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Explore the significance of replacement decisions in business operations, specifically analyzing the transition from old machine and equipment to new ones. Learn about differential cost analysis and its role in long-term investment decisions, considering annual and whole basis approaches. Understand the relevance of book values in determining replacement decisions and the need for a comprehensive capital budgeting evaluation.
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Replacement Decision • A company may have been producing products in an old machine and equipment. • Management may be interested to produce products replacing these old machine and equipments by new ones. • The decision of whether to produce the products in old equipment or produce them in new only by replacing old ones is known as replacement decision. • It is a long term investment decision. In order to take decision, differential cost analysis is followed. • Replacement decision can be analyzed on two ways • Annual basis ( based on annual proportion) • Whole basis (Based on total period) • In replacement decision, book values of the old machines are regarded as relevant cost which is the main determinant of the replacement decision. However, it does not consider the present value of the cash inflows and outflows. Therefore, the details should be studied in the capital budgeting decision.
