Disassembling the Replacement Analysis in Capital Budgeting

When teaching capital budgeting replacement projects, instructors often struggle to explain why the market value of the old machine is recognized in addition to its continued depreciation. Typical explanations about capturing the effect of replacing the old machine and its true impact on the project fall short of illuminating the rationale behind this traditional approach. We disassemble the analysis into two parts: keeping the old machine and purchasing the new machine. This separation shows students that the old machine’s sale is a benefit of purchasing the new machine and depreciating the old machine is associated with keeping the old machine.