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Replacement Decision Capital Budgeting

Replacement Decision Capital Budgeting

Capital budgeting refers to the process we use to  make decisions concerning investments in the long-term assets of the firm.

Replacement decision—a decision concerning whether an existing asset should be replaced by a newer version of the same machine or even a different type of machine that has the same functionality as the existing machine. Such replacements are generally made to maintain existing levels of operations, although profitability might change due to changes in expenses (that is, the new machine might be either more expensive or cheaper to operate than the existing machine).

Therefore analysis of replacement decision follows certain steps:

Step I. Net cash outflow (assumed at current time /[Present value of cost]):

a. (Book value of old equipment – market value of old equipment) × Tax Rate = Taxpayable/savings from sale

b. Cost of new equipment – [Tax payable/savings from sale + market value of old equipment] = Net cash outflow

Step II. Estimate change in cash flow per year, if replacement decision is implemented.

Change in cash flow = [(Change in sales + Change in operating costs) – Change in depreciation] (1 – tax rate) + Change in depreciation

Step III. Present value of benefits = Present value of yearly cash flows + Present value of estimated salvage of new system

Step IV. Net present value = Present value of benefits – Present value of costs

Step V. Decision rule:

Accept when present value of benefits > present value of costs.

Reject when the opposite is true.

Replacement Decision Capital Budgeting

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