An organisation may be faced with a decision on the best policy regarding the replacement of assets. If the asset is to be replaced with an “identical asset” the question is how long to retain the asset and the optimum interval between replacement ?
When making this decision the cash flows which must be considered are:
- Capital Cost – the more frequent the replacement cycle, the more frequently this will be incurred.
- Maintenance/Running Cost – this tends to increase with the age of the asset.
- Resale/Residual Value – this tends to decrease with the age of the asset.
EQUIVALENT ANNUAL COST
One method of identifying the optimum replacement cycle for an asset is to calculate the Equivalent Annual Cost (EAC).
This technique examines the various replacement options and calculates the present value of the total costs, over one cycle only. For example, if a machine has a life of three years there are only three options – replace every year, every two years or every three years. For each option identify the cash flows over one cycle:
- Replace every year – identify cash flows over a one year cycle
- Replace every two years – identify cash flows over a two year cycle
- Replace every three years – identify cash flows over a three year cycle
Finally, having obtained the present value of the cash flows over each cycle, convert them to an Equivalent Annual Cost by dividing the total costs by the appropriate annuity factor (one year; two year or three year).