ACFI3203

Business Finance
Lecture 3

Lecturer:
Landry Simo
landry.simo@dmu.ac.uk
Office: HU 3.59
Office hours: Thursday 2 – 4 pm

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Lecture Objective
To understand the importance of replacement decisions and depreciation

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 Estimating the Annual Equivalent
Annuity (AEA)
The calculation of equivalent annual costs is a tool that can be used to assist in this decision-making
process.

The equivalent annual cost method involves the following steps:

Step 1 – Calculate the net present value (NPV) of cost for each potential replacement cycle.

Step 2 – For each potential replacement cycle an equivalent annual cost is calculated.

The decision – The replacement cycle with the lowest equivalent annual cost may then be chosen,
although other factors may also have to be considered.
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AEA- Example
The cost of capital of the company is 11% per year.

Calculate the optimal replacement cycle for the machine.

Time 0 1 2 3
Costs -3,500
Maintenance -900 -1,000 -1,200
Residual Value 2,100 1,600

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AEA- Example
Step 1- Calculate the NPV for each potential cycle (2 year)

Time 0 1 2

Costs -3,500
Maintenance -900 -1,000
Residual Value 2,100

Net Cash Flow (3500) (900) 1100

11% discount 1 0.901 0.812
PV (3500) (811) 893

NPV (3418)

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AEA- Example
Step 1- Calculate the NPV for each potential cycle (3 year)
Time 0 1 2 3

Costs -3,500
Maintenance -900 -1,000 -1,200
Residual Value 1,600

Net Cash Flow (3500) (900) (1000) 400

11% discount 1 0.901 0.812 0.731

PV (3500) (811) (812) 292

NPV (4831)

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AEA- Example
Step 2- Equivalent Annual Cost

Annual equivalent flow = ∑PV (cash flows)

PVAF

For 2 year: EAC = $-3,418/1.713 = $-1,995 per year

al
For 3 year: EAC = $-4,831/2.444 = $-1,977 per year tim
Op le
cyc

or (or read in formula sheets and table)

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Asset replacement
Decision basis:
Lowest cost

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 AEA Example: Unequal lives
Assume that the NPV of cash outflows for asset replacement

Asset A NPV is £64,300, with discounting at 12% and an asset life

of 4 years, while

for Asset B, the NPV of outflows is £79,355, also after discounting

at 12% but with an asset life of 6 years.

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AEA Example: Project A
Assume that the NPV of cash outflows for asset replacement
Asset A is £64,300, with discounting at 12% and an asset life of 4
years,

Annual equivalent costs are:

3.037 (AF for 4 years at 12%)

Asset A: 64,300 / 3.037 = 21,172

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AEA Example: Project B
For Asset B, the NPV of outflows is £79,355, also after discounting
at 12% but with an asset life of 6 years.

Annual equivalent costs are:

4.111 (AF for 6 years at 12%)

Asset B: 79,355 / 4.111 = 19,303

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AEA Example: Unequal lives
Annual equivalent costs are:

Asset A: 64,300 / 3.037 (AF for 4 years at 12%) = 21,172

Asset B: 79,355 / 4.111 (AF for 6 years at 12%) = 19,303

So on an annualised basis, Asset A has the higher advantage and

would be preferred

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The Replacement Decision
 The project forms part of a continuous replacement cycle.

 We need to apply a “modified” NPV decision rule.

 Cash flows may vary across different time periods.

 All cash inflows/outflows have to be put on an “equivalent

annual” basis.

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The Replacement Decision
Photolysis uses 10% discounting rate for project appraisal.
It is considering purchasing a machine which when it comes to
the end of its economic life is expected to be replaced by an
identical machine
The machine has a maximum life of three years but, as its
productivity declines with age, it could be replaced after just one
or two years

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THE REPLACEMENT
DECISION: EXAMPLE
Either one year, or two year, or three year cycle

Year 0 1 2 3

Outlay -£1,000
Revenues £900 £800 £700
Costs -£400 -£350 -£350
Scrap Value £650 £400 £150

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The Replacement Decision
Estimating the NPV of the replacement cycles – ONE YEAR CYCLE

Year 0 1
Outlay
Revenues
Costs
Scrap Value

Cash Flow

discount @ 10%

Present value

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The Replacement Decision
Estimating the NPV of the replacement cycles – ONE YEAR CYCLE

Year 0 1
Outlay -£1,000
Revenues £900
Costs -£400
Scrap Value £650

Cash Flow -£1,000 £1,150

discount @ 10% 1.000 0.909

Present value -1000 1045.35 45.35

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The Replacement Decision
Estimating the NPV of the replacement cycles – TWO YEAR CYCLE

Year 0 1 2
Outlay
Revenues
Costs
Scrap Value
Cash Flow
discount @ 10%

Present value

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The Replacement Decision
Estimating the NPV of the replacement cycles – TWO YEAR CYCLE

Year 0 1 2
Outlay -£1,000
Revenues £900 800
Costs -£400 -£350
Scrap Value £400
Cash Flow -£1,000 £500 £850
discount @ 10% 1.000 0.909 0.826

Present value -1000 454.5 702 156.6

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The Replacement Decision
Estimating the NPV of the replacement cycles – THREE YEAR CYCLE

Year 0 1 2 3
Outlay
Revenues
Costs
Scrap Value
Cash Flow
discount @ 10%

Present value

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The Replacement Decision
Estimating the NPV of the replacement cycles – THREE YEAR CYCLE

Year 0 1 2 3
Outlay -£1,000
Revenues £900 800 700
Costs -£400 -£350 -£350
Scrap Value 150
Cash Flow -£1,000 £500 £450 £500
discount @ 10% 1.000 0.909 0.826 0.751

Present value -1000 454.5 372 376 201.7

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The Replacement Decision

Estimating the NPV of the replacement cycles

 Dispose at year 1: 45.4

 Dispose at year 2: 156.6

 Dispose at year 3: 201.7

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Annuity factor

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The Replacement Decision

t NPV AEF Equivalent Annual

Cash Flow
1 £45.4 (1/0.909) = 1.1001 49.95
2 £156.6 (1/1.736) = 0.5761 90.22
3 £201.7 (1/2.487) = 0.4021 81.10

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The Replacement Decision

t NPV AEF Equivalent Annual

Cash Flow
1 £45.4 (1/0.909) = 1.1001 49.95

2 £156.6 (1/1.736) = 0.5761 90.22

3 £201.7 (1/2.487) = 0.4021 81.10

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AEA Example
 Annual Equivalent Annuity DIY
discount factor= 9%

Time 0 1 2 3
Cost (4500)

Maintenance (1000) (1200) (1400)

Residual 3100 3000 2500

Value
 YEAR 1
Time 0 1
Cost (4500)
Maintenance (1000)
Residual Value 3100

Net CF (4500) 2100

PV (4500) 1927

NPV= -2573
 YEAR 2
Time 0 1 2
Cost (4500)
Maintenance (1000) (1200)
Residual Value 3000

Net CF (4500) (1000) 1800

PV (4500) (917) 1515

NPV= -3902
 YEAR 3
Time 0 1 2 3
Cost (4500)
Maintenance (1000) (1200) (1400)
Residual Value 2500

Net CF (4500) (1000) (1200) 1100

PV (4500) (917) (1010) 849

NPV= -5578
AEA
Year 1: -2573/0.9174= -2805
Year 2: -3902/1.7591 = -2218
Year 3: -5578/ 2.5313 = -2204

Your decision?
 Project Appraisal: Cash Flow
Identify and apply relevant and incremental cash flows in net
present value calculations

Recognize and deal with:

◦ Sunk costs
◦ Opportunity costs
◦ Allocated overheads

Issues Affecting Cash Flows

◦ Depreciation
◦ Working Capital
◦ Incremental Cash Flows
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Example: ABC Plc

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ABC Plc: An example of adjustment to profit and loss account

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discount rate of
12%
NPV = £14,099

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Quality of Information
Information varies greatly in its reliability, which often depends upon its source
The financial manager or analyst is often dependent on the knowledge and
experience of other specialists
Information should also have the following qualities:
◦ Relevance
◦ Completeness
◦ Consistency
◦ Accuracy
◦ Reliability
◦ Timeliness

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Now....
Download tutorial exercise and have a go before class next week
Read
Arnold – Corporate Financial Management Chapter 4

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