ASSETS REPLACEMENT DECISION Most items of equipment need replacement which is the process by which the various cost

consequences involved are studied so that the optimum replacement decisions can be taken. Once a decision has been made to acquire an asset for a long term project, its likely that the asset will need to be replaced periodically throughout the life of such asset. The decision we are concerned with is how often the asset should be replaced. The two most common replacement decisions relate to: 1) Sudden Failure: These are parts or components that work adequately up to a point and then fail suddenly e.g. Fan Belts, Light Bulbs, Industrial belts etc. 2) Gradual Deterioration: These are the items that deteriorate gradually, these are usually expensive items which could be kept functioning with increasing amount of maintenance e.g. Vehicles, Plant, Machinery & Equipment, and Boiler etc.

Replacement of assets would involve an outlay of capital expenditure which would be deferred when the decision to replace is postponed. The realizable value of an asset will decline as the asset gets older. Early replacement means that higher realizable value would be obtained from the existing asset. Some salient points in Asset replacement Decision are as stated below: As the assets get older, the realizable value will continue to decrease while the maintenance, operating & running cost will increase. The initial, maintenance, operating & running cost of the asset are expected to be deferred over the period of the asset replacement so as to decide the period at which assets can be replaced. The revenue (if any) generated from the usage of the assets are also expected to be deferred over the period of the asset replacement so as to decide the period at which assets can be replaced. The realizable value of the assets is not expected to be deferred because it is the scrap value of the assets at every period. FACTOR TO CONSIDER IN ASSET REPLACEMENT DECISION (mnemonics C,S,O R,I,T,O) 1) 2) 3) i) ii) Capital cost of the new assets: The higher cost of the equipment or asset must be considered and compared with the realizable value of the existing asset. Source of fund: The source of fund to acquire the asset should also be considered against known or possible technical improvements. Operating or Running cost of Existing Asset: Operating cost will be expected to increase as the asset deteriorates over time. It is as a result of: Increase in repairs and maintenance cost Lower quality and quantity of output

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Increase in ideal time due to repairs and maintenance. Realisable value of the existing Asset: This is the extent to which old equipment can be traded in for the new one. Therefore, the earlier the replacement the higher is the realizable value of the existing asset and vise versa. Inflation: The general increase in price level and relative movement in the prices of goods and services will influence asset replacement decision. Taxation and Investment Incentives: Taxation and availability of investment incentives (such as capital allowance & investment allowance) will influence asset replacement decision. Opportunity Cost: This is the net benefit forgone as a result of trying to replace the existing asset with a new one. The new asset might increase productivity more than the old asset.

TYPE OF ASSET REPLACMENT DECISION There are two types of replacement decisions: Identical replacement decision Non-identical replacement decision 1) Identical Replacement decision: This involves the replacement of an existing asset with a new but identical asset. Two assets are termed identical if they produce the same cash flows i.e. both the existing asset and the replacing asset have the same financial characteristics. The problem therefore is to decide how frequently the asset should be replaced (i.e. what is the optimum replacement cycle). Non-identical replacement Decision:- When an asset is to be replaced with a non-identical asset the two assets are said to produce different cash flows. The problem is that of deciding on the best time (i.e. when) to replace the existing asset rather than the frequency of replacement. The optimal replacement option can be determined by using the equivalent annual cost which represents the cost of replacement.

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STEPS INVOLVED IN NON-IDENTICAL REPLACEMENT DECISION 1) 2) 3) 4) Determine the replacement option of the new asset. Identify the value of the relevant cash flows and discount this using the companys cost of capital. Calculate the Equivalent annual cost/Annual Equivalent Value of the new asset that would be used to replace the existing asset. Determine the replacement options for the existing asset.

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Estimate the relevant cash flows for each replacement options. The cash flow for each option will include the Equivalent annual cost or Annual Equivalent Value of the new asset. Calculate the NPV of each replacement options. The option with lowest NPV of cost or highest NPV of revenue will represent the optimal replacement period.

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METHODS OF EVALUATION IN ASSET REPLACEMENT DECISION 1) AVERAGE COST METHOD: This method involves the determination of average cost of each asset. It has to do with replacement decision without discounting.

It is calculated as: Average Cost = TC/RP Where: TC = Total cost RP = Replacement Period. The period which gives the lowest average cost represents the optimal replacement period. This method is used where discount rate is not given in the question. Wyse Pack Q1 pg 61 T Ltd 2) SUDDEN FAILURE METHOD There are three categories of cost under this method:1) 2) 3) The replacement cost of the asset: This is usually the purchase price at the time of replacement The consequential cost of failure The cost involved in the actual replacement of the assets.

STEPS INVOLVED IN SUDDEN FAILURE METHOD a) Calculate the expected life of the assets to be replaced using expected value technique. b) Calculate the average replacement of the assets.

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AR=

Total items available = Expected life

Number in use Expected life

Where: AR= Average replacement c) Calculate cost of individual replacement as they fail that is Average Replacement X Cost of Individual Replacement. d) Form an Asset failure table to calculate the Cumulative replacement e) Calculate the total cost as: TC = cumulative replacement cost + mass replacement cost. f) Calculate average cost for decision making AC = TC/RP Wyse Pack Q 2 Pg 61

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EQUIVALENT ANNUAL COST METHOD(EAC) OR ANNUAL EQUIVALENT VALUE(AEV) METHOD:- The length of life of an asset should not affect the decision on the asset but where the asset can be replaced or where a project is repeatable then the length of life of an asset becomes relevant factor to be considered. The investment criteria will be based on equivalent annual cost or annual equivalent value method which is defined as follows: EAC = NPV of Cost Annuity Factor OR AEV = NPV of Revenue Annuity factor

The best strategy is to calculate the NPV of cost/revenue over one of replacement and then divide by the Annuity Factor. Therefore, the optimal replacement period will be the period that has the lowest EAC or the highest AEV. The EAC is that amount that could be paid annually in arrears to finance the replacement options. NOTE:1) 2) Where project are one-off investment the selection procedure will be based on NPV. Where projects can be repeated indefinitely, the selection procedure would be based on EAC or AEV.

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Where the NPV of project is positive Annual Equivalent Value will be calculated and the option with the highest annual equivalent value will represent the optimal solution.

Wyse Pack Q3 Pg 61 Wyse Pack Q 4 Pg 62 ABDUL LTD 4) LOWEST COMMON MULTIPLE METHOD (LCM): The LCM of the various replacement cycles is determined and the NPV of cost over this cycle of replacement is also calculated. The LCM is used to determine the numbers of replacement cycle and it is very useful when inflation is involved in asset replacement decision.

STEPS INVOLVED IN LCM METHOD 1) Determine the replacement options 2) Determine LCM of the period of all the replacement cycle. 3) Estimates the cash flows over the LCM of the period for each option. 4) Discount the cash flows using the cost of capital over the LCM of the period. 5) The option with the lowest NPV of cost or highest NPV of revenue will represent the optimal replacement period. Wyse Pack Q9 Pg63 Kwara Express Wyse Pack Q8 pg63 Non identical replacement decision Question Wyse Pack Q12 Pg65 NEW SAW Wyse Pack Q12 Pg65 - OLD SAW 5) FINITE HORIZON: In practice when the maximum life of the asset is more than four (4) years, the lowest common multiple method becomes a difficult process and very long to compute. This will give rise to finite horizon method. For example, if the life of the asset is 5, the replacement option would be 1,2,3,4 or 5 year and the LCM would be 120. It would be difficult to use Lowest Common Multiple Method; therefore finite horizon method would be used to calculate the present value of cost over a significant time.

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