Module 7: Replacement Analysis (Chap 9)

New Flood Control Pump

After Hurricane Katrina there was a need to replace outdated hydraulic flood
control pumps in New Orleans. These old pumps are powered by pressurized oil,
and they can be replaced by a newer and more expensive type of pump that
utilizes an up-to-date drive design having solid drive shafts instead of pressurized
oil. A systematic and formal comparisons of replacement alternatives such as the
one in New Orleans is required. Such studies can lead to enormous savings in
subsequent operating and ownership costs to an organization.
 Chapter Objectives

At the end of this chapter, you will be able to:

• Investigate economic value of existing asset

• Evaluate replacement strategies and costs

• Determine the expected economic life of asset

3
 Case Study – UTP GDC

To ensure sufficient and economical supply of

chilled water, UTP decided to build the
chilled water plant using Gas District Cooling
(GDC) technology. It is a technology powered
by a cheaper (subsidized) natural. The plant
also supplies electricity (reducing dependency
on direct TNB supply).
As gas subsidy is removed, and the plant is
aging and operating below optimal capacity,
UTP is replacing the system with electric
chiller and direct supply from TNB.

❑ At issue:
o What basis do they make the replacement
decisions?
o How much savings in energy cost would
justify the purchase of the new electric
chiller?
 Asset Evaluation
 Defender: an old machine  Sunk cost: any past cost unaffected
 Challenger: a new machine by any future decisions
 Current market value: selling price  Trade-in allowance: value offered
of the defender in the marketplace by the vendor to reduce the price of
a new equipment
 Asset Evaluation

What to do with an existing asset?

 Keep it
 Abandon it (do not replace)
 Replace it, but keep it for backup purposes
 Augment the capacity of the asset
 Dispose of it, and replace it with another

Three reasons to consider a change.

 Physical impairment (deterioration)
 Altered requirements
 New and improved technology is now available.
The second and third reasons are sometimes referred to as different
categories of obsolescence.
 Factors to be Considered

• Recognition and acceptance of past errors

• Sunk costs
• Existing asset value and the outsider viewpoint
• Economic life of the proposed replacement asset (challenger)
• Remaining (economic) life of the old asset (defender)
• Income tax consideration
 Factors to be Considered

Replacement: past estimation errors

 Any study today is about the future—past estimation “errors”
related to the defender are irrelevant.
 The only exception to the above is if there are income tax
implications forthcoming that were not foreseen.

Replacement: watch out for the sunk-cost trap

 Only present and future cash flows are considered in replacement studies.
 Past decisions are relevant only to the extent that they resulted in the current situation.
 Sunk costs—used here as the difference between an asset’s BV and MV at a particular
point in time—have no relevance except to the extent they affect income taxes.
 Factors to be Considered

Replacement: the outsider viewpoint

 The outsider viewpoint is the perspective taken by an impartial third party to

establish the fair MV of the defender. Also called the opportunity cost approach.
 The opportunity cost is the opportunity foregone by deciding to keep an asset.
 If an upgrade of the defender is required to have a competitive service level with
the challenger, this should be added to the present realizable MV.

Replacement: economic life of the challenger

 The economic life of the challenger minimizes the Equivalent Uniform Annual Cost EUAC.
 Often shorter than the useful or physical life.
 Economic data regarding challengers are periodically updated.
 Replacement studies are repeated to ensure an ongoing evaluation of
improvement opportunities.
 Factors to be Considered

Replacement: economic life of the defender

 The economic life of the defender is often one year, so a proper analysis may
be between different-lived alternatives.
 The defender may be kept longer than it’s apparent economic life as long as
it’s marginal cost is less than the minimum EUAC of the challenger over it’s
economic life.

Replacement: income taxes

 Replacement often results in gains or losses from the sale of depreciable
property.
 Studies must be made on an after-tax basis for an accurate economic analysis
since this can have a considerable effect on the resulting decision.
 Example 1 – CNC Machine

Before-tax PW example
Acme owns a CNC machine that it is considering
replacing. Its current market value is $25,000, but it can
be productively used for four more years at which time its
market value will be zero. Operating and maintenance
expenses are $50,000 per year
Acme can purchase a new CNC machine, with the same
functionality as the current machine, for $90,000. In four
years, the market value of the new machine is estimated to
be $45,000. Annual operating and maintenance costs will
be $35,000 per year.
Should the old CNC machine be replaced using a before-
tax MARR of 15% and a study period of four years?
 Example 1 – CNC Machine (MARR=15%)
Example solution
Defender

Challenger

PW of the challenger is greater than PW of the defender (but it is close).

 Example 2 – Sunk Costs

❑ Given: ❑ Relevant Cost for Replacement

o Original investment = $20,000 Analysis:
o Current market value = $10,000 o Lost investment value, $10,000
o Repair cost made in the past = o Repair cost made, $5,000
$5,000 o Total sunk cost = $15,000
❑ Find: (a) Sunk cost, (b) Relevant o Current market value =
cost for replacement analysis $10,000
 Economic Life

Proper analysis requires knowing the economic life (minimum EUAC) of

the alternatives.
 The Equivalent Uniform Annualized Costs (EUAC) of a new asset can be
computed if the capital investment, annual expenses, and year-by-year market
values are known or can be estimated.
 The difficulties in estimating these values are encountered in most engineering
economy studies, and can be overcome in most cases.

 Basic Principle: Treat the proceeds from sale of the old machine as the
investment required to keep the old machine.
 Compute the Annual Equivalent Costs AEC for each alternative and select the
one with the minimum AEC.
 Economic Costs

 Capital Cost

 Operating Cost

 Total Cost

 Objective: Find n* that

minimizes AEC(i)

n*
Example 3 – Opportunity Costs

❑ Given:
o Defender
• Market price: $10,000
• Remaining useful life: 3
years
• Salvage value: $2,500
• O&M cost: $8,000

o Challenger
• Cost: $15,000
• Useful life: 3 years
• Salvage value: $5,500
• O&M cost: $6,000

❑ Find: Replace the

defender now?
 Example 3 – Opportunity Costs

𝑃𝑊(12%)𝐷 = 10,000 + 8,000 𝑃Τ𝐴 , 12%, 3 − 2,500 𝑃Τ𝐹 , 12%, 3 = 27,435

𝐴𝐸𝐶𝐷 = 𝑃𝑊𝐷 𝐴Τ𝑃 , 12%, 3 = 27,435 0.4163 = 11,423

𝑃𝑊(12%)𝐶 = 15,000 + 6,000 𝑃Τ𝐴 , 12%, 3 − 5,500 𝑃Τ𝐹 , 12%, 3 = 25,496

𝐴𝐸𝐶𝐶 = 𝑃𝑊𝐶 𝐴Τ𝑃 , 12%, 3 = 25,496 0.4163 = 10,615

❑ Decision:
Replace the defender
 Annual Costs
Finding the EUAC of the challenger requires finding the total marginal
cost of the challenger, for each year. The minimum such value identifies
the economic life.
This equation represents the present worth, through year k, of total
costs. (Although the sign is positive, it is a cost. Eq. 9-1.)

Total marginal cost formula

The total marginal cost is the equivalent worth, at the end of year
k, of the increase in PW of total cost from year k-1 to year k.

This can be simplified to (eq. 9-2)

 Example 4 – CNC Machine (MARR=15%)

Finding the economic life of the new CNC machine. (Price = $90,000)
Year 1 Year 2 Year 3 Year 4
O&M costs $35,000 $35,000 $35,000 $35,000
Market value $75,000 $60,000 $50,000 $45,000

Marginal costs:
Year 1 Year 2 Year 3 Year 4
O&M $35,000 $35,000 $35,000 $35,000
Depreciation $15,000 $15,000 $10,000 $5,000
Int. on capital (15%) $13,500 $11,250 $9,000 $7,500
TC $63,500 $61,250 $54,000 $47,500
Example 9-4 – Economic Life of Challenger

A new forklift truck will require an investment of $30,000 and is expected to

have year-end MVs and annual expenses as shown. If the before-tax MARR is
10% per year, how long should the asset be retained in service?

End of Market Value, Annual

Year MV Expenses
0 30,000
1 22,500 3,000
2 16,875 4,500
3 12,750 7,000
4 9,750 10,000
5 7,125 13,000
Example 9-4 – Economic Life of Challenger

EOY Market Loss in MV Annual Cost of Total EUAC

(k) Value (MVEOY – MVBOY) Expenses Capital Marginal
( MV) (MARR of Cost
BOY MV) (TC)
0 30,000

1 22,500 7,500 3,000 3,000 13,500 13,500

2 16,875 5,625 4,500 2,250 12,375 12,964

3 12,750 4,125 7,000 1,688 12,813 12,918

4 9,750 3,000 10,000 1,275 14,275 13,211

5 7,125 2,625 13,000 975 16,600 13,766

𝑬𝑼𝑨𝑪𝒌 = ෍ 𝑻𝑪𝒋 𝑷Τ𝑭 , 𝒊%, 𝒋 (𝑨Τ𝑷 , 𝒊%, 𝒌)

𝒋=𝟏
 Example 9-4 – Economic Life of Challenger

0 1 2 3 4
0 1 2 3

13,500 12,375 12,813 14,275

13,500 12,375 12,813

𝐸𝑈𝐴𝐶1 = 13,500 𝑃Τ𝐹 , 10%, 1 𝐴Τ𝑃 , 10%, 1 = 13,500

𝐸𝑈𝐴𝐶2 = 13,500 𝑃Τ𝐹 , 10%, 1 + 12,375(𝑃Τ𝐹 , 10%, 2) 𝐴Τ𝑃 , 10%, 2 = 12,964

𝐸𝑈𝐴𝐶3 = 13,500 𝑃Τ𝐹 , 10%, 1 + 12,375 𝑃Τ𝐹 , 10%, 2 + 12,813(𝑃Τ𝐹 , 10%, 3) 𝐴Τ𝑃 , 10%, 3 = 12,918

EOY EUAC
𝐸𝑈𝐴𝐶4 = [13,500 𝑃Τ𝐹 , 10%, 1 + 12,375 𝑃Τ𝐹 , 10%, 2 + 12,813 𝑃Τ𝐹 , 10%, 3 1 13,500
+14,275(𝑃Τ𝐹 , 10%, 4)](𝐴Τ𝑃 , 10%, 4) = 13,211
2 12,964
𝐸𝑈𝐴𝐶5 = [13,500 𝑃Τ𝐹 , 10%, 1 + 12,375 𝑃Τ𝐹 , 10%, 2 + 12,813 𝑃Τ𝐹 , 10%, 3 3 12,918
+14,275 𝑃Τ𝐹 , 10%, 4 + 16,600(𝑃Τ𝐹 , 10%, 5)](𝐴Τ𝑃 , 10%, 5) = 13,766
4 13,211
5 13,766
 Exercise 1 – Economic Life of Challenger

In a replacement analysis for an industrial saw, the following data are

known about the challenger. Initial investment is $18,000. Annual
maintenance costs begin at the end of year three, with a cost at that time
of $1,000, with $1,000 at the end of year four, increasing by $8,600 each
year thereafter. The salvage value is $0 at all times. Using a MARR of
6% per year, what is the economic life of the challenger?
 Exercise 1 – Economic Life

From the economic life table below, we see the EUAC reaches a
minimum in year 4, which is the economic life of this challenger.
MV@ Loss in Cost of Annual TC for
EOY MV Capital Expense year
EOY EUAC
0 18,000

1 0 18,000 1,080 0 19,080

2 0 0 0 0 0

3 0 0 0 1,000 1,000

4 0 0 0 1,000 1,000

5 0 0 0 9,600 9,600

6 0 0 0 18,200 18,200
 MV@ Loss in Cost Annual TC for
Exercise 1 – Economic Life EOY MV of
Capit
Expens
e
year

EOY al EUAC
0 18,000
1 0 18,000 1,080 0 19,080 19,080
2 0 0 0 0 0 9,818
3 0 0 0 1,000 1,000 7,048
4 0 0 0 1,000 1,000 5,666
5 0 0 0 9,600 9,600 6,364
6 0 0 0 18,200 18,200 8,060

𝐸𝑈𝐴𝐶1 = 19,080 𝑃Τ𝐹 , 6%, 1 𝐴Τ𝑃 , 6%, 1 = 19,080

𝐸𝑈𝐴𝐶2 = 19,080 𝑃Τ𝐹 , 6%, 1 𝐴Τ𝑃 , 6%, 2 = 9,818

𝐸𝑈𝐴𝐶3 = 19,080 𝑃Τ𝐹 , 6%, 1 + 1,000(𝑃Τ𝐹 , 6%, 3) 𝐴Τ𝑃 , 6%, 3 = 7,048

𝐸𝑈𝐴𝐶4 = [19,080 𝑃Τ𝐹 , 6%, 1 + 1,000 𝑃Τ𝐹 , 6%, 3 + 1,000(𝑃Τ𝐹 , 6%, 4)](𝐴Τ𝑃 , 6%, 4) = 5,666

𝐸𝑈𝐴𝐶5 = [19,080 𝑃Τ𝐹 , 6%, 1 + 1,000 𝑃Τ𝐹 , 6%, 3 + 1,000 𝑃Τ𝐹 , 6%, 4
+9,600(𝑃Τ𝐹 , 6%, 5)](𝐴Τ𝑃 , 6%, 5) = 6,364

𝐸𝑈𝐴𝐶6 = [19,080 𝑃Τ𝐹 , 6%, 1 + 1,000 𝑃Τ𝐹 , 6%, 3 + 1,000 𝑃Τ𝐹 , 6%, 4
+9,600 𝑃Τ𝐹 , 6%, 5 + 18,200(𝑃Τ𝐹 , 6%, 6)](𝐴Τ𝑃 , 6%, 6) = 8,060
 Defender Life

The economic life of the defender

 If a major overhaul is needed, the life yielding the minimum EUAC is likely the
time to the next major overhaul.
 If the MV is zero (and will be so later), and operating expenses are expected to
increase, the economic life will be the one year.
 The defender should be kept as long as its marginal cost is less than the minimum
EUAC of the best challenger.
Replacement cautions.
 In general, if a defender is kept beyond where the TC exceeds the minimum
EUAC for the challenger, the replacement becomes more urgent.
 Rapidly changing technology, bringing about significant improvement in
performance, can lead to postponing replacement decisions.
 When the defender and challenger have different useful lives, often the analysis
is really to determine if now is the time to replace the defender.
 Repeatability or cotermination can be used where appropriate.
 Example 5 – CNC Machine (MARR=15%)

Finding the economic life of the defender CNC machine.(Price = $25,000)

Year 1 Year 2 Year 3 Year 4
O&M costs $50,000 $50,000 $50,000 $50,000
Market value $15,000 $10,000 $5,000 $0

MV@ Loss in Cost of Annual TC for

EOY EUAC
EOY MV Capital Expense year

0 25,000

1 15,000 10,000 3,750 50,000 63,750

2 10,000 5,000 2,250 50,000 57,250

3 5,000 5,000 1,500 50,000 56,500

4 0 5,000 750 50,000 55,750

 Example 5 – CNC Machine (MARR=15%)

MV@ Loss in Cost of Annual TC for

EOY MV Capital Expense year
EOY EUAC
0 25,000

1 15,000 10,000 3,750 50,000 63,750 63,750

2 10,000 5,000 2,250 50,000 57,250 61,795

3 5,000 5,000 1,500 50,000 56,500 60,274

4 0 5,000 750 50,000 55,750 59,372

𝐸𝑈𝐴𝐶1 = 63,750 𝑃Τ𝐹 , 15%, 1 𝐴Τ𝑃 , 15%, 1 = 63,750

𝐸𝑈𝐴𝐶2 = 63,750 𝑃Τ𝐹 , 15%, 1 + 57,250(𝑃Τ𝐹 , 15%, 2) 𝐴Τ𝑃 , 15%, 2 = 61,795

𝐸𝑈𝐴𝐶3 = 63,750 𝑃Τ𝐹 , 15%, 1 + 57,250 𝑃Τ𝐹 , 15%, 2 + 56,500(𝑃Τ𝐹 , 15%, 3) 𝐴Τ𝑃 , 15%, 3 = 60,274

𝐸𝑈𝐴𝐶4 = [63,750 𝑃Τ𝐹 , 15%, 1 + 57,250 𝑃Τ𝐹 , 15%, 2 + 56,500 𝑃Τ𝐹 , 15%, 3
+55,750(𝑃Τ𝐹 , 15%, 4)](𝐴Τ𝑃 , 15%, 4) = 59,372
 Abandonment

Abandonment is retirement without replacement.

 For projects having positive net cash flows (following an initial investment)
and a finite period of required service.

 Should the project be undertaken? If so, and given market (abandonment)

values for each year, what is the best year to abandon the project? What is its
economic life?

 These are similar to determining the economic life of an asset, but where
benefits instead of costs dominate.

 Abandon the year PW is a maximum.

 Example 6 – Lathe Machine
Abandonment example
A machine lathe has a current market value of $60,000 and can be
kept in service for 4 more years. With a MARR of 12% per year,
when should it be abandoned? The following data are projected for
future years. Year 1 Year 2 Year 3 Year 4

Net receipts $50,000 $40,000 $15,000 $10,000

Market value $35,000 $20,000 $15,000 $5,000

35,000 20,000 15,000 5,000

50,000 50,000 40,000 50,000 40,000 15,000 50,000 40,000 15,000 10,000

1 2 1 2 3 1 2 3 4
1

60,000 60,000 60,000 60,000

 Example 6 – Lathe Machine
35,000 15,000 5,000

50,000 50,000 40,000 15,000 50,000 40,000 15,000 10,000

1 1 2 3 1 2 3 4

60,000 60,000 60,000

𝑃𝑊1 = −60,000 + 85,000 𝑃Τ𝐹 , 12%, 1 = 𝟏𝟓, 𝟖𝟗𝟑

𝑃𝑊2 = −60,000 + 50,000 𝑃Τ𝐹 , 12%, 1 + 60,000(𝑃Τ𝐹 , 12%, 2) = 𝟑𝟐, 𝟒𝟕𝟒

𝑃𝑊3 = −60,000 + 50,000 𝑃Τ𝐹 , 12%, 1 + 40,000 𝑃Τ𝐹 , 12%, 2

+30,000 𝑃Τ𝐹 , 12%, 3 = 𝟑𝟕, 𝟖𝟖𝟒 Abandon EOY 3

𝑃𝑊4 = −60,000 + 50,000 𝑃Τ𝐹 , 12%, 1 + 40,000 𝑃Τ𝐹 , 12%, 2

+15,000 𝑃Τ𝐹 , 12%, 3 + 15,000(𝑃Τ𝐹 , 12%, 4) = 𝟑𝟔, 𝟕𝟒𝟎
 Taxation

Taxes can affect replacement decisions (will not discussed in detailed now).

 Most replacement analyses should consider taxes.

 Taxes must be considered not only for each year of operation of an asset, but

also in relation to the sale of an asset.

 Since depreciation amounts generally change each year, spreadsheets are an

especially important tool to use.

 Infinite Life

Replacement Strategies under the Infinite Planning Horizon

❑ Decision Rules
 Step 1: Compute the AECs for both the defender and challenger at its
economic service life, respectively.
 Step 2: Compare AECD* and AECC*.
o If AECD* > AECC* , replace the defender now.

o If AECD* < AECC* , keep the defender at least for the duration of its
economic service life if there are no technological changes over that life.
 Step 3: If the defender should not be replaced now, conduct marginal
analysis to determine when to replace the defender.
Infinite Life
 Summary
35

 For an asset with non-increasing operating cost, keep the asset as long as it
lasts.
 If everything remains the same, a higher interest rate will tend to extend the
economic service life (or defer the replacement decision).
 Decision to either retain, abandon or even replace depends on the economic
annual costs comparison of alternatives.