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Sir, I don’t get what u said about EAC in ur asset replacement lecture. Please correct me if I understood wrong from your example.
It is assumed that the cost of replacing the asset discounted through the EAC formula is the cost of replacing an asset every two years forever…
This means that if EAC is ($44,878) which is the cost of replacing the asset every two years so we have a cash outflow of ($44,878) every year and the PV of those two years of replacing the asset is ($72972) .
Is that correct. Please explain!
Not quite the way you have put it. The EAC is the equivalent annual cost.
Paying out 44,878 per year is equivalent to repeating the actual 2 year flows every 2 years, because the PV is the same.
We need the EAC to be able to compare the different replacement periods.
Replacing every two years = NPV ($72,972)
This is the cost of replacing the asset every two years – means that we will sell this machine after two years at a cost of $72,972 and this is going to be paid every two years time even if we bought a new machine.
You said in the lecture that we can’t compare the asset replacing every 2 years with the replacing every 3 years because there would be different NPVs resulted due to differences in years of asset replacement [Is that correct?]
So to make comparable the asset replacement of every 2 years & every 3 years; We calculate EAC which means to discount the NPV $72,972 with the Annuity Discount Factor of 15% for 2 years of replacement which would result in a cost of ($44,878) which is paid every year.
If we discount the EAC of ($44,878) every 2 years it will be equal to the NPV of ($72,972) like as such:
[Time 1]
$44878 / (1.15)^1 = $39,025
[Time 2]
$44878 / (1.15)^2 = $33,935Sum of the figures would be equal to $72,972 replacing every two years. The difference is due to the rounding issue…
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