Discounted Cash Flow Further Aspects, Replacement – ACCA Financial Management (FM)
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Sir,
For example, if the useful life of an asset is 5 years and we’ve calculated the NPV also based on cash flows over the 5 year period.
But let’s say, replacing it every 3 years is the decision we’ve taken as that’s the best way to minimize the costs. Now shouldn’t we recalculate the NPV of the asset by only considering the cash flows until the third year and then only decide whether to buy it or not?
Hi, why does the replacement calculate a PV rather than a NPV? Is this because revenue is not in the calculation?
Correct.
Hi, thank you for the lectures.
you say within the renovations that if we will only need the car for 6 years and have the option of replacing every year/ 2 years/ 3 years, then the answer would change.
but I couldn’t understand why the answer will change?
Because we have assumed that we replace in perpetuity. If we are only replacing for 6 years then we need to calculate the PV for those six years.
hello sir can you please explain to me why the replacement cost aren’t comparable? just by discounting. aren’t the cost brought to year 0. if every cost are at year 0 then why it is not comparable?
No, they are not comparable. You cannot compare a PV that occurs every 2 years for ever with a PV that occurs every 3 years for ever. That is why we need the second step so as to make them comparable.
Sir I have been having a very hard time understanding this part. would you be kind enough to maybe give an example?
But I do explain this and give examples in the lecture.
Hi. Thank you for the well presented lecture. However, I have one question. I once read that you can’t charge maintenance costs in the year of replacement. Like for instance, in year 2 the relevant cash flows are the initial cost, year 1 running costs and the year 2 scrap value only since we don’t maintain the asset in the year of disposal. May you please explain further because I’m confused now
It depends on the wording of the question and there is no ‘rule’. Just as in real life, they might need to pay for maintenance in the year of disposal to be able to keep it running for that year, or they might not need to pay for maintenance simply because they are disposing of it.
Hi! I am confused about where you get 1.626. Could you please explain?
It is the 2 year annuity factor at 15% from the tables provided in the exam.
If you are unsure about annuity factors then do watch the Paper MA lectures on investment appraisal.
Hi,
Is the after pre-tax cost of capital used for replacement while the after-tax cost of capital used for lease vs buy?
thanks
No – the post-tax cost of capital
Hi John,
I had got this question wrong in an ACCA specimen paper where they had used the pre tax value of 12% and I had used the post tax value of 7%, However I see now that the question had stated, “Where relevant, all information relating to this project has already been adjusted to include expected future inflation.Taxation and tax allowable depreciation must be ignored in relation to machine 1 and machine 2”. So to my understanding unless stated otherwise use the post tax cost of capital.
Thanks
Sir,
Won’t the replacement cost be cheaper always in the last year mentioned in the question?
For eg, over here the machine has a maximum life of 3 years, so the replacement cost is cheaper at the end of 3rd year. If the machine had the maximum life of supposing, 5 years, then the replacement would have been cheaper at the end of 5 years.
Why on earth should the cost of buying a new (replacement) machine be any cheaper?
Not particularly. Try it for yourself and mess around with the numbers.
If the running costs say were a lot higher than 12000 in the third year or if there was maybe no scrap value at all, then it might be cheaper to replace the machine every two years instead, where you still get a $9600 scrap value and the maintenance of the machine would be more affordable.
Ofcourse, the cost/purchase price of buying a replacement/new machine at any point would not change. (or that is the assumption anyway for this chapter)
Sir,
Why are running costs recognised at the end of the year?
Wouldn’t these be incurred throughout the year?
We always assume that operating cash flows occur at the end of years unless specifically told otherwise.
I do explain this (and the reason for it) in my earlier lectures on investment appraisal.
Well presented. Thank you
Sir i couldn’t understand why we are calculating EAC when we are replacing machine every one year.We have to pay 57,384 now, every one year till infinity so isn’t this comparable to 2 years and 3 years EAC?
No, because that is 0 to infinity, whereas the EAC is from 1 to infinity.
One thing that I am curious about is, when an investment decision is made considering the cash inflows and outflows from the project, isn’t the cost of replacement already been considered? When an asset within a project is then replaced , doesn’t it affect out previous NPV calculation?
Thank You.
No, because the cost of the new asset is taken into account in calculating the NPV of the first machine. This is then repeated and therefore includes again the cost of the replacement machine.