Model Answer
0 min readIntroduction
Replacement analysis is a critical aspect of capital budgeting, particularly for organizations relying on machinery with finite useful lives. Determining the optimum replacement period involves evaluating the economic viability of continuing to use an existing asset versus acquiring a new one. This decision is influenced by factors such as decreasing efficiency, increasing maintenance costs, technological advancements, and the time value of money. A well-timed replacement can lead to cost savings, increased productivity, and a competitive advantage. This answer will outline the process of determining the optimum replacement period for the machine in question, assuming relevant cost data is available.
Understanding the Replacement Problem
The core of the problem lies in comparing the costs associated with continuing to operate the existing machine versus replacing it with a new one. These costs include:
- Operating Costs: Costs directly related to running the machine (e.g., power, labor, raw materials).
- Maintenance Costs: Costs associated with keeping the machine in working order (e.g., repairs, preventative maintenance). These typically increase with the age of the machine.
- Salvage Value: The estimated resale value of the machine at the end of each period.
- Cost of New Machine: The initial investment required to purchase a new machine.
Methods for Determining Optimum Replacement Period
Several methods can be used to determine the optimum replacement period. Two common approaches are:
1. Equivalent Annual Cost (EAC) Method
The EAC method converts all costs and benefits associated with each option (keeping the old machine or replacing it) into an equivalent annual series. The option with the lowest EAC is considered the most economical.
- Calculate the Present Value of Costs: Determine the present value of all future costs associated with each option. This includes operating costs, maintenance costs, and salvage value.
- Calculate the Annual Equivalent Cost: Convert the present value of costs into an equivalent annual cost using the appropriate discount rate and the number of years considered. The formula for EAC is: EAC = PV / [(1 - (1 + r)^-n) / r], where PV is the present value of costs, r is the discount rate, and n is the number of years.
- Compare EACs: Compare the EAC of keeping the old machine with the EAC of replacing it. The option with the lower EAC is the more economical choice.
2. Present Value Analysis
This method involves calculating the present value of all future cash flows associated with each option. The option with the higher present value is considered the most economical.
- Estimate Future Cash Flows: Project the expected cash inflows (e.g., revenue generated by the machine) and cash outflows (e.g., operating costs, maintenance costs) for each option over the relevant time horizon.
- Calculate the Present Value of Cash Flows: Discount all future cash flows back to their present value using the appropriate discount rate.
- Compare Present Values: Compare the present value of cash flows for each option. The option with the higher present value is the more economical choice.
Illustrative Example (Using EAC)
Let's assume the following data (hypothetical):
| Year | Operating Cost | Maintenance Cost | Salvage Value |
|---|---|---|---|
| 0 | - | - | ₹50,000 |
| 1 | ₹20,000 | ₹5,000 | ₹40,000 |
| 2 | ₹25,000 | ₹8,000 | ₹30,000 |
| 3 | ₹30,000 | ₹12,000 | ₹20,000 |
Cost of New Machine: ₹60,000. Discount Rate: 10%
We would calculate the EAC for each year of potential replacement (Year 1, Year 2, Year 3). The year with the lowest EAC would represent the optimum replacement period. (Detailed calculations are omitted for brevity but would be included in a full answer). For instance, if the EAC is lowest at Year 2, then replacing the machine after 2 years would be the optimal strategy.
Considerations Beyond Financial Analysis
While financial analysis is crucial, other factors should also be considered:
- Technological Advancements: If a new technology is expected to significantly improve efficiency or reduce costs, it may be worthwhile to replace the machine even if the financial analysis is marginal.
- Strategic Considerations: The replacement decision should align with the organization's overall strategic goals.
- Availability of Spare Parts: As machines age, spare parts may become difficult or expensive to obtain.
- Downtime Costs: Increased downtime due to breakdowns can significantly impact productivity.
Conclusion
Determining the optimum replacement period for a machine requires a thorough analysis of costs, benefits, and qualitative factors. The Equivalent Annual Cost (EAC) and Present Value analysis are valuable tools for evaluating the economic viability of different options. However, it’s crucial to consider technological advancements, strategic goals, and operational factors alongside the financial calculations. A holistic approach ensures a well-informed decision that maximizes long-term value and minimizes risk.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.