The Replacement Decision A Special Case of Mutually Exclusive Projects

In a replacement decision, we evaluate the replacement of an existing investment with a new one, generally because the existing investment has aged and become less efficient. In a typical replacement decision,

• the replacement of old equipment with new equipment will require an initial cash outflow, because the money spent on the new equipment will exceed any proceeds obtained from the sale of the old equipment.

• there will be cash inflows during the life of the new machine as a consequence of either the lower costs of operation arising from the newer equipment or the higher revenues flowing from the investment. These cash inflows will be augmented by the tax benefits accruing from the greater depreciation that will arise from the new investment.

• the salvage value at the end of the life of the new equipment will be the differential salvage value — i.e., the excess of the salvage value on the new equipment over the salvage value that would have been obtained if the old equipment had been kept for the entire period and had not been replaced. This approach has to be modified if the old equipment has a remaining life that is much shorter than the life of the new equipment replacing it.

replace.xls: This spreadsheet allows you to analyze a replacement decision.

Illustration 6.6: Analyzing a Replacement Decision

Bookscape would like to replace an antiquated packaging system with a new one. The old system has a book value of $50,000 and a remaining life of 10 years and could be sold for $15,000, net of capital gains taxes, right now. It would be replaced with a new machine that costs $150,000 and has a depreciable life of 10 years, and annual operating costs are $40,000 lower than with the old machine. Assuming straight line depreciation for both the old and the new system, a 40% tax rate, and no salvage value on either machine in 10 years, the replacement decision cash flows can be estimated as follows: Net Initial Investment in New Machine = - $150,000 + $ 15,000 = $ 135,000 Depreciation on the old system = $ 5,000 Depreciation on the new system = $ 15,000

Annual Tax Savings from Additional Depreciation on New Machine = (Depreciation on old machine - Depreciation on new machine) (Tax rate) = ($15,000-$5,000)*0.4 = $ 4000

Annual After-tax Savings in Operating Costs = $40,000 (1-0.4) = $ 24,000

The cost of capital for the company is 12%, resulting in a net present value from the replacement decision of

Net Present Value of Replacement Decision = - $135,000 + $ 28,000 * PV(A,12%,10 years) = $23,206

This result would suggest that replacing the old packaging machine with a new one will increase the firm's net present value by $23,206 and would be a wise move to make.

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Responses

  • terri talley
    Is replacement decision mutually exclusive?
    7 years ago

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