Question

Let's look "beyond accounting" for a moment. From a business perspective, why should there be "high scrutiny" before the decision is made to dispose of an asset - even if it is old and not "state of the art?" As a hint, think about using an old car vs. buying a new one that might be a bit more fuel efficient. Is the extra monthly payments really going to offset the gas guzzling old vehicle? Why do managers need to look at the decision from a higher level?

Answer 1

The problem in the question is whether to repair or replace-

In businesses, there are many factors which one needs to be considered

Old Assets-

Amount involved in regular maintenance

Consumption in terms of energy, fuel

Downtime due to frequent repairs

Reduction in production due to downtime

Resale value

New Asset

Life of an asset

Cost involved

Increase in production/efficiency

Whether the necessary results can be achieved with these investments?

Funding for such assets

Decision regarding replacement of an existing asset with another is based on the net present value and internal rate of return of the incremental cash flows, i.e. the difference between periodic net cash flows if the existing asset is kept and the periodic net cash flows if the asset is replaced.

In capital budgeting and engineering economics, the existing asset is called the defender and the asset which is proposed to replace the defender is called the challenger. Estimation of incremental cash flows for such replacement analysis involves calculation of net cash flows of the defender, net cash flows of the challenger and then finding the difference in cash flows for both the assets.

Calculating periodic cash flows of existing asset is straight forward. Since the existing asset is already purchased, the initial investment outlay is zero and the periodic net cash flows are calculated based on the following formula:

Net cash flows = (revenue – operating expenses – depreciation) * (1 – tax rate) + depreciation

If the asset is replaced, it involves investment is the new asset and sale or disposal of the existing asset. Disposal of exiting asset has some income tax implications which need to be reflected in the calculation of initial investment as follows:

Initial investment after replacement = cost of new asset - sale proceeds of old asset +/- tax on disposal

Tax on disposed asset = (sale proceeds of old assets – book value of old asset) * tax rate

As evident from the equation above, if the old asset is sold at an amount higher than its book value, the company bears a related tax cost which is added to the initial investment. Similarly, if the sale proceeds are lower than the book value of the asset sold, there is a resulting tax shield which is subtracted from sum of cost of new asset and sale proceeds of the old asset.