Replacement Analysis

OBJECTIVES

1. What is Replacement Analysis?

2. Methods
3. Numerical / Problems
LEARNING
 What is Replacement Analysis?

Whether to buy a new and more efficient equipment?

OR
Continue to use existing equipment?

• The existing old asset being

Defender considered as the asset to be replaced

• The asset proposed to be the

replacement
Challenger
 What is Replacement Analysis?
• There are three basic reasons for considering the replacement of an
equipment –

1. Physical deterioration of the equipment

2. Obsolescence of the equipment.
1. Functional Obsolescence (due to the decrease in demand of output)
2. Economic Obsolescence (due to presence of similar asset-capable of producing at
lower cost)
3. Inadequacy (not having sufficient capacity to fill current and expected demands)

• Under such situations, the following alternatives will be considered.

1. Replacement of the existing equipment with a new one.
2. Augmenting the existing one with an additional equipment.
 What is Replacement Analysis?

• Replacement refers to a broad concept of selecting similar but new assets to

replace existing assets.(Based purely on economic merit)
• A replacement decision is a choice between the present asset ( defender) and
currently available replacement alternative ( Challenger).
• Replacement studies are usually made as EAC calculations .
 Key Points
• The economy of scrapping an efficient old machines lies in
the conservation of effort, energy, material and time.
• Additional expenses incurred for the installation of a new
machine before operation should be considered as part of
initial cost.
• When a old machine is replaced its removal may entail
expenses which must be deducted from the amount
received to arrive at net salvage value.
 Terminologies
• Sunk cost
For example, suppose a machine acquired for $50,000 three
years ago has a book value of $20,000. The $30,000 is a sunk
cost that does not affect a future decision involving its
replacement.
Present book value – Present market value
 Methods
1. Outsider’s point of view

2. Cash flow approach / Insider point of view

3. Economic life of an asset

 Cash flow approach / Insider point of view
An 8 year old asset may be replaced with either of the two
assets. Current data for each alternative is given below. Using the cash
flow approach and an interest rate of 18% per year determine the best
course of action.

Current asset Challenger 1 Challenger 2

First cost (P) - 30000 54000

Defender trade in Rs - 10500 7500
Annual Operating 9000 4500 3600
Cost (AOC)
Salvage value (S) 1500 3000 1500
Service life (yrs) 5 5 5
 Cash flow approach
Soln:
Defender:
1,500
i=18%
0 1 2 3 4 5

A=9,000 A=9,000

EUAC (Defender or Current asset) = 9000 – 1500(A/F, 18, 5)

= Rs. 8790.33/-
 Cash flow approach
Soln:
Challenger 1:
10,500 3000
i=18%
0 1 2 3 4 5

30000 A=4,500

EUAC(Challenger 1)= (30000–10500)*(A/P, 18,5)+4500–3000(A/F, 18, 5)

= 19500 (0.3198) + 4500 – 3000(0.1398)
= 6236.1 + 4500 – 419.4
= 10316.7/-
 Cash flow approach
Soln: Challenger 2:
7,500 1500
i=18%
0 1 2 3 4 5

54000 A=3600

EUAC(Challenger 2) = (54000–7500)*(A/P, 18,5)+3600–1500(A/F, 18, 5)

= 18260.10/-
Result: It is economical to retain the defender. By doing so, the saving per
year is as follow:
Defender vs Challenger 1 = 10316.37 – 8790.33 = Rs. 1526.04/-
Defender vs Challenger 2 = 18260.10 – 8790.33 = Rs. 9469.77/-
 Outsider point of view

Problem 5: A company purchased machine ‘X’, a year ago for Rs.

8500/- with the following characteristics. Estimated life = 6 years,
salvage value = Rs. 1000/-, operating expenses = Rs 8000/- per year.
At the end of the first year, a salesman offers machine ‘Y’ for Rs
11500/- which has an estimated life of 5years, a salvage value of
1500/- and an operating cost of only Rs. 5500/- per year due to
improvement. The salesman offers Rs. 3500/- for the machine ‘X’, if
the machine ‘Y’ is purchased. Assume an interest rate of 8% and
determine the best course of action by taking outsider’s point of
view.
 Outsider point of view
Soln: The outsider will consider the following data for machine ‘X’ and
machine ‘Y’ (Outsider point view)
Defender Challenger
(Machine ‘X’) (Machine ‘Y’)
First cost (P) 3500 11500
Annual Operating Cost 8000 5500
(AOC)
Salvage value (S) 1000 1500
Service life (yrs) 6-1 = 5 yrs 5 yrs

1,000
Machine ‘X’: i=8%
0 1 2 3 4 5

A=8,000 A=8,000
3500
 Outsider point of view
EUAC (X) = P (A/P, i,n) + A – S (A/F,i,n)
= 3500 (A/P, 8 , 5) + 8000 – 1000(A/F,8,5)
= 3500 (0.25046) + 8000 – 1000(0.17046)
= Rs. 8706.15/-

1,500
Machine ‘Y’: i=8%
0 1 2 3 4 5

A=5,500 A=5,500
11500
EUAC (Y) = P (A/P, i,n) + A – S (A/F,i,n)
Result: It is
= 11500(A/P, 8 , 5) + 5500 – 1500(A/F,8,5)
economical to
= 11500 (0.25046) + 5500 – 1500(0.17046) replace machine
= Rs. 8124.60/- ‘X’ by machine ‘Y’