Replacement

Analysis
Why replacement studies?
The basic replacement study is designed
to determine if a currently used asset
should be replaced.
Whether unplanned or anticipated,
replacement is considered for one or more
of several reasons:
Reduced performance
Altered requirements
Obsolescence
Reduced Performance
Because of the physical deterioration of
parts, the ability to perform at an expected
level of reliability (being available and
performing correctly when needed) or
productivity (performing at a given level of
quality and quantity) is not present.
This results in increased cost of operation,
higher scrap and rework costs, lost sales, and
larger maintenance expenses.
Altered Requirements
New requirements of accuracy, speed or
other specifications may have been
established.
These new requirements cannot be met by
existing equipment or system.
Often, the choice is between complete
replacement or enhancement through
retrofitting or augmentation.
Obsolescence
International competition and the rapidly
changing technology of automation,
computers, and communications make
currently used systems and assets
perform acceptably but less productively
than equipment coming onto the market.
A replacement analysis will guide
engineers in deciding if an asset needs
replacement due to obsolescence.
Why replacement studies?
A replacement study is usually designed to
first make the economic decision to retain
or replace an asset now.
If the decision is to replace, the study is
complete.
If the decision is to retain, the cost
estimates and decision will be revisited
each year to ensure that the decision to
retain is still economically correct.
Basic Concepts
Defender
This is the asset currently owned (or in place).
Challenger
This is one of the alternatives being
considered.
Outsider or Consultant Perspective
We assume that we currently own or use
neither asset (defender nor challenger) and
we must select between the challenger and
the in-place defender.
Basic Concepts
Outsider Perspective
In order to acquire the defender, we must
invest in the prevailing market value of the
defender.
This estimated market or trade-in value
becomes the first cost of the defender.

Basic Concepts
Outsider Perspective
There will be new estimates for the
remaining economic life, annual operating
cost, and salvage value for the defender.
All these values will likely differ from the
original estimates.
Because of the outsider perspective, all
estimates made and used previously should
be neglected in the replacement analysis.
Sunk Cost
Since the past is common to alternatives,
past costs are considered irrelevant in a
replacement analysis.
This includes a sunk cost, which is an
amount of money invested earlier that
cannot be recovered now or in the future.
This may occur due to changed economic,
technological, or other conditions or ill-
advised business decisions.
Sunk Cost
In industry, a sunk cost occurs when an
asset is considered for replacement, and
the actual market or trade-in value is less
than that predicted by the depreciation
model used to write off the original capital
investment, or is less than the estimated
salvage value.
Sunk Cost

Sunk Cost = Present BV Present MV

If the resulting difference is a negative
number, then there is no sunk cost
involved.
Sunk Cost
For example, an asset purchased for
$100,000 five years ago now has a
depreciated book value of $50,000. A
replacement study is being conducted and
only $20,000 is offered as the trade-in
amount. Hence,

Sunk cost = $50,000 - $20,000 = $30,000
Sunk Cost
In replacement studies, the sunk cost
should not be included in the economic
analysis.
It is incorrect to recover the sunk cost of
the defender by adding it to the first cost of
the challenger.
This penalizes the challenger, making its first
cost appear higher and thereby biasing the
decision.
Replacement Analysis
To perform a replacement analysis, the
evaluator takes the perspective of a
consultant to the company.
If choosing between two replacement
alternatives, then it is assumed (for
analysis purposes) that
neither asset is currently owned, and
the outcome is either to acquire the used
asset or to acquire a new asset
Replacement Analysis
There are two equivalent approaches that
may be taken in a replacement study
when determining the first cost for the
alternatives and when performing the
analysis:
Cash-flow approach
Opportunity-cost approach
Cash-flow Approach
When a challenger is selected, the
defenders market value is a cash inflow to
each challenger alternative.
When the defender is selected, there is no
actual capital outlay.
Cash-flow Approach
Recognize that there is an actual cash-
flow advantage to the challenger if the
defender is traded.
For the analysis, use the following:
Defender: First cost amount is zero
Challenger: First cost is the actual cost minus
the quoted trade-in value of the
defender
Cash-flow Approach
Important Note:
The estimated lives of the defender (that
is, its remaining life) and of the challenger
must be equal to use this method.
The comparison must be made over the
same study period.
Opportunity-Cost Approach
Also called the conventional approach,
the opportunity-cost approach uses
the defenders trade-in or current
market value as the first cost of the
defender, and the initial cost of the
replacement as the challengers first
cost.
Opportunity-Cost Approach
If the defender is chosen, the owner forgoes
an amount of capital equivalent to the trade-
in value, hence an opportunity cost.
i.e., the opportunity is lost, hence the cost.
This approach is cumbersome when there
are multiple challengers each quoting a
different trade-in value for the defender,
because it requires a different defender first
cost for comparison with each challenger.
Opportunity-Cost Approach
Assume the defender trade-in amount is
forgone and the defender service can be
acquired as a used asset at its trade-in
value.
Defender: First cost is the trade-in value
Challenger: First cost is its actual cost
Opportunity-Cost Approach
For convenience and uniformity, we will
consistently use the opportunity-cost
approach in solving problems on
replacement analysis.
Suppose that you have an old car 10 years old
that could be sold to a dealer for $400 cash.
Assume its MV two years from now is zero. The
annual maintenance expenses will average
$800 into the future, and the car averages only
10 miles per gallon. Gasoline costs $1.50 per
gallon, and you average 15,000 miles per year.
You now have an opportunity to replace the old
car with a better one that costs $8,000.
Because of a two-year warranty, the
maintenance expenses for the new car are
negligible. The new car averages 30 miles per
gallon. (continued at next slide)
Sample Problem 1
Use the IRR method to determine
which alternative you should
select. Utilize a two-year
analysis period and assume
that the new car can be sold for
$5,000 at the end of year two.
Ignore the effects of income
taxes and let your MARR be
15% per year.
Sample Problem 1
An industrial lift truck has been in service for
several years and management is
contemplating on replacing it. A planning
horizon of five years is to be used in the
replacement study. The old lift truck has a
current market value of $1,500. If the
defender is retained, it is anticipated to
have annual expenses of $7,300. It will
have a zero market value at the end of five
additional years of service.
(continued at next slide)
Sample Problem 2
The new lift truck (challenger) will
cost $10,000 and will have annual
expenses of $5,100. It will have a
market value of $2,500 at the end
of the planning horizon. Determine
the preferred alternative, using a
present worth comparison and an
MARR (before tax) of 20% per
year.
Sample Problem 2
After-Tax Investment Value
of the Defender
If the defender were sold, then

EOY BTCF d T.I. ITCF ATCF
0 MV
0
none MV
0
-BV
0
-t(MV
0
-BV
0
) MV
0
-t(MV
0
-BV
0
)

If the defender were NOT sold, then

EOY BTCF d T.I. ITCF ATCF
0 -MV
0
none -(MV
0
-BV
0
)

t(MV
0
-BV
0
) -MV
0
+ t(MV
0
-BV
0
)

The Midcontinent Power Authority purchased
new coal extraction equipment 3 years ago for
$600,000. Management has discovered it is
technologically outdated now. A new
equipment alternative (the challenger) has
been identified and costs $1,000,000. If a
generous trade-in of $400,000 is offered for
the current equipment, perform AW analyses
using a 7% per year after-tax MARR and an
effective tax rate of 34%. Apply straight-line
depreciation with zero salvage value for both
alternatives.
(continued at next slide)
Sample Problem 3
The following additional data are applicable:

Defender Challenger
Annual cost $100,000 $15,000
Recovery period
(years) 8 (originally) 5



Sample Problem 3
AW and Study Period
A replacement study is an application of the
AW method of comparing unequal life
alternatives.
In a replacement study with no specified
study period, the AW values are determined
by a technique of cost evaluation called the
economic service life (ESL) analysis.
If a study period is specified, the procedure is
different from that used when no study period
is set.
AW and Study Period
The AW of a primarily cost cash flow
pattern is sometimes called the
equivalent uniform annual cost (EUAC).
Because this term is commonly used in
the definition of the economic life of an
asset, the EUAC will be used in
replacement studies when referring to the
AW.
Study Period in
Replacement Analysis
The study period or planning horizon is the
number of years selected for the economic
analysis to compare the defender and
challenger.
There are two typical situations:
The anticipated remaining life of the defender
equals the life of the challenger
The anticipated remaining life of the defender
is shorter than the life of the challenger

Study Period in
Replacement Analysis
When a defender may be replaced with a
challenger having an estimated life
different from that of the defenders
remaining life, the length of the study
period must be determined.
It is common practice to use a study period
equal to the life of the longer-lived asset.
Then, the AW value of the shorter lived asset
will apply throughout the entire study period.
Study Period in
Replacement Analysis
Sometimes, an abbreviated study period is
imposed in economic evaluations.
This approach will force the recovery of
the initial investment and the required
MARR over a shortened period of time
compared to what my be longer lives of
alternatives.
Replacement Analysis
When the defenders remaining life and the
challengers life are unequal, it is
necessary to preselect a study period for
the analysis.
Useful Life < Study Period
The annual worth is commonly assumed
to continue at the same calculated amount
for an alternative with an N value less
than the study period.
If this assumption is inappropriate, perform
the analysis using new estimates for the
defender, the challenger, or both.
Useful Life > Study Period
If the study period is abbreviated to be less
than one or both of the alternatives life
estimates, it is necessary to recover the first
cost and the required return at the MARR in
less time than normally expected.
This will artificially increase the AW values.
It is usually a management decision on
whether to use an abbreviated study period.
Economic Service Life (ESL)
The minimum number of years that an
asset should be retained in service to
minimize its total cost, considering the
time value of money, capital investment
recovery, and annual operating and
maintenance costs, is called the economic
service life (ESL).
Economic Service Life (ESL)
With each passing year of asset use, the
following trends are usually observable:
The equivalent annual worth of the annual
operating cost (AOC) or operating and
maintenance (O&M) cost increases.
The equivalent AW of the assets initial
investment or first cost decreases.
The actual trade-in amount or salvage value
decreases relative to the first cost.
Economic Service Life (ESL)
Economic Service Life
The aforementioned factors cause the
assets total AW curve to decrease for
some years and to increase thereafter.
The minimum total AW value indicates the
N value for the economic service life.
That is, the N value when replacement is
most economical.
This should be the estimated asset life used
in engineering economic analysis, if only
economics is considered.
Economic Service Life






Where P = initial investment or first cost
SV
k
= salvage value after retaining
asset for k years
AOC = annual operating cost for year j
(j = 1, 2, , k)
) k %, i , P / A ( ) j %, i , F / P ( AOC
) k %, i , F / A ( SV ) k %, i , P / A ( P AW
k j
1 j
j
k k
(
(

+ =
=
=
Robert Roe has just purchased a four-year-
old used car, paying $3,000 for it. A friend
suggested that he determine in advance
how long he should keep the car so as to
ensure the greatest overall economy.
Robert has decided that, because of style
changes, he would not want to keep the
car longer than four years, and he has
estimated the annual expenses and
market values for years 1 to 4 as follows:
(continued at next slide)
Sample Problem 4
Annual Expenses Market Value
Year 1 $950 $2,250
Year 2 $1,050 $1,800
Year 3 $1,100 $1,450
Year 4 $1,550 $1,160

If Roberts capital is worth 12% per year, at
the end of which year should he dispose of
the car?
Sample Problem 4
An existing robot is used in a commercial material
laboratory to handle ceramic samples in the
high-temperature environment that is part of
several test procedures. Due to changing
customer needs, the robot will not meet future
service requirements unless it is upgraded at a
cost of $2,000. Because of this, a new
advanced technology robot has been selected
for potential replacement. Assume that a robot
will be needed for an indefinite period of time.
The firms before-tax MARR is 25%. Should the
existing robot be replaced?
(continued at next slide)
Sample Problem 5
Sample Problem 5
Defender Challenger
Current market
value
$38,200 $51,00
(purchase price)
Upgrade cost $2,000 $0
Annual
expenses
$1,400 in year
one, and
increasing by
8% per year
$1,000 in year
one, and
increasing by
$150 per year
Useful life 6 years 10 years
Market value at
end of useful life
-$1,500 $7,000
Four years ago, the Attaboy Lawn Mower
Company purchased a piece of equipment.
Because of increasing maintenance costs for
this equipment, a new piece of machinery is
being considered for the assembly line. The
cost characteristics of the defender and the
challenger are shown at the next slide.
Suppose a $6,000 market value is available
now for the defender. With an after-tax MARR
of 10%, determine which alternative to select.
The effective tax rate is 40%. Straight-line
depreciation with zero salvage value is applied.
Sample Problem 6
Sample Problem 6
Defender Challenger
Original Cost $9,000 $11,000
(purchase price)
Maintenance $500 in year one
(four years ago)
increasing by a
uniform gradient
of $100 per year
thereafter
$150
Original
estimated life
9 years 5 years
Market value at
end of useful life
$0 $3,000
Use the PW method to select the better of the
following alternatives:
Sample Problem 7
Annual
expenses
Defender:
Alternative A
Challenger:
Alternative B
Labor $300,000 $250,000
Material $250,000 $100,000
Insurance and
property taxes
4% of initial
capital
None
Maintenance $8,000 None
Leasing cost None $100,000
Continued at next slide
Assume the defender was installed five years ago
and that its MACRS (GDS) property class is
seven years. The after-tax MARR is 10% per
year, and the effective income tax rate is 40%.
Definition of alternatives:
A: Retain an already owned machine (defender) in
service for eight more years
B: Sell the defender and lease a new one
(challenger) for eight years
Alternative A (additional information):
Cost of defender five years ago = $500,000
BV now = $111,550
Estimated MV eight years from now = $50,000
Present MV = $150,000
Sample Problem 7
A company is considering replacing a machine
that was bought six years ago for $50,000.
However, the machine can be repaired and its
life extended by five more years. If the current
machine is replaced, the new machine will cost
$44,000 and will reduce operating expenses by
$6,000 per year. The seller of the new machine
has offered a trade-in allowance of $15,000 for
the old machine. If the MARR is 12% per year
before taxes, how much can the company
spend to repair the existing machine?
(a) $22,371 (b) $50,628
(c) $7,371 (d) -$1,000
Sample Problem 8
Machine A was purchased three years ago for
$10,000 and had an estimated market value of
$1,000 at the end of its 10-year life. Annual
operating costs are $1,000. The machine will
perform satisfactorily for the next seven years.
A salesman for another company is offering
machine B for $50,000 with a market value of
$5,000 after 10 years. Annual operating costs
will be $600. Machine A could be sold now for
$7,000. The MARR is 12% per year.
(a) What is the equivalent uniform annual cost
(EUAC) of continuing to use Machine A?
(b) What is the EUAC of buying Machine B?
Sample Problem 9