Page 1 - CIMA MCS Workbook February 2019 - Day 2 Suggested Solutions

Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

CHAPTER EIGHT

TASK 1 ‐ REPLACEMENT ANALYSIS AND CAPITAL RATIONING

To: Senior financial manager
From: Financial Manager
Date: Today
Subject: Asset replacement

Capital asset replacement analysis

Capital assets naturally wear out over time. One question that a business has is how frequently to
replace the assets it uses. This is particularly relevant for capital assets and even more so for
Crowncare where we need to have high quality, up to date equipment.

For instance, the dentists’ chairs used by the company are in constant use and have several
moving parts. Without a working chair, the dentist will not be able to offer dental services. If the
chairs owned by Crowncare are allowed to wear out to the point where it they not performing
adequately, this would severely compromise our ability to operate.

However, the expense of the chairs means that replacing them too frequently would mean
significant excessive expenditure on them. A balance therefore needs to be struck that means
holding onto them for long enough to get a good level of productivity from them, while not
holding on to them for so long that maintenance costs and downtime become prohibitive or they
fail completely.

There is a method of analysing the costs in relation to replacement cycles for capital assets called
equivalent annual cost analysis.

This involves the use of discounted cash flow techniques to calculate the present values of costs
for each possible cycle of replacement. For instance, we might wish to compare the costs of
replacing on 2, 3 and 4 year cycles.

Once the present costs are calculated, another calculation is needed so that we can directly
compare the present costs for these cycles of different lengths.

By taking the present values and dividing them by an annuity factor for the length of the cycle, we
calculate a figure that represents an equivalent annual spend if we were to spread the costs
evenly over the length of the cycle and repeat the cycle over and again.

It is then a case of comparing these annual costs to see which is cheapest.

This technique allows us to minimise the spend we incur on replacement.

However, it has some significant drawbacks, due to the assumptions made in the calculations.

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