Page 5 - CIMA May 18 - MCS Day 1 Suggested Solution

SUGGESTED SOLUTIONS

CHAPTER FOUR

1. REPLACEMENT DECISIONS

An equivalent annual cost (EAC) is calculated by taking the present value of the costs of a
particular capital investment choice and dividing it by the annuity factor (cumulative discount
factor) for the period over which the present costs have been evaluated.

For instance, if a capital asset purchase was evaluated over a period of three years, a present
value covering the entire cash flows over the three years would be calculated. A calculation of the
equivalent annual cost would produce a figure that is the equivalent annual spend if the present
cash flows were to be spread evenly over the three year period.

EAC calculations are useful in two situations:

‐ where a capital need can be fulfilled by different types of asset that last for different periods of
time.

In Menta’s case this could be the related to the purchase of new buses from different suppliers.
One supplier may offer vehicles at a cheaper cost than another, but the useful life of its buses may
be shorter.

In this case, simply calculating the present value of the types of bus purchase over their useful
lives will not be enough to make an appropriate decision between them.

For instance, one supplier may offer a bus that has a present cost of $150,000 over a ten year
period. Another may offer a bus that has a present cost of $180,000 but is expected to have a
useful life of 12 years.

The present value calculations are not directly comparable due to the differing timescales that the
expenditure relates to.
An EAC calculation would convert these figures into annual costs, meaning that a direct
comparison can be made between the two types.

‐ where the asset to be purchased is known but the length of the replacement cycle has yet to be
determined.

In this situation, where an asset’s useful life can be extended by appropriate levels of
maintenance, it may not be immediately obvious whether to replace assets frequently, saving
money on maintenance costs and receiving a higher resale value on disposal, or to replace them
less frequently, incurring more maintenance costs and receiving a lower resale value but incurring
the initial capital cost less frequently.

In Menta’s case, it may have a preferred bus type that it wishes to purchase, but is undecided on
how frequently it should refresh the fleet of those buses.

If the company just calculates the present costs of each cycle, it may find that the present cost of
replacing a bus every 6 years is cheaper than replacing it every 10 years due to the extra
maintenance costs during the extra four years and the lower disposal value after another four
years of use.

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