costs are irrelevant to replacement Sunk decisions, except to extent they affect income taxes • When tax considerations are involved, sunk When costs must be included in study EXISTING ASSET INVESTMENT VALUE -- AN OUSIDER VIEWPOINT VALUE • Perspective of impartial third party in Perspective establishing fair market value (MV) of your used asset your • Present realizable MV modified by Present appropriate income tax effects defines correct investment amount for asset in replacement studies replacement • Consider the opportunity cost of Consider retaining the asset -- the defender retaining THE OUTSIDER VIEWPOINT THE The total investment in the 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 with INCOME TAX CONSEQUENCES INCOME • Replacement of assets often result in Replacement gains or losses from sale of land or depreciable property depreciable • Studies must be made on an after-tax Studies basis basis • Prospective gain from asset disposal Prospective can be reduced by as much as 40% or 50% as a result of taxes 50% ECONOMIC LIFE OF THE CHALLENGER ECONOMIC • Economic life of an asset minimizes Economic equivalent uniform annual cost of owning and operating an asset and • Economic life is often shorter than useful Economic or physical life or • Economic data regarding challengers are Economic periodically (often annually) updated periodically • Replacement studies then repeated to Replacement ensure most up-to-date evaluation ECONOMIC LIFE OF DEFENDER ECONOMIC • Often one year • Because different lives are involved, care Because should be taken when comparing defender with challenger defender • Defender should be kept longer than Defender apparent economic life as long as its marginal cost < minimum equivalent uniform annual cost of challenger over its economic life its USEFUL LIFE(S) OF DEFENDER AND / OR CHALLENGER INESTIMABLE OR When useful life of defender or When challenger is unknown and can’t be reasonably estimated, must rely on: reasonably • economic life • minimum EUAC • total year-by-year marginal costs for defender and best alternative for challenger challenger BEFORE-TAX ANALYSIS BEFORE-TAX Determining Present worth of total costs Determining total PWk ( i%) = I - MVk (P / F, i%,k) + Σ k Ej (P / F, i%, j) Ej j=1 Sum of Sum • PW of initial capital investments occurring after PW time 0 time • PW of MV at end of year k • PW of annual expenses through year k BEFORE-TAX ANALYSIS BEFORE-TAX Determining Present Worth of Marginal Determining Costs Costs • Marginal cost is the difference in present Marginal worth of total cost for year ‘k’ minus the present worth of total cost for year ‘k - 1’ present • Total amount of this marginal cost is Total marginal found by: found TCk(i%) = (PWk - PWk-1) (F / P, i%,k) BEFORE-TAX ANALYSIS BEFORE-TAX Determining Present Worth of Marginal Costs • Simplification of Total calculation of marginal Simplification cost cost TCk(i%) = MVk-1 - MVk + iMVk-1 + Ek This is the sum of: • the loss in MV during year of extended service the • the opportunity cost of capital invested in the the asset at the beginning of year ‘k’ asset • the annual expenses incurred in year ‘k’ the BEFORE-TAX ANALYSIS BEFORE-TAX • The total marginal (Year-by-year) costs The are used to find the EAUC through each year ‘K’ each • The minimum EAUCk value during the useful life of the asset, determines its before-tax economic life before-tax • Before-tax economic life = N* Before-tax N* • Extending the Before-Tax Analysis equation to Extending account for income tax effects: account PWk(i%) = I + Σ k [ ( 1 - t ) Ej - tdj ] ( P / F, i%, j ) (i%) j=1 AFTER-TAX ANALYSIS AFTER-TAX [ ( 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 adding after-tax PW of annual expenses through year k, including adjustments for annual depreciation amounts depreciation • adjusting the total after-tax PW of costs by the adjusting after-tax consequences of gain or loss on disposal of asset at end of year k disposal AFTER-TAX ANALYSIS AFTER-TAX Determining Present Worth of Marginal Costs Total amount of this after-tax marginal cost: TCk = ( PWk - PWk-1 ) ( F / P, i%, k ) Simplifying TCk (i%) = (1 - t)(MVk-1 - MVk + iMVk-1 + Ek) + i (t)(BVk-1) The economic life of the asset on an after-tax basis The is N*AT N* • When major outlay for alteration or overhaul is When required, the life that will yield least EUAC is likely time to next alteration or overhaul likely • When defender MV is 0 and operating expenses When expected to increase annually, the remaining life that will yield least EAUC will be 1 year that • When MVs are greater than 0 and expected to When decline from year to year, calculate remaining economic life in same manner as for before-tax analysis analysis • By using outsider viewpoint, the present By realizable MV is considered its investment value realizable DETERMINING THE ECONOMIC LIFE OF A DEFENDER LIFE RETENTION OF THE DEFENDER DEFENDER The defender should be kept longer The than the apparent economic life of the defender as long as its marginal marginal cost (total cost for an additional year of service) is less than the minimum EUAC for the best alternative challenger challenger COMPARING DEFENDERS AND CHALLENGERS WITH DIFFERENT USEFUL LIVES USEFUL • Requires use of the repeatability or Requires coterminated assumptions coterminated • Normally, the second stipulation of the Normally, repeatability assumption can not be met for the (older and used) defender the • Failure to meet this stipulation may be Failure circumvented if period of needed service is indefinitely long and purpose of analysis is simply to determine timing of defender replacement replacement PROJECT RETIREMENT WITHOUT REPLACEMENT -- ABANDONMENT REPLACEMENT Two assumptions apply: • Once capital investment made, firm desires to Once postpone project abandonment as long as its present equivalent value (PW) is not decreasing present • The project will be terminated at the best The abandonment time and will not be replaced by the firm the ...
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