Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, Replacement Basics

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, of 52 Chapter 11 Replacement Decisions Replacement Analysis Fundamentals Economic Service Life Replacement Analysis When a Required Service is Long Replacement Analysis with Tax Consideration

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, of 52 Replacement Terminology Sunk cost: any past cost unaffected by any future decisions Trade-in allowance: value offered by the vendor to reduce the price of a new equipment Defender: an old machine Challenger: a new machine Current market value: selling price of the defender in the market place

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, of 52 Sunk Cost associated with an Assets Disposal $0 $5000 $10,000 $15,000 $20,000 $25,000 $30,000 Original investment $10,000$5000 Market value $10,000 Lost investment (economic depreciation) Repair cost $20,000 Sunk costs = $15,000

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, of 52 Replacement Decisions Cash Flow Approach Treat the proceeds from sale of the old machine as a down payment toward purchasing the new machine. Opportunity Cost Approach Treat the proceeds from sale of the old machine as the investment required to keep the old machine.

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, of 52 Example 11.2 Replacement Analysis – Cash Flow Approach $8000 $2500 $15,000 $6000 $5500 (a) Defender(b) Challenger $10,000 Sales proceeds from defender

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, of 52 Annual Equivalent Cost - Cash Flow Approach Defender: PW(12%) D = $2,500 (P/F, 12%, 3) - $8,000 (P/A, 12%, 3) = - $17, AE(12%) D = PW(12%) D (A/P, 12%, 3) = -$7, Challenger: PW(12%) C = $5,500 (P/F, 12%, 3) - $5,000 - $6,000 (P/A, 12%, 3) = -$15, AE(12%) C = PW(12%) C (A/P, 12%, 3) = -$6, Replace the defender now!

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, of 52 Example 11.3 Opportunity Cost Approach $8000 $2500 $15,000 $6000 $5500Defender Challenger $10,000 Proceeds from sale viewed as an opportunity cost of keeping the old asset

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, of 52 Defender: PW(12%) D = -$10,000 - $8,000(P/A, 12%, 3) + $2,500(P/F, 12%, 3) = -$27, AE(12%) D = PW(12%) D (A/P, 12%, 3) = -$11, Challenger: PW(12%) C = -$15,000 - $6,000(P/A, 12%, 3) + $5,500(P/F, 12%, 3) = -$25, AE(12%) C = PW(12%) C (A/P, 12%, 3) = -$10, Opportunity Cost Approach Replace the defender now!