Replacement Analysis with Tax Consideration Lecture No 48

Replacement Analysis with Tax Consideration • When computing the net proceeds from sale of

Example 14. 6: Net Proceeds from the Disposal of an Old Machine q Given:

Example 14. 7: Replacement Analysis Using the Opportunity Cost Approach q Given: o Depreciation

Excel Worksheet (Example 14. 7) Defender Contemporary Engineering Economics, 6 th edition Park Challenger

Example 14. 8: Economic Service Life of a Lift Truck on After-Tax Basis q

Economic Service Life Based on After-Tax Cash Flows Contemporary Engineering Economics, 6 th edition

Economic Service Life Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by

Example 14. 9: Replacement Analysis under the Infinite Planning Horizon Defender Contemporary Engineering Economics,

Summary of Economic Service Lives q Defender: o ND* = 2 years o AECD*

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

Summary o In replacement analysis, the defender is an existing asset; the challenger is

o The opportunity cost approach views the net proceeds from sale of the defender

o Ultimately, in replacement analysis, the question is not whether to replace the defender,

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Replacement Analysis with Tax Consideration Lecture No. 48 Chapter 14 Contemporary Engineering Economics Copyright © 2016 Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

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) Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

Example 14. 6: Net Proceeds from the Disposal of an Old Machine q Given: Depreciation schedule, tax rate = 40%, and market value = $10, 000 q Find: Market value to be used in replacement analysis Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

Example 14. 7: Replacement Analysis Using the Opportunity Cost Approach q Given: o Depreciation schedule o Tax rate = 40% o Discount rate = 10% o All other financial information as given in Example 14. 2 q Find: Whether or not to replace the defender now Contemporary Engineering Economics, 6 th edition Park AECD = $7, 524 AECC = $6, 723 Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

Example 14. 8: Economic Service Life of a Lift Truck on After-Tax Basis q Given: Financial data as given in Example 14. 3, depreciation schedule, tax rate = 40%, and discount rate = 9% q. Forecasted Operating Costs and Net Proceeds from Sale as a Function of Holding Period q Find: Economic service life Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

Example 14. 9: Replacement Analysis under the Infinite Planning Horizon Defender Contemporary Engineering Economics, 6 th edition Park Challenger Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

Summary of Economic Service Lives q Defender: o ND* = 2 years o AECD* = $3, 030 q Challenger: o NC* = 5 years o AECC* = $3, 541 Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

Equivalent Annual Cash Flow Streams q 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 Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

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. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

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. o 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. o We should use the respective economic service lives of the defender and the challenger when conducting a replacement analysis. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved

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. Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved