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, 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?

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.

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.

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.

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.

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 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?

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?

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.

noitiut says

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?

Kt-lou says

Hi, why does the replacement calculate a PV rather than a NPV? Is this because revenue is not in the calculation?

John Moffat says

Correct.

lopok says

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?

John Moffat says

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.

dennissherpa101 says

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?

John Moffat says

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.

dennissherpa101 says

Sir I have been having a very hard time understanding this part. would you be kind enough to maybe give an example?

John Moffat says

But I do explain this and give examples in the lecture.

tafarabako says

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

John Moffat says

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.

Farjana027 says

Hi! I am confused about where you get 1.626. Could you please explain?

John Moffat says

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.

adch111 says

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

John Moffat says

No – the post-tax cost of capital

adch111 says

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

simran98 says

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.

John Moffat says

Why on earth should the cost of buying a new (replacement) machine be any cheaper?

Shivangi says

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)

pelvinn says

Sir,

Why are running costs recognised at the end of the year?

Wouldn’t these be incurred throughout the year?

John Moffat says

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.

faith20ul19 says

Well presented. Thank you

fahad100 says

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?

John Moffat says

No, because that is 0 to infinity, whereas the EAC is from 1 to infinity.

Gajendra says

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.

John Moffat says

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.