Question 6

Replacement decision can be defined as a capital budgeting decision to acquire a new asset or replace
and retire an old asset or to continue using the old asset. In short it is an investment in the replacement
of existing equipment or facilities. (Gallagher 2003, 317)

An expansion project can be defined as one in which company adds a project and does not
replace an existing one. Hence it is an investment in projects that expand existing equipment
or facilities. (Gallagher 2003, 317)

In the case of expansion decision one has to estimate both the costs which will be incurred
and the receipts which will be earned if investment is undertaken. Here a difficulty lies in the
fact that both costs and revenues will occur in future and it may not be easy to predict them.

The difference between costs and revenues is known as net cash flow from the asset or the
project and we have to estimate the net cash for each year of the asset’s life. More precisely,
the net cash flow is equal to the receipts from the sale of the output of the asset minus all the
cost (except depreciation on the assets) incurred in producing that output. The net cash flows
are then compared with the amount to be invested. (Kumar, n.d)

In the case of replacement decision, the question of shall we replace the existing equipment
with more efficient equipment will arise. Replacement projects include the maintenance of
existing assets to continue the current level of operating activity. On the other hand, reduction
of cost in projects such as replacing old equipment or improving the efficiency, are also
considered replacement projects.
In fact, replacement is seldom made without improvement. A worn out piece of equipment is
rarely replaced with an identical item. In this case we have to match the costs with the
expected increases in earnings i.e. Savings resulted from lower operating costs and or profit
from additional volume.

In analysing and evaluate replacement projects, comparison of the value of the firm with the
replacement asset to the value of the firm without that same replacement asset must be made.
By doing this comparison, opportunity cost can be identified. Hence what cash flows would
have been if the firm had stayed with the old asset can be evaluated. (Fabozzi, Peterson &
Drake 2003, 361-363)
In the case given, if new machine is to be used, useful life of the machine will be longer and
it can be use for another foreseeable future. At the same time, cost can be cut down as well
especially maintenance and expenses cost in relation to it. However, if new product is
purchase, it will cost more as stated in the case.
Looking at the risk aspect, slight risk is involved in the cash flows from replacement projects.
The form is simply replacing equipment or buildings already operating and producing cash
flows. And the firm typically has experience in managing similar new equipment.

As for expansion projects, which are intended to enlarge a firm’s established product or
market, also involve little risk. However, investment projects that involve introducing new
 products or entering into new markets are riskier mainly because the firm might has little or
no management experience in the new product or market.

Fabozzi F.J, Peterson P.P, Drake P.P, Financial Management and Analysis,
John Wiley and Sons 2003

Gallagher T.J, Andrew J.D, Financial Management; Principles and Practice,4th Edition
Upper Saddle River, N.J Prentice Hall 2003

Kumar N., Managerial Economics, Anmol Publications PVT, LT