Lecture no48 replacement analysis with tax consideration

Replacement Analysis with Tax Consideration

Lecture No. 48
Chapter 14
Contemporary Engineering Economics
Copyright © 2016

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Replacement Analysis with Tax Consideration

•

When computing the net proceeds from sale of the old asset, any gains or losses must be
identified to determine the correct amount of the opportunity cost. (Example 14.6)

•

Whenever possible, replacement decisions should be based on the cash flows after taxes.
(Example 14.7)

•

All basic replacement decision rules including the way of computing economic service life remain
unchanged. (Examples 14.8 and 14.9)

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Example 14.6: Net Proceeds from the Disposal of an Old Machine

 Given: Depreciation schedule, tax rate = 40%,
and market value = $10,000

 Find: Market value to be used in replacement
analysis

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Example 14.7: Replacement Analysis Using the Opportunity Cost
Approach

 Given:
o

o
o
o

Depreciation schedule
Tax rate = 40%
Discount rate = 10%
All other financial information as
given in Example 14.2

 Find: Whether or not to replace the
defender now

AECD = $7,524
AECC = $6,723

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Excel Worksheet (Example 14.7)

Defender

Challenger

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Example 14.8: Economic Service Life of a Lift Truck on After-Tax Basis

 Given: Financial data as given in

Example 14.3, depreciation schedule, tax
rate = 40%, and discount rate = 9%



Forecasted Operating Costs and Net Proceeds from Sale as a Function of Holding Period

 Find: Economic service life

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Economic Service Life Based on After-Tax Cash Flows

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Economic Service Life

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Example 14.9: Replacement Analysis under the Infinite Planning Horizon

Defender

Challenger

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Summary of Economic Service Lives





Defender:

o

ND* = 2 years

o

AECD* = $3,030

Challenger:

o

NC* = 5 years

o

AECC* = $3,541

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Equivalent Annual Cash Flow Streams
 PW for an infinite cash flow stream when the

Defender is Kept for n Years followed by Infinitely
Repeated Purchases of the Challenger Every 4 Years

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Summary
o

In replacement analysis, the defender is an existing asset; the challenger is the best
available replacement candidate.

o

The current market value is the value to use in preparing a defender’s economic analysis.

Sunk costs—past costs that cannot be changed by any future investment decision—should
not be considered in a defender’s economic analysis.

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o
o
o

The opportunity cost approach views the net proceeds from sale of the defender as an
opportunity cost of keeping the defender. This approach works in all situations of
replacement problems.
Economic service life is the remaining useful life of a defender, or a challenger, that results in
the minimum equivalent annual cost or maximum annual equivalent revenue.
We should use the respective economic service lives of the defender and the challenger
when conducting a replacement analysis.

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o

Ultimately, in replacement analysis, the question is not whether to replace the defender, but when
to do so.

o

The AEC method provides a marginal basis on which to make a year-by-year decision about the
best time to replace the defender.

o

As a general decision criterion, the PW method provides a more direct solution to a variety of
replacement problems, with either an infinite or a finite planning horizon, or a technological
change in a future challenger.

o

The role of technological change in asset improvement should be weighed in making long-term
replacement plans.

o

Whenever possible, all replacement decisions should be based on the cash flows after taxes.

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Contemporary Engineering Economics, 6 edition
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