CHAPTER 6

REPLACEMENT ANALYSIS
Prepared By:
SHANKAR YADAV (018058)
DAMODAR POKHREL(31017)
KEDAR BHUSAL (31032)
SANJIV KUMAR CHOUBEY (31033)
ROHAN PARAJULI (31047)
RAJIN MAHARJAN (31131)
SURENDRA PANT (31133)
 • Introduction
• Reasons for Replacement Analysis,
• Factors to Consider in Replacement
Studies
OUTLINE • Limitation of Replacement Analysis
• Determining the Economic Life of a New
and an Existing Asset
• Replacement Decisions
• Summary
 Replacement Analysis is the method used
in capital budgeting which helps to decide
whether the existing assets need to
replace or not.

An entity needs to execute the effective

replacement of the assets such as
machinery, the roof of building, or group
Introduction assets.

Replacement decisions occur all around us. Maybe we

replaced a camera, a car, a cell phone, a computer, a printer, a
sound system, or a television. If this is the case, our decision
was most likely influenced by economics, capacity concerns,
deteriorating service quality, changing requirements, prestige,
fads, or a variety of other factors.
 Equipment are considered for replacement for the
following reasons:

DETERIORATION:
• Increase in maintenance costs.

Reasons for • Reduction in product quality and rate of production.

• Increase in labor costs, and

Replacement • Loss of operating time due to breakdowns.

Analysis OBSOLESCENCE:
• The equipment gets obsolete due to advancement in
technology and the unwarranted manufacturing
costs arising from such obsolete equipment will:
• Reduce profits.
• Impair competition.
• Cause loss in value of machinery.
 INADEQUACY:
When the existing equipment becomes inadequate
to meet the demand or it is not able to increase the
production rate to desired level.
Reasons for WORKING CONDITIONS:
Replacement Unsafe conditions for workers and leads to accidents,
making the environment noisy and smoky etc.
Analysis
ECONOMY
The existing units/equipment have outlived their
effective life and it is not economical to continue with
them.
FACTORS TO CONSIDER IN REPLACEMENT STUDIES
TECHNICAL
Whether the present
equipment has become
obsolete due to technological
developments, inadequate in
meeting increased product
demand.
Deteriorated due to wear and
tear.
Reduced safety as compared
to new machine available.
How often the present
equipment requires repairs
and maintenance
FINANCIAL/COST
High repair and maintenance
cost of existing equipment
Salvage value of existing
equipment and challenger at
the end of its useful life.
Effect on consumption of
power by replacing the
existing machine by new
machine.
TANGIBLE
These factors involve
sociological and humanitarian
considerations with far
reaching effects Like
Replacing the existing
machine which causes
unpleasantness and unsafe
working conditions leading to
accidents.
 The company may decide to replace to asset
due to a technology update, however, the new
asset may require to replace again after
purchase.
Limitation
The analysis does not include the impact of tax
so it is not reflected in real-world business.

The production capacity may not continue in

perpetuity.
 • Economic life is the length of time an asset is
expected to be useful to the owner.
• Assumptions when calculating economic life are

Economic Life that the asset will be operated at a normal level of

usage and with preventative maintenance.
• Economic life can be reduced or ended by asset
wear and damage, asset obsolescence, and changes
in business operations.
Replacement Decisions
• In replacement analysis, the defender is an existing asset; the challenger is the best
available replacement candidate.
• Two basic approaches to analyzing replacement problems are cash-flow approach and the
opportunity-cost approach.
• Sunk costs to be ignored
• Existing asset value need not be considered
• Income tax to be avoided
• The optimal replacement cycle is one which has lowest equivalent annual cost
• The replacement decision will apply indefinitely.
• Economic life of the challenger and the defender should not consider
 ANALYSIS
Economic life
To determine estimated life
where costs are at
minimum.
SUMMARY
Calculate A if use 1 year, 2
years and so on until (m+1)
years
where Am+1 > Am < Am-1
Economic life is m years.
Replacement
To determine if defender
should be replaced with
challenger.
If A Defender > A challenger retain
Defender.
If A Defender < A Challenger ,
replace defender with
challenger
References

• https://corporatefinanceinstitute.com/resources/accounting/economic-life/
• https://accountantskills.com/replacement-analysis-worked-example-limitations
• https://accountinguide.com/replacement-analysis/
• https://xplaind.com/186107/replacement-decision
• https://wps.prenhall.com/ecs_park_fee_2/87/22280/5703748.cw/index.html