You can access this menu option by right-clicking an image. So why would you want to replace an image, why not just delete it?
When you double-click an image you can add clickable areas called hotspots, and set properties. If you delete the image then these are lost. So in order to maintain them you would use this option.
Use the "Select a New Image" button to choose the new image and click "Replace with New Image" when ready.
You can optionally choose to delete the original image by checking the Delete box.