Replacement Analysis
Replacement Analysis is the method used in capital budgeting which helps to decide whether the existing assets need to replace or not. An entity needs to execute the effective replacement of the assets such as machinery, the roof of building, or group assets.
As time passed, assets are depreciated or impaired, and they are reaching the end of useful life. They will lose their capacity and some of them even broken before the end of useful life. If these assets broke down in the middle of the operation, it will impact the production as well as profit. In order to prevent such events, management needs to prepare the budget plan to replace these assets before they cause any troubles.
Moreover, assets may require to replace due to economic requirements, change in technology, and physical damage. Assets may be damaged due to an accident or disaster, so company needs to replace them before the end of useful life. Furthermore, some machines still in good condition, but we need to replace them due to technological change. If we do not make a change, our products cannot compete in the market.
Replacement Force
Replacement forces are the condition or factors which require the company to replace the assets otherwise it will have subsequent impact. These are the reasons which we need to replace the exiting assets.
| Factors | Explanation |
|---|---|
| Physical Deterioration | It is the condition which assets’ quality has decrease significantly and the performance also reduce. And it impact to the company production as it fall below standard level. |
| Technology Obsolescence | Technology change very fast, so company has to keep update if the assets have a significant impact on the final product. New update machine will produce better quality product. Some assets are required to replace as their spare parts are no longer available due to technology outdate. |
| Functional Obsolescence | The assets fail to operate as they suppose to be. They may in good physical condition but the main functions do not work and they cannot provide good quality to entity. |
| Legal Obsolescence | It is the order from government or regulators to retire the assets. Entity is forced to dispose the assets otherwise there will be subsequent penalties from governement. |
| Style Obsolescence | For hotels and restaurants, it requires up-to-date style and decoration. So they have to replace the assets when they are out date otherwise it will impact the company revenue. |
| Economic Obsolescence | Entity need to update production machinery in order to save cost of production such as material, labor and time. |
Replacement Analysis Example
Company ABC is considering replacing the existing bakery machine with a new one. A new machine costs $ 100,000 with the free maintenance cost of 2 years. Company cost of capital is 10%. The detailed information of both machines are included below:
Current Machine
| Year | Scrape Value at End of year | Maintenance Cost |
| 0 | 30,000 | 15,000 |
| 1 | 25,000 | 15,000 |
| 2 | 20,000 | 15,000 |
| 3 | 15,000 | 15,000 |
| 4 | 10,000 | 15,000 |
New Machine
| Year | Scrape Value at End of year | Maintenance Cost |
| 0 | 50,000 | |
| 1 | 40,000 | 5,000 |
| 2 | 30,000 | 5,000 |
| 3 | 20,000 | 5,000 |
| 4 | 20,000 | 5,000 |
| Existing (Defender) | New (Challenger) | |
| Price (P) | 30,000 | 100,000 |
| Annual Operating Cost | 10,000 | 0 |
| Salvage Value | 20,000 | 40,000 |
| Time (N) | 4 | 4 |
Defender EAC = 15,000 + 30,000 (AP,10,4) – 10,000 (AF,10,4)
= 15,000 + 30,000 (0.31547) – 10,000 (0.21547) = 22,309
Challenger EAC = 5,000 + 50,000 (AP,10,4) = 20,773
As the challenger spend less cost, the company should replace the asset at the end of 4th year.
Limitation of Replacement Analysis
- The company may decide to replace to asset due to a technology update, however, the new asset may require to replace again after purchase.
- The analysis does not include the impact of tax so it is not reflected in real-world business.
- The production capacity may not continue in perpetuity.