Effects On Incentives To Replace An Asset

Audio Transcript of Asset Replacement

Link to the spreadsheet used in the above video

Asset Replacement, the Personal Case

Most individuals are rational and thrifty. This is to say that we hold onto things for a very long time and usually won't replace anything until it no longer works.
For the most part we try and squeeze every ounce of value out of an asset and then discard it.

Asset Replacement, the Business Case

The incentive to replace an asset for a business is very different. One of the facts of life that organizations must deal with and account for is that fixed assets lose their value, even as they continue to function and contribute to the firm. The function of depreciation accounting is used to address this loss of value over time. The IRS tax code has specific guidelines in place which dictate the method (MACRS) of depreciation. This creates incentives for businesses to replace assets at a much more accelerated rate then an individual would.

Asset Replacement, Personal Vs. Business

As an asset ages, such as a type writer, it depreciates Physically and Functionally. Physically, the mechanics of the machine may wear down over time, turning the typewriter into a glorified paperweight. Functionally the typewriter may lose the value it added to productivity as more and more of its services are transfered over to computers. Both forms of depreciation reduce the utility of an asset. An individual only takes these two forms of depreciation into account when they are considering replacing an asset. They will chose to replace the asset only when the change in utility (usefulness) between the current and replacement asset is at least as great as the cost of the replacement asset. The individual is only concerned with a single cash flow, the upfront cost of the asset (assuming both the original and replacement have the same O&M costs).

When a business considers replacing an asset, Physical and Functional depreciation still play a role, but a new from of depreciation also impacts the decision process, accounting depreciation. Accounting depreciation refers to the monetary depreciation of an asset that is reflected in its book value over its depreciable life. Accounting depreciation results a different cash flow for a business compared to an individual, due to the tax structure of depreciable assets. Tax savings (change in cash flow) are received relative to the decrease in an assets book value from year to year. A company receives tax breaks equal to the amount of accounting depreciation of the asset multiplied by the tax rate. For a business, the choice to replace an asset still depends on the utility the asset creates for the business, but for a business the change in utility between assets does not have to be as great as compared to the individual's case. A business will choose to replace an asset sooner than an individual, because the business receives decreased cash flows compared to an individual; the difference results from the tax breaks a firm receives during the assets depreciable life. Ultimately, for a business to choose to replace an asset, the utility created by the replacement asset has to be at least as large as the present value of a new asset.

When an individual is considering replacing their mattress, they will only choose do so if their utility will increase by at least as much as the value of the new mattress; their cash flow consists only of the mattresses initial purchase price. When a hotel chooses to replace its mattresses, it will choose to do so if the benefits created by the new mattresses are valued at least as highly as the present worth of the mattress's cash flow. The hotel's cash flow consists of the initial purchase price, and all following tax breaks resulting from the mattresses depreciation. In the end the hotel's cash flow is significantly lower than the individuals, which is evident when comparing the present worth of the mattress between the individual and the hotel. The following is a numerical example of a $2000 mattress (our asset) for an individual and a hotel:

For a individual to choose to replace their mattress, which will cost $2000, they will need to receive $2000 worth of benefits from the new mattress. Their cash flow is simply the initial $2000 cost. On the other hand; if a hotel were to replace the same mattress, which will cost $2000, they will only need $1,399.41 worth of benefits to be created by the new mattress over the course of seven years. This is due to the mattress having a 7 year depreciable life, with an initial cost of $2000, a tax rate of 30% and a 0.05 MARR. (1,399.41 is the present worth of the cash flow for the full depreciable life of the mattress. After the first year, the company receives positive cash flows for the remainder of a asset's depreciable life) —Below is a "table" to correspond with this example.

Year Depreciation Rate Depreciation Value Book Value After Tax (Depreciation) Post Tax Cash Flow
1 0.1429 $285.80 $1,714.20 $85.74 -$1,914.26
2 0.2449 $489.80 $1,224.40 $146.94 $146.94
3 0.1749 $349.80 $874.60 $104.94 $104.94
4 0.1249 $249.80 $624.80 $74.94 $74.94
5 0.0893 $178.60 $446.20 $53.58 $53.58
6 0.0892 $178.40 $267.80 $53.52 $53.52
7 0.0893 $178.60 $89.20 $53.58 $53.58
8 0.0446 $89.20 $0.00 $26.76 $26.76
Purchase Price Present Value Cash Flow:
$2,000.00 Business: -$1,399.41
Tax Rate Individual: -$2,000.00
0.3
MARR
0.05

A copy of this table as a spreadsheet with formulas and explanations of each formula can be found at https://docs.google.com/spreadsheets/d/1uoLbsuzkKiZN3uG5Le7iVVp5TX4nyhAnFtp1wjR64Q8/

The same decision process is used for a dentist office considering to replace furniture in its waiting room, compared to an individual looking to refurbish their home. Or for an accounting firm considering to replace its computers, as opposed to a individual looking to upgrade their computer.

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