Investment Appraisal, Part II: Replacement Cycles and Taxation

There are many decisions that companies have to make involving the investment of capital in long and short-term assets. Whether a company classifies certain assets as long or short-term will often depend on the replacement cycle policy, hence the need to properly assess the costs of replacement cycles. Likewise, when making capital investments through purchasing capital items such as cars, fixtures and fittings, machinery etc., there are certain tax reliefs i.e. capital allowances (annual investment allowance, first year allowance, tax written down allowances [for different asset pools]) which may be claimed, reducing the amount of tax to be paid on the assets. As this is a monetary aspect, this will affect future cash flows, and thus the expected net present value will be affected, which may in turn impact on the replacement cycle decision.

Replacement Cycles

Many assets that companies buy have finite lives e.g. buildings, motor vehicles etc. This means that at some point they need to be replaced. Items to consider in terms of the regularity of the asset replacement will most likely include;

  • Technological change
  • Cost savings e.g. newer assets are likely to be more efficient (cars – fuel)
  • Increased maintenance costs – generally older assets require more upkeep
  • Scrap values (resale value) – the faster the asset is replaced, the higher its resale value
  • Cost of new asset – normally very expensive to buy brand new

Some items such as vehicles are often replaced on a regular basis, thus a replacement cycle can be calculated. This helps to determine how often the assets should be replaced to make sure the best financial benefit is achieved i.e. greatest profit on resale, or lowest loss.

Replacement life cycles need to be made equivalent as they vary in length and thus cannot be compared directly. This could be done in a number of ways;

Lowest Common Multiple (LCM) – in the example below, the LCM would be 6, so cash flows could be calculated over 6 years.

Annual Equivalent Annuity (AEA) – this is the annuity the company would need to achieve the NPV of the project (PV/AF). As it is an annual figure, and is therefore comparable even though the projects are of different length. It is calculated using the relevant annuity factor as follows:

AEA

The AEA method is only useful for assets that have high predictability of cash flows. If the price of the asset is expected to change rapidly then this method is not suitable. However, the AEA can be used as a guide along with good judgement which is often developed and enhanced by experience or example from other companies that have perhaps undertaken a similar project under similar conditions.


Worked Example: Replacement Cycles

Dickins Transport Ltd. owns several cars and is looking to implement a replacement cycle policy for renewing its vehicular assets. At present, they have decided that they could replace the cars every year, every two years, or every three years. The initial cost of a car is £10,000, this does not include annual maintenance fees nor does it account for any scrap values upon sale of the assets. The following information is available regarding annual maintenance costs and scrap values:

Maintenance:                Scrap values:

Year 1 –   £   400            Year 1 – £7,500

Year 2 –   £   700            Year 2 – £5,400

Year 3 –   £1,100             Year 3 – £2,900

Due to the company’s capital structure, they also have a cost of capital of 12% and expect this to remain as the cost of capital for the foreseeable future.

Q.      Advise the company as to how often they should replace their vehicular assets, giving a reasonable explanation of your answer.

Answer: click here to download answer.


 

Taxation

If a project affects the tax liabilities of a firm, then the incremental effects need to be included in the cash flow – this often means calculating capital allowances. The effect of profits/losses of a project on the overall tax bill of a firm also needs to be considered.


Worked Example: Taxation

HammerJacks Plc. are thinking about buying a new machine costing £90,000, which will have a life of three years and a scrap value of £8,000. It is expected to generate cash flows of £52,000 in year one, £79,000 in year two and £64,000 in year three. Capital allowances are available at 25% on a reducing balance basis. Corporation tax is 30% payable in the year the profit is made. The cost of capital is 10%.

Q.      Calculate the expected net present value (NPV) of the project after allowing for capital allowances and tax.

Answer: click here to download answer.


 

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