Asset Replacement Decision

Question 1

What is the discounted cash flow (DCF) technique for asset replacement decisions?

Answer 1

• DCF Technique: Assists in deciding the frequency of asset replacement, especially when replacing with an identical asset.
• Equivalent Annual Cost Method: Calculates the optimum replacement cycle by converting the NPV of the cost over the asset’s life cycle into an equivalent annual cost or annuity.
• Calculation Steps:
  
  • Calculate the present value of costs for each replacement cycle over one cycle only.
  • Convert the present value into an equivalent annual cost (an annuity).
• Continuous Costs: The method considers costs that are continuous and not comparable due to different time periods.

Question 2

What is the equivalent annual benefit and how is it calculated?

Answer 2

• Equivalent Annual Benefit: It is the annual annuity that has the same value as the net present value (NPV) of an investment project. (NPV/Annuity Factor)
• Calculation Examples:
  
  • Project A: With an NPV of $3.75m over 6 years at a 12% discount rate, the equivalent annual annuity is calculated as $$ \frac{3.75}{4.111} = 0.91 $$.
  • Project B: With an NPV of $4.45m over 7 years, the equivalent annual annuity is $$ \frac{4.45}{4.564} = 0.98 $$.
• Project Comparison: Project B will be ranked higher than Project A using this method, which is useful for comparing projects with unequal lives.

Question 3

What is the Lowest Common Multiple Method in asset replacement decisions?

Answer 3

• Lowest Common Multiple Method: This approach finds the lowest cost of different possible cycles over a common time frame, which can accommodate the lowest possible number of complete cycles for each option.
• Inflation Consideration: Unlike the equivalent annual cost method, this method can take inflation into account.
• Examples:
  
  • For a 1 or 2 years replacement cycle, the lowest common multiple would be 3.
  • For a 1, 2, or 3 years replacement cycle, the lowest common multiple would be 6.
  • For a 4 or 6 years replacement cycle, the lowest common multiple would be 12.