Business finance : theory and practice

Chapter 5 • Practical aspects of investment appraisal
5.9 Replacement decisions
A particular type of investment decision is determining when to replace an existing
asset with an identical one.
Example 5.8
A business owns a fleet of identical motor vehicles. It wishes to replace these vehicles after
either three or four years. Each one costs £10,000 to replace with a new vehicle. If the business
replaces the vehicles after three years it can trade in the old vehicles for £5,000 each.
If it retains the vehicles for a further year the trade-in price falls to £4,000. Assuming that the
business regards a 15 per cent discount rate as appropriate, which trade-in policy will be
cheaper?
Assume that the running costs of the vehicles, ignoring depreciation, are identical for
each year of the vehicles’ life.
Unhelpful
‘solution’
The relevant cost of owning one vehicle, expressed in present value terms, as at the date of
buying a new vehicle, is:
Replace after Replace after
3 years 4 years
£ £
Cost of the vehicle (10,000) (10,000)
Present value of the disposal proceeds:
£5,000 × [1/(1.00 + 0.15) 3 ] 3,288
£4,000 × [1/(1.00 + 0.15) 4 ] 2,287
Net present cost of owning the vehicle 6,712 7,713
For a wealth-maximising business, it would appear at first glance that the threeyear
replacement cycle offers the better option. These two figures cannot, however, be
directly compared because one of them is the net present capital cost of owning a vehicle
for three years, whereas the other is the net present capital cost of owning the
vehicle for four years.
One solution to this problem is to look at the position over 12 years. This is because
whichever of the two replacement periods (after three years or after four years) is
selected, after 12 years the business would be on the point of replacing the vehicle and
would have had continual use of a vehicle throughout this period. In other words we
should be comparing two costs that have both led to a similar provision.
130