Question

A. Explain in detail how the following can affect replacement decisions: i) taxes; ii)
existing asset value; iii) economic life of the challenger and the defender; iv) technology

Answer 1

ANSWER:

Replacement Decisions:

The defender is current asset and the challenger is the best available replacement applicant. The present market value is the value to use in preparing a defender’s financial analysis. Sunk costs—past costs that cannot be changed by any future investment decision— should not be considered in financial analysis.

1. Affect on taxes:

Replacement decisions affect on taxes while calculating the net profits from sale of the old asset, any gains or losses must be identified to determine the correct amount of the opportunity cost. If possible, replacement decisions must be based on the cash flows after taxes.

Every basic replacement decision rules including the way of calculating financial service life remain unchanged.

2. Affect on existing asset value:

The parts replacement decision should be based on facts and figures. The judgment is based on the costs of keeping the old equipment against the cost of its replacement. It includes the elements involved in making cost comparison.

Gradually, equipments deteriorate and become obsolete. Frequent breakdowns occur, defective output increases, unit labor costs rise, and production schedules cannot be met. At this point, one should decide whether or not to replace the equipment.

To recognize the better alternative, know the total cost of each alternative - keeping the old equipment or buying a replacement. Once these costs are determined, compare them and identify the more economical equipment.

3. Economic life of the challenger and the defender

The existing asset that is currently in service and which will be replaced in future with a new asset is the challenger asset.   

Analysis of the defender asset includes a benchmark comparison with one or more of the financial metrics associated with the defender asset.