RETIREMENT & REPLACEMENT

ANALYSIS FOR EQUIPMENT ASSETS

The lectures in this topic would include:

. The reasons for and economy of replacement and retirement of assets

. Defender/challenger concept
. Increment cost, sunk costs and replacement analysis
. Problem solving on replacement and retirement of assets

1. INTRODUCTION

1.1 Retirement

The disposal of an asset by its owner is considered as Retirement. The

present owner will not have any further use for this particular machine.

1.2 Replacement
(a) When an asset is retired, another asset may be taken in to
perform the same task. This is Replacement.

(b) If an asset is not retired but merely transferred to some other use
then a new asset may be acquired in its place. This, also,
constitutes Replacement.

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1.3 What makes Retirement / Replacement necessary?
Retirement of an asset becomes necessary due to

(a) Deterioration
or (b) Obsolescence
or (c) combination of both.

1.4 Deterioration

Deterioration may be defmed as the lowering of the engmeermg

efficiency of an equipment compared to that was existing when the
equipment was new.

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Disbursements on the equipment will increase due to a combination of
the following factors :

(a) Increased fuel and power usage

(b) Increased maintenance and repair costs
(c) More frequent breakdowns and consequent fall in productivity
(d) Losses due to increased incidence of inferior quality product
(e) Increased labour requirements.

1.5 Obsolescence

Obsolescence may be defmed as the lowering of the engmeermg

efficiency of the present equipment if compared with the best
engineering efficiency (of later models) currently available.

Advancing Technology is continuously bringing forth new machines

with better performance and efficiency. Thus a continuous evaluation
and comparison of existing machines with the expected performance of

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 the new machines need be made in order to arrive at the right
conclusion.

1.6 When should a machine be retired

It is a common mistake committed by business organisations to fix the

life period of a machine in an arbitrary manner. Selecting the wrong
period leads to erroneous conclusions about its economic viability as
illustrated in the example below.

EXAMPLE

A manual operation costs $7,000 a year for labour. This operation may
be performed by a machine costing $10,000 with annual 0 & M costs
of $4,000.

Compare the two methods if the life of the machine is taken as

(a) 6 years
(b) 4 years

Assume zero salvage value and minimum rate of return of 10 % in both

cases.

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 SOLUTION

Life of machine -6 Years

Capital recovery = 10,000 (AlP, 10%,6)
= 10,000 x 0.2296 = $ 2,296
o & M costs = $ 4,000
EUAC (Machine) = $ 6,296

Compared to manual operation costs of $7,000, the machine IS

economically advantageous.

Life of Machine - 4 years

Capital recovery = 10,000 (AlP, 10%,4)
= 10,000 x 0.3154 = $ 3154
o & M costs = $ 4000
EUAC = $ 7154

Now the manual method is economically advantageous.

Thus. if the life of the machine could be six Years but was taken to be
four Years then a wrong decision to continue with the manual
operation would have been made.

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 2. MINIMUM COST LIFE OR ECONOMIC LIFE

Ideally, a machine should be used over a life period so that the EUAC of
owning and operating a machine is the least. This life period is termed
"Minimum Cost Life" or "Economic Life" of the machine.

For a chosen life period of n years

(EUAC)n = (CR)n + (EUOM)n

where

(CR)n = Capital Recovery over n years

(EUOM)n = 0 & M costs for n years expressed as annual equivalent
uniform disbursements.

2.1 (CR)n
(CR)n depends on (i) Initial cost, C

(ii) Salvage value Sn (decreases with time)

(CR)n = C (AlP, i%, n) - Sn (AIF, i% , n)

(C.R>,.,

,..,

Variation of (CR)n with life (n)

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2.2 0 & M costs

o & M disbursements remain somewhat constant during the earlier

stages of the life of the machine but increases steeply during the latter
part. The 0 & M costs over the life period of n years may be expressed
as Equivalent Uniform Operation and l\iIaintenance, (EUOM)n .

lEUCM)
n

Variation of (EUOM)n with life (n)

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 2.3 EUAC

(EUAC)n = (CR)n + (EUOM)n

! Capital reco!ery with return (Cje)

I
I

L,//-~Ecc.;oMlC life-.
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Asset life in years

Variation of (EUAC)n with life (n)

2.4 Exercise

An earth moving equipment costs $20,000. Its prospective end of the

year salvage values (Sn) and the annual operating and maintenance
(0 & M) disbursements are as given in table below.

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 Year Sn ($) O&M ($)

1 17,000 8,000

2 14,400 9,000

3 12,300 10,000

4 10,500 11,000

5 8,900 12,000

If the minimum rate of return for the company is 20%, determine the
economic life of the equipment and the annual cost associated with it.

2.5 Solution

2.5.1 To calculate (CR)n

If life of the equipment is n years, then

(CR)n = 20000 (NP, 20%,n) - Sn(AfF, 20%,n)

n (CR)n($)
1 7000
2 6546
3 6115
4 5770
5 5492

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 To calculate (EUOM)n
The annual 0 & M costs are in a Gradient of 1000.

(EUOM)n = 8000 + 1000 (NG, 20%, n)

n (EUOM)n (CR)n (EUAC)n

1 8 000 7 000 15 000

2 8455 6546 15 00 1

3 8879 6 115 14 994

4 9274 5770 15 044

5 9641 5492 15 133

MinimumEUAC = $14,994
Economiclife = 3 years

3. COST OF CONTINUING THE SERVICE OF AN ASSET

ALREADY OWNED

In an economy study involving prospective replacement, it is necessary to

compare the cost of continuing the use of the existing asset until a future date
with the cost if a replacement is acquired.

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3.1 Illustration

A construction machinery, which is two years old now, was initially

bought for $25,000. Its present net resale value in a second-hand
market is $13,000 and this is expected to decrease to $10,000 if the
machinery is held for another year and to $7,500 if held for two more
years and to $5,500 if held for three more years.

Compare the capital recovery costs of continuing the service of the

existing asset if the interest rate of the company is 15%.

3.1.1 Relevance of First Cost

First cost is a past outlay. This investment had been made already and
cannot therefore influence future outcomes.

In making a decision between alternatives for the future, the first

cost has no effect and is irrelevant.

3.1.2 Relevance of Book Value

Through the normal process of depreciation accounting, the asset will
have a certain book value at this stage. This value, however, is not
always realisable on disposal of asset and thus has no relevance to the
capital that is being locked up if the asset is continued in service.

However, the book value may have some tax consequence depending
on the prevailing company tax rules. This aspect will be dealt with
later.

If Capital Gain is made, then the company may be liable to Capital

Gains Tax.

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 If on the other hand, a Capital Loss is made on disposal of the machine,
the loss may be applied to reduce the Taxable Income. This loss
cannot be recovered if the asset is sold and is regarded as a "Sunk
Cost".

3.1.3 Investment Made in Continuing with the Old Machine

If the existing asset is continued in use, is any investment being made
now?

If the old machine is discontinued and sold, then a capital of $13,000

can be obtained. This capital of $13,000 can then be invested on other
projects.

If it is not discontinued, then this capital of $13,000 is not available for

any other investments.

Thus, in continuing with the existing asset, a capital of $13,000 is

.locked-up and should be regarded as equivalent to making an
investment of $13,000.

3.1.4 Future Capital Recovery Costs on Continuing

(i) CR Cost of Continuing service for one year
This decision is being taken now.

Net realisable value now = $ 13,000

Investment on continuing = $ 13,000
Salvage value after I year = $ 10,000

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 CR = 13000 (AlP, 15%, 1) - 10 000 (NF, 15%, 1)
= 13000 x 1.1500- 10 000 x 1.000
= 4.950

(ii) CR Cost of Continuing service for two years

This decision is being taken now.

Investment on continuation now = $ 13,000

Salvage value after two years = $ 7,500

CR = 13 000 (AlP, 15%,2) - 7 500 (AIF, 15%,2)

= 13000 x 0.6151-7500 x 0.9651
= 4508.2

(iii) CR Cost of Continuing service for 3 years

This decision is being-taken now.

Salvage value after 3 years = $ 5,500

CR = 13 000 (AlP, 15%, 3) - 5 500 (AIF, 15%,3)

= 13 000 x 0.4380 - 5 500 x 0.2880
= 4110

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 3.1.5 Future Capital Recovery Costs/or Extending Service/or Each o/the
Next 3 years on a Year-by-Year Basis

Extending for the 1st Year

This decision is being taken now.

CR = 4950 [as in (i) before]

Extending for the 2nd year

This decision will be taken at the end of year 1.

Investment (at the end of the 1st year) = $ 10,000

Salvage value ( at the end of the 2nd year) = $ 7,500

CR = 10000 (AlP, 15%,1) - 7 500 (AIF, 15%, 1)

= 10 000 x 1.1500 - 7 500 x 1.0000
= 4.000

. Extending for the 3rd Year

This decision will be taken at the end of year 2.

Investment (end of year 2) = $ 7,500

Salvage value (end of year 3) = $ 5,500

CR = 7500 (AlP, 15%,1) - 5 500 (AIF, 15%, 1)

= 7500 x 1.1500 - 5 500 x 1.0000
= 3.125

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 If the decision to continue the use of the asset is taken at the end of each year,
then the resulting capital recovery costs are. as given below:

CR cost for the Ist year = 4 950

CR cost for the 2nd year = 4000
CR cost for the 3rd year = 3 125

Equivalent Annual CR cost = [{ 4950 (P/F, 15%, 1)

+ 4000 (p/F, 15%,2) + 3125 (P/F, 15%,3) } ] (AlP, 15%,3)

= [4950 x 0.8696 + 4000 x 0.7561 + 3125 x 0.6575 ] x 0.438

= 4.110.0 [as in 3.1.4 (iii)]

This result should be expected as the CR for continuing for three years should
be the same whether the decision is made now or on a year by year basis. The
end result will be the same.

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 REPLACEMENT ECONOMY

1. INTRODUCTION

1.1 Concepts of Defender and Challenger

In replacement analysis, we make comparisons between continuing to
use the existing asset and the possible acquisition of a new asset. The
existing asset is known as the Defender and the new asset being
considered for possible purchase is regarded as the Challenger.

In making an economic decision, we take the "Consultant's View

point" i.e. we assume that we do not own either asset but we wish to
invest on one of them. We ignore any attachment (emotional or
otherwise) towards the defender because of its past s~rvice.

1.2 Factors to be considered

1.2.1 Defender

(1) Investment: Capital locked up = Net Realisable

Net realisable value:
(2) Life (remaining):
value now (and not the book value)
Sale price now + any tax rebate due
to loss on disposal or minus any tax
payable if there is a gain on sale
Period of continuation of service

(3) Annual Disbursements: Projected future 0 & M Costs

(4) Value at Disposal: Net realisable value (NRV) at the
end of continued service

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 1.2.2 Challenger
(1) Investment: First cost

(2) Any Investment Tax Credit: Depends on taxation policy of Govt.

(3) Life: Usually the Economic life unless a
different life is specified
(4) Annual Disbursements: Expected 0 & M Costs
(5) Value on Disposal: NRV at the end of the life

2. BEFORE- TAX CONSIDERATIONS

2.1 Illustrative Example

A piece of construction equipment was purchased 4 years ago at a cost
of $120,000. The projected annual operation and repair costs for the
machine for the next two years are $29,000 and $50,000 respectively.
This equipment can be sold for $40,000 now, for $30,000 next year
and for $20,000 in two year's time.

The first cost of a new model is $150,000. It is expected that the annual
disbursements will be $3,000 for the first year of operation but will
increase by $2,000 per year thereafter. The equipment may be used
most effectively by keeping it in service for 5 years and disposing it for
$30,000.

Discuss what should be the decision as to the replacement of the

existing machine if MARR before - tax is 18 %.

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 2.2 Solution
All cashflowsgiven below are in termsof $1,000.

The relevanti* = 18%

Challenger

To be used for its economic life of 5 years

30

150 G of2

CR = 150(A/P, 18%,5) - 30(AIF, 18%,5)

= l50x0.3198-30x0.1398 = 43.77

O&M = 3 + 2(A/G, 18%,5)

= 3 + 2 x 1.673 = 6.35
EUAC = 50.12

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2.2.1 Defender to be used for 1 more Year
If sold now, the capital available = $ 40,000
If continued, investment (capital locked up) = $ 40,000

29

"f -t0

CR = 40(AJP,18%,1) - 30(AIF, 18%, 1)

= 40 x 1.1800 - 30x 1.0000 = 17.20
O&M = 29.00
EUAC = 46.20

2.2.2 Defender to be used for 2 more years

... 20
I

o \ 2

40r-~9
50.

CR = 40(AJP,18%,2)- 20(AIF, 18%,2)

= 40 x 0.6387- 20 x 0.4587 = 16.37
0& M = [29(P/F, 18%, 1)+ 50(P/F,18%,2) 1(AJP,18%,2)
[ 29 x 0.8475+ 50 x 0.7182] x 0.6387
= 38.63
EUAC = 16.37 + 38.63 = 55.00

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 Use existing equipment for one more year and then replace it with the
new model

3. AFTER-TAX CONSIDERATIONS

3.1 Illustrative Example

The following additional information is provided for the example given
in section 2.1 :

(i) straight line depreciation is used for taxation accounting

(ii) book values of the existing machine has been computed

assuming a life of 10 years and zero salvage value

(iii) the company is currently paying income tax at a rate of 40%

(iv) any loss on disposal can be applied to reduce the taxable

Income.

(v) The relevant after-tax i* is 12 % .

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 J.1. Solution

3.2.1 Compare Continuing the Defender for one more year with acquiring
the Challenger now.

(i) Compute the Influence on taxable income

Challenger
Annual disbursements = 3 + 2 (AlG, 12%, 5)
= 3+2x1.775 = 6.55

Depreciation = (150 - 30) / 5 = 24.00

Influence on TI ( reduced by) = 30.55

Defender for one more year

Annual disbursement = 29.00
Depreciation = (120 - 0 ) / 10 = 12.00
Influence on TI ( reduced by ) = 41.00

Extra taxable income if challenger is acquired

= 41.00 - 30.55 = 10.45
Extra tax payable = 0.4 x 10.45 = 4.18

The extra tax payable if the challenger is acquired is deemed to

be an additional expense for the challenger.

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 (ii) Compute the influence of tax on Capital locked-up

Time Book Value Sale price Loss Tax Rebate

Now 72 40 32 12.8

One year 60 30 30 12.0

later

If defender is sold now, the sale price and the tax rebate will be
received. If not sold but continued, this amount will not be
received and will be considered as the capital locked up.

Capital locked up now = 40 + 12.8 = 52.8

Net realisablevalueone year later = 30 + 12.0 = 42.0

(iii) Compute the EDACs for the defender and Challenger

Defender
CR = 52.8(A/P,12%,1) - 42.0(AIF,12%, 1)
= 52.8 x 1.1200 - 42.0 x 1.0000 = 17.14
EDaM = 29.00
EDAC = 46.14

Challenger
CR = 150(A/P,12%,5) - 30(AIF, 12%,5) = 36.89
EDaM = 6.55
Extra tax payable = 4.18
EUAC = 47.62

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 Continuing with the defender for one more year is more economical
than acquiring the challenger.

3.2.2 Compare Continuing the use of the defender for two more years
against acquiring the Challenger
Repeat the three steps as before. Some of the important answers are
given here:

Step (i)
Extra taxable income if challenger = 20.36
Extra tax payable = 8.14

Step (ii)
For defender capital locked up now = 52.8
Net realisable value two years later = 31.2

Step (ill)
EUAC for defender = 55.43
EUAC for challenger = 51.58

Acquiring the challenger is more attractive than extending the service

of the defender for two more years.

FINAL DECISION

Use the defender for one more year, then dispose of it and purchase the
challenger.

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