ES ECON 1

CHAPTER 4.5
REPLACEMENT STUDIES
A decision situation often encountered in business firms and
government organizations, as well as by individuals, is
whether an existing asset should be retired from use,
continued in service, or replaced with a new asset. As the
pressures of worldwide competition continue to increase,
requiring higher quality goods and services, shorter
response times, and other changes, this type of decision is
occurring more frequently. Thus, the replacement problem,
as it is commonly called, requires careful engineering
economy studies to provide the information needed to
make sound decisions that improve the operating efficiency
and the competitive position of an enterprise.
Reasons for Replacement Studies
• Physical Impairment (Deterioration)
These are changes that occur in the physical condition of an asset. Normally,
continued use (aging) results in the less efficient operation of an asset.
• Altered Requirements
When the demand for a good or service either increases or decreases or the design
of a good or service changes, the related asset(s) may have the economics of its use
affected.
• Technology
The impact of changes in technology varies among different types of assets.
TYPES OF LIVES OF TYPICAL ASSETS
• Economic life is the period of time (years) that results in the minimum
equivalent uniform annual cost (EUAC) of owning and operating an
asset.
• Ownership life is the period between the date of acquisition and the
date of disposal by a specific owner.
• Physical life is the period between original acquisition and final
disposal of an asset over its succession of owners.
• Useful life is the time period (years) that an asset is kept in productive
service (either primary or backup). It is an estimate of how long an
asset is expected to be used in a trade or business to produce income.
FACTORS THAT MUST BE CONSIDERED
IN REPLACEMENT STUDIES
1. Recognition and acceptance of past errors
2. Sunk costs
3. Existing asset value and the outsider viewpoint
4. Economic life of the proposed replacement asset
(challenger)
5. Remaining (economic) life of the old asset (defender)
6. Income tax considerations
1. Past Estimation Errors
This refers to decisions about replacing assets in a business. It suggests that when
considering replacements, the focus should be on the future rather than dwelling on
past errors in estimating existing asset values.
It argues that discrepancies between a asset's book value and current market value
may not be mistakes but rather a result of the challenge of accurately predicting the
future during initial estimates.
The past estimation errors encourages accepting changing economic conditions and
making decisions based on future competitiveness instead of being fixated on past
issues. Additionally, it emphasizes that delaying replacement due to reluctance to
admit loss is counterproductive, as the loss has already taken place.
2. The Sunk-Cost Trap
when considering whether to replace an asset, only focus
on current and future cash flows. The unamortized values
of the existing asset and sunk costs (except for tax
implications) should not influence replacement decisions,
as they are tied to past decisions and can lead to errors if
not handled correctly in studies.
3. Investment Value of Existing Assets
and the Outsider Viewpoint
It is advised to use an "outsider viewpoint" when assessing the value of
existing assets for replacement. This perspective focuses on the fair
market value and avoids getting stuck on past costs.
It suggests that the right investment amount for an existing asset is its
present realizable market value, considering the opportunity cost of not
selling it at that value. If upgrading is needed, the extra cost should be
added.
The total investment in the existing asset is then the opportunity cost of
not selling at current market value plus the upgrade cost. Importantly, the
market value of the existing asset should not reduce the capital
investment of the new option to avoid unfair advantages.
4. Economic Life of the Challenger
an asset's economic life minimizes the Equivalent Uniform
Annual Cost (EUAC) of owning and operating it, and this
period is typically shorter than its physical or useful life. It
emphasizes the importance of understanding the
economic life of a challenger when comparing new and
existing assets over their optimum lives. Economic
information about challengers is regularly updated,
usually annually, and replacement studies are conducted
again to continuously assess improvement opportunities.
5. Economic Life of the Defender
The economic life of the defender is often one year.
6. The Importance of Income Tax
Consequences
The replacement of assets often results in gains or losses from the
sale of depreciable property. Consequently, to perform an accurate
economic analysis in such cases, the studies must be made on an
after-tax basis. It is evident that the existence of a taxable gain or
loss, in connection with replacement, can have a considerable effect
on the results of an engineering study.
A prospective gain from the disposal of assets can be reduced by as
much as 40% or 50%, depending on the effective income tax rate
used in a particular study. Hence, the decision to dispose of or retain
an existing asset can be influenced by income tax considerations.