The class is called Managerial Accounting This week's topic of discussion is: Managerial Accounting and Job-Order Costing Let's look "beyond accounting" for a moment

Answer:

The issue is deciding whether to repair or replace. There are numerous factors that must be taken into account in business.

Old Assets

• Amount involved in regular maintenance
• Consumption in terms of energy, fuel
• Downtime due to frequent repairs
• Reduction in production due to downtime
• Resale value

New Asset

• Life of an asset
• Cost involved
• Increase in production/efficiency
• Funding for such assets

Step-by-step explanation

The net present value and internal rate of return of the incremental cash flows, i.e. the difference between periodic net cash flows if the existing asset is kept and periodic net cash flows if the asset is substituted, are used to make the decision to replace an existing asset with another.

The existing asset is referred to as the defender in capital budgeting and engineering economics, and the asset recommended to replace the defender is referred to as the challenger. Estimating incremental cash flows for such replacement analyses entails calculating the defender's net cash flows, the challenger's net cash flows, and then calculating the difference in cash flows for both assets.

It is simple to calculate the periodic cash flows of an existing asset. Because the existing asset has already been purchased, the initial investment is zero, and the periodic net cash flows are computed using the formula given:

Net cash flows = (revenue - operating expenses - depreciation) * (1 - tax rate) + depreciation

If an asset is substituted, it necessitates an investment in the new asset as well as the sale or disposal of the existing asset. The sale of an existing asset has some income tax implications that must be considered when calculating the initial investment, as shown:

Initial investment after replacement = cost of new asset - sale proceeds of old asset +/- tax on disposal

Tax on disposed asset = (sale proceeds of old assets - book value of old asset) * tax rate

As shown in the equation above, if the old asset is sold for more than its book value, the company incurs a tax cost that is incorporated to the initial investment. Equally, if the sale proceeds are less than the book value of the asset sold, a tax shield is created that is deducted from the sum of the cost of the new asset and the sale proceeds of the old asset.