The decision to replace an asset

1
The decision to replace an asset

• Concepts and examples

2

• Use NPV analysis

3
Exemplification

• Larry Likkonen, the manager of Kenora Heavy Works
  Inc. is considering replacing the current
  excavator of the company with a new model.
• The existing excavator was originally purchased
  for 326,000 three years ago, but its market
  value has dropped to only 100,000 today. In ten
  years it will be worth only 20,000.
• The new excavator costs 200,000, and would
  increase operating revenues by 20,000 annually.
  The new equipment has a 10-year life span and
  expected salvage value of 40,000.
• The tax rate of the company is 42, the required
  rate of return is 12, and the CCA rate for both
  excavators is 30. For simplicity, assume that
  the current UCC of the old excavator is 100,000.
  Should Larry replace the old excavator?

4
Approach

• Calculate the NPV of the incremental cash flow.

5
The incremental cash flow of replacing a fixed
asset

• Replacing an asset will always impact the PV of
• - Initial outlay
• - Depreciation tax shields
• - Net capital spending (PV of the salvaged asset)

6
The incremental cash flow of replacing a fixed
asset

• Replacing an asset may or may not impact the PV
  of
• - ATNOR
• - Changes in NWC

7
Incremental initial cost

• Cost of new - Current market value of old
• 200,000 - 100,00 100,000
• Note that the original purchase price of the old
  excavator is irrelevant

8
Incremental ATNOR

• Change in ATNOR (Change in NOR)(1- T)
• 20,000(1- 0.42) 11,600 each year,
• PV change in ATNOR 11,600PVA(12,10) 65,543

9
Incremental depreciation tax savings (CCATS)

• PV changes in depreciation tax shields
• T(d)(Cnew-Cold)(1r/2)/(rd)(1r) -
  T(d)(Snew-Sold)/(dr)(1r)t
• PV changes in depreciation tax shields 26,461

10
Incremental Net Capital Spending

• Change in NCS (40,000-20,000)/(1.12)10 6,439

11
Putting it together

• Change in NPV Change in PV of
• (ATNOR Tax shields NCS - Chg in NWC - Initial
  outlay)
• Change in NPV
• 65,543 26,461 6,439 0 - 100,000
  -1,557

12
Recommendation

• Do not replace the old excavator

13
Equipment with unequal lives

• How should we evaluate the choice of purchasing
  relatively similar essential equipment, but with
  different economic lives?

14
Exemplification 1

• Machine A costs 100 m to buy and 10 m/year to
  operate. Its expected economic life is two years,
  and has to be replaced after it wears out.
• Machine B costs 140 m to buy and 8 m/year to
  operate. Its expected economic life is three
  years, and has to replaced after it wears out.
• Both machines are similar in their technological
  performance. Buying either one is essential to
  our project.
• No taxes or depreciation and r 10

15
Problem

• We ought to choose the one that costs less.
• Since they have unequal lives, comparing the PV
  of acquisition and operating costs is not
  relevant.
• PV cost(A) 100 10/(1.1) 10/(1.1)2
  117.36 m
• PV cost(B) 140 8/(1.1) 8/(1.1)2
  8/(1.1)3 159.89 m

16
Solution

• Find a common denominator
• Calculate an equivalent annual cost EAC
• Choose the project with the lowest EAC

17
EAC calculation

• PV (costs) PV(EAC)
• PV costs EAC/(1r) EAC/(1r)2 EAC/(1r)t
• EAC(A) PVcosts(A)/PVA(10, 2) 117.36/1.7355
  67.62
• EAC(B) PVcosts(B)/PVA(10, 3) 159.89/2.4869
  64.29
• Choose B

18
Exemplification 2 EAC with taxes

• Equipment X costs 1.1 m to install and
  60,000/year to operate.
• Expected life 5 yrs.
• Equipment Y costs 1.9 m to install and
  10,000/year to operate.
• Expected life 8 yrs.
• Both assets are considered lease-hold
  improvements (straight line depreciation), and
  will have zero salvage value at the end of their
  life.
• Tax rate 40
• Discount rate 12

19
PV of costs
20
PV of costs
21
PV of costs
22
PV of costs
23
PV of costs
24
PV of costs

• PV costs(X) -1.1 m 52,000PVA(12, 5)
  -912,550
• PV costs(Y) -1.9 m 89,000PVA(12, 8)
  -1,457,884

25
EAC calculation

• PV (costs) PV(EAC)
• EAC(X) -912,550/PVA(12, 5) -253,149
• EAC(Y) -1,457,884/PVA(12, 8) -293,479
• Choose X

26
Summary

• EAC is standardizing the cost associated with
  replacement choices.
• EAC enables a meaningful comparison.
• EAC calculation requires that the assets under
  question be very similar and essential to the
  operation of the project.