416 REPLACEMENTANALYSIS
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A laptop word processor model SK-30 was purchased 2 years ago for $1600; it has been depre-
ciated by straight-line depreciation using a 4-year life and zero salvage value. Because of recent
innovationsin wordprocessors, the current price of t4e SK-30 laptop has been reduced from $1600
to $995. An officeequipment supply finn has offered a trade-in allowance of $350 for the SK-30
onanew $1200 model EL-40 laptop. Some discussionrevealed that without a trade-in, the EL-40
can be purchased for $1050, indicating the originally quoted price of the EL-40 was overstated
to allow a larger trade-in allowance. The true current market value of the SK-30 is probably only
$200. In a replacement analysis, what value should be assigned to the SK-30 laptop?SOLUTION I
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In the example, five different dollar amounts relating to the SK-30 laptop have been outlined:- Original cost: The laptop cost.$1600 2 years ago.
- Present cost:The laptop noW'.sells for $995.
3..Book value;The original cost less 2 years of depreciationis 1600 -%(1600 ~O)=$800. - Trade-in value.~'The offer was $350.
- Market value:The estimate>was$200.
We know that an economic analy§i§is based on the CUrrentsituation, not 0)1the past. We ,refer
tP past costs asrill. ..'c... sunkcosts to emphasize tbat, since these costs caUJ10tbe a1tet;~d,they are not, ','.. .,'. .:"',.. .',. ,'.. ..' ", ,_.-,,"
r.elevant.(There is one exception: past costs may affect present or futUreincome taxes.) In the
analysis we want to use actual,cashftows for each altemativ~.a~re the questioI;lis, What value
should be used in an economic analysis for ,theSK~30?Tbe relevant costis the present market
Kaluefor the equipment. Neither the ori~inalcost, thepresent cost,the book value,)lorthetrade..in
)!'alueis relevant. >"At first glance, the trade-in value of an asset would appear to be a suitable present
value for the equipment. Often the trade-in price is inflatedalong withthe price for the new
item. (This practice is so common in new-car showroomsthat the termovertradeis used
to describe the excessive portion of the trade-in allowance.The purchaser is also quoted a
higher price for the new car.) Distortion of the present value of the defender, or a distorted
price for the challenger, can be serious because these distortions do not cancel out in an
economic analysis.
Example 13-9 illustrated that of the several different valuesthat can be assigned to the
defender, the most appropriate is the present market value. If a trade-in value is obtained,
care should be taken to ensure that it actually represents a fair market value.
Determining the value for the installed cost of the challenger asset should be less
difficult. In such cases the first cost is usually made up of purchase price, sales tax,
installation costs, and other items that occur initially on a one-time basis owing to the
selection of the challenger. These values are usually rather straightforward to obtain if a
thorough analysis is conducted. One aspect to consider in assigninga first cost to the chal-
lenger is the potential disposition (or market or salvage)valueof the defender.One must not