Repair vs. Replacement Decisions

Repairing vs. replacing equipment is a choice between alternative investments

The cost of the old asset is the repair cost plus the salvage value

There are guidelines for determining when you can ignore depreciation and income taxes in the calculation

The choice between repairing and replacing a piece of equipment is essentially a choice between alternative investments. For the repair vs. replacement decision, the cost of the old asset is the repair cost plus the foregone sale price (or salvage value). Consider the following simplified example, which ignores income taxes.

You can salvage a 15-year-old air handler for $8,000, or you could have it extensively repaired at a cost of $5,000 and use it for 10 more years, at which time it would be worthless. A new air handler costs $30,000 and would last for 20 years, with no salvage value at the end of 20 years. The new air handler is much more energy efficient and costs $10,000 per year for operation and upkeep, versus $13,000 per year for the old unit. Assume that the annual operating and repair costs increase at 3% per year. The cost of capital is 10%.

The cost of the old air handler is the foregone $8,000 salvage value plus the repair costs of $5,000 for a total of $13,000.
The present value (PV) of the operating and repair costs for 10 years is $89,489. Add that to the $13,000 for a total PV of $102,489 over the five years.
Converting the 10-year total of $102,489 into an equivalent annual cost, we solve for the annual payment that would be equivalent to the 10-year total, using the cost of capital of 10%. This calculation obtains an equivalent annual cost of $16,680 per year.
The cost of the new air handler is $30,000.
The PV of the operating and repair costs for 20 years is $104,505. Add that to the $30,000 for a total PV of $134,505 over the 20 years.
The equivalent annual cost for this option is $15,799 per year over the 20-year life.

The conclusion: replacing the air handler is the better decision, with a lower equivalent annual cost.

Note that many capital investment decisions made by managers involve non-revenue-producing systems. The right decision when replacing the airport courtesy van, the roof, the boiler, fryers, etc., is to minimize the equivalent annual costs of ownership. As with most decisions, good judgment and solid analysis tools are necessary. Part of the judgment needed is to know when to ignore depreciation and income taxes for simplicity purposes, and to economize on analysis effort.

Income taxes and depreciation can be ignored when one or more of the following apply:

The investment is small relative to the capital investment budget.
The tax life is short (less than 6 years), as is the useful life of the investment.
Marginal tax rates are under 20%.

You can download the spreadsheet used to make these calculations on the next page.