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Asset investment decisions and capital rationing

Replacement decisions

If a capital asset is to be replaced, there are different potential replacement
strategies.

Issues arise where there are competing replacements for a particular asset:

 Equivalent available assets may last for different lengths of time

 Assets may need to be replaced at regular intervals

Calculation of the present costs of each available asset will make each individual set
of cash flows equivalent to each other in terms of time value but will not make the
overall decisions comparable to each other.

For instance an asset that lasts for two years may be cheaper than an asset that
lasts for four but the replacement cash flows would have to be spent twice as
frequently.

In order to make the different strategies comparable, use equivalent annual costs
(EACs).

PV of costs
Equivalent Annual Cost = –––––––––––––––––––
Annuity factor for year n

Where n is the length of the replacement period in years

This converts the cost of each decision into an equivalent annuity figure meaning that
they can be compared on a like for like basis.

The decision that has the lowest EAC will be the one chosen.

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