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IE 50
Engineering Economics for
Industrial Engineering
Lecture 15
Replacement Analysis:
Before-Tax Replacement Studies,
After-Tax Replacement Studies

Edgardo G. Atanacio
Department of Industrial Engineering and
Operations Research, College of Engineering
Rev. 1 University of the Philippines Diliman
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Replacement Analysis
 Replacement studies are performed
using the same basic methods as
other economy studies involving two
or more alternatives.
 The decision is whether to replace an
existing asset with a new asset.

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Replacement Analysis
 The existing or old asset is called the
defender.
 The one or more alternative
replacement or new assets are called
the challengers.

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Reasons for Replacement Analysis

1. Physical impairment (deterioration):

Due to changes that occur in the
physical condition of the asset.
Examples: increased maintenance
and operating costs, increased
energy use, higher breakdown and
downtime costs

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Reasons for Replacement Analysis

2. Altered requirements:
Due to changes in the demand or
design of a good or service
3. Technology:
Due to changes in technology
 Reasons 2 and 3 are collectively
called obsolescence.

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Definitions
 Economic life: the period of time
(years) that results in the minimum
equivalent uniform annual cost
(EUAC) of owning and operating an
asset.
 Useful life: the time period (years) that
an asset is kept in productive service.
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Factors to Be Considered
1. Recognition and acceptance of past
errors
2. Sunk costs
3. Existing asset value and the outsider
viewpoint
4. Economic life of the proposed
replacement asset (challenger)
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Factors to Be Considered
5. Remaining economic life of the old
asset (defender)
6. Income tax considerations

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1. Past Estimation Errors

 The economic focus in a replacement
study is the future.
 Any estimation errors made in a
previous study related to the defender
are not relevant (unless there are
income tax implications) and should
have no bearing on the replacement
analysis.
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2. Sunk Costs
 Sunk cost is the difference between
an asset’s book value and its market
value at a particular point in time.
 Sunk costs have no relevance to the
replacement decisions that must be
made, except when income tax
considerations are involved.
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3. Investment Value of Existing Asset

 Using the outsider viewpoint, the total

investment in the defender is the
opportunity cost of not selling the
existing asset for its current market
value, plus the cost of upgrading it to
be competitive with the best available
challenger.
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4. Economic Life of a Challenger

Market Value Annual

End of Year,
at End of Expenses,
k
Year k Year k
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

MARR = 10%
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4. Economic Life of a Challenger

A B C D E F = C+D+E G
Market Loss in Cost of Total EUAC
End of Value at Market Capital Annual Marginal through
Year, k End of Value, (10%) Expenses Cost for Year k
Year k Year k Year k
0 30,000
1 22,500 7,500 3,000 3,000 13,500 13,500
2 16,875 5,625 2,250 4,500 12,375 12,964
3 12,750 4,125 1,688 7,000 12,813 12,918 ◄
4 9,750 3,000 1,275 10,000 14,275 13,211
5 7,125 2,625 975 13,000 16,600 13,766
C[k] = B[k-1] – B[k] G[k] = (Σn=1,k F[n](P/F,10%,n))(A/P,10%,k)
D[k] = B[k-1] × 0.10
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5. Economic Life of a Defender

Market Value Annual

End of Year,
at End of Expenses,
k
Year k Year k
0 7,500
1 6,000 8,250
2 4,500 9,900
3 3,000 11,700
4 1,500 13,200

MARR = 10%
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5. Economic Life of a Defender

A B C D E F = C+D+E G
Market Loss in Cost of Total EUAC
End of Value at Market Capital Annual Marginal through
Year, k End of Value, (10%) Expenses Cost for Year k
Year k Year k Year k
0 7,500
1 6,000 1,500 750 8,250 10,500 10,500 ◄
2 4,500 1,500 600 9,900 12,000 11,214
3 3,000 1,500 450 11,700 13,650 11,950
4 1,500 1,500 300 13,200 15,000 12,607
C[k] = B[k-1] – B[k] G[k] = (Σn=1,k F[n](P/F,10%,n))(A/P,10%,k)
D[k] = B[k-1] × 0.10
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Before-Tax Replacement Analysis

1. Determine the investment value of
the existing asset.
2. Determine the economic lives of the
defender and challengers.
3. Use a basic economy study method
to determine which among the
defender or challengers should be
chosen.
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Example 15.1
Existing Machine A (Defender):
Capital investment when purchased
five years ago 170,000
Annual expenses:
Replacement of parts 17,500
Operating and maintenance 32,500
Taxes and insurance 3,400
Total annual expenses 53,400
Present market value 7,500
Estimated market value after 9 more years 2,000
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Example 15.1
Replacement Machine B (Challenger):
Capital investment 160,000
Annual expenses:
Operating and maintenance 30,000
Taxes and insurance 3,200
Total annual expenses 33,200
Estimated market value at the end of 9 years 32,000

Before-tax MARR = 10%

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Example 15.1.1
 Keep Old Machine A:
PWA(10%) = -7500 + 5.7590
-53400(P/A, 10%, 9) +
2000(P/F, 10%, 9) 0.4241
PWA(10%) = -7500 + -307530.6 +
848.2
PWA(10%) = -314182.4
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Example 15.1.1
 Replace with Machine B:
PWB(10%) = -160000 +
5.7590
-33200(P/A, 10%, 9) +
32000(P/F, 10%, 9) 0.4241
PWB(10%) = -160000 +
-191198.8 + 13571.2
PWB(10%) = -337627.6
 PWA < PWB, keep Machine A.
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Example 15.1.2
 Keep Old Machine A:
ACA(10%):
Annual expenses 53400
Capital recovery cost:
0.1736
7500(A/P, 10%, 9) –
2000(A/F, 10%, 9) 0.0736 1150
Total ACA(10%) 54550
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Example 15.1.2
 Replace with Machine B:
ACB(10%):
Annual expenses 33200
Capital recovery cost:
0.1736
160000(A/P, 10%, 9) –
0.0736
32000(A/F, 10%, 9) 25420
Total ACB(10%) 58620
 ACA < ACB, keep Machine A.
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After-Tax Replacement Analysis

1. Determine the after-tax investment
value of the existing asset.
2. Equalize the lives of the defender and
the challengers.
3. Determine the after-tax cash flows for
the defender.
4. Determine the after-tax cash flows for
the challengers.
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After-Tax Replacement Analysis

5. Use a basic economy study method
to determine which among the
defender or challengers should be
chosen.

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Example 15.2
Existing Machine X (Defender):
Capital investment when purchased
five years ago 170,000
Estimated life, years 10
Estimated salvage value at the end of 10 years 17,000
Annual disbursements 53,400
Present market value 7,500
Estimated market value after 10 more years 2,000
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Example 15.2
Replacement Machine Y (Challenger):
Capital investment 160,000
Estimated life, years 10
Annual expenses 25,000
Estimated market value at the end of 10 years 16,000

Depreciation method: Straight line

After-tax MARR = 10%
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Example 15.2
Machine X estimated salvage value ► 17000
53400 ◄ annual disbursements

1 2 3 4 5 6 7 8 9 10

170000 ◄ orig. capital invest. 15300 ◄ annual depreciation

(170000 – 17000) / 10 = 15300
five years ago
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Example 15.2
Machine X 7500
33300
2000

-5 -4 -3 -2 -1 1 2 3 4 5 6 7 8 9 10

7500 – 93500 = -86000

170000
-86000 × -0.30 = 25800
now 7500 + 25800 = 33300

Book value of Machine X after 5 years:

170000 – ((170000-17000)*(5/10))
170000 – 76500 = 93500
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Example 15.2 No depreciation

anymore from 17000
Machine X 17000 6th to 10th years
33300
2000

-5 -4 -3 -2 -1 1 2 3 4 5 6 7 8 9 10

170000

now
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Example 15.2
17000
Machine X 6500
33300
2000

-5 -4 -3 -2 -1 1 2 3 4 5 6 7 8 9 10

2000 – 17000 = -15000

170000
-15000 × -0.30 = 4500
now 2000 + 4500 = 6500
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Example 15.2
Machine X 6500

1 2 3 4 5 6 7 8 9 10

33300 32790 53400 37380

15300

now -53400 – 15300 = -68700-53400 – 0 = -53400

-68700 × -0.30 = 20610 -53400 × -0.30 = 16020
-53400 + 20610 = -32790-53400 + 16020 = -37380
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Example 15.2
 Machine X:
One-time tax effects (investment):
Book value of Machine X:
5
B5 = 170000 – (170000 – 17000)
10
= 93500
Loss, if sold = 7500 – 93500 = -86000
One-time tax recovery = -(-86000)(0.30)
= 25800
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Example 15.2
 Machine X:
One-time tax effects (investment):
After-tax investment in Machine X, if kept:
= 25800 + 7500
= 33300
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Example 15.2
 Machine X:
One-time tax effects (salvage value):
Salvage value of Machine X:
Original salvage value = 17000
Loss when sold = 2000 – 17000 = -15000
One-time tax recovery = -(-15000)(0.30)
= 4500
After-tax salvage value = 2000 + 4500
= 6500
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Example 15.2
Machine X:
Year BTCF d/B TI / CL CFIT ATCF
0 7500 93500a -86000 25800 (-)33300
1-5 -53400 15300b -68700 20610 -32790
6-10 -53400 0 -53400 16020 -37380
10 2000 17000c -15000 4500 6500

5
a B5 = 170000 – (170000 – 17000) = 93500
10

b 170000 – 17000
d= = 15300
10
c original salvage value, B10
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Example 15.2
Replacement Machine Y (Challenger):
Capital investment 160,000
Estimated life, years 10
Annual expenses 25,000
Estimated market value at the end of 10 years 16,000

Depreciation method: Straight line

After-tax MARR = 10%
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Example 15.2
Machine X 6500

1 2 3 4 5 6 7 8 9 10

33300 32790 37380

now
16000
25000
Machine Y
1 2 3 4 5 6 7 8 9 10

160000 14400
(160000 – 16000) / 10 = 14400
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Example 15.2
Machine X 6500

1 2 3 4 5 6 7 8 9 10

33300 32790 37380

now
16000
25000
Machine Y

-25000 – 14400 = -39400 1 2 3 4 5 6 7 8 9 10

-39400 × -0.30 = 11820
-25000 + 11820 = -13180 160000 14400
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Example 15.2
Machine X 6500

1 2 3 4 5 6 7 8 9 10

33300 32790 37380

now
16000

Machine Y

-25000 – 14400 = -39400 1 2 3 4 5 6 7 8 9 10

-39400 × -0.30 = 11820 13180
-25000 + 11820 = -13180 160000
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Example 15.2
Machine X 6500

1 2 3 4 5 6 7 8 9 10

33300 32790 37380

16000

Machine Y
1 2 3 4 5 6 7 8 9 10
13180
160000
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Example 15.2
Machine Y:
Year BTCF d TI CFIT ATCF
0 -160000 -160000
1-10 -25000 14400d -39400 11820 -13180
10 16000 16000

d 160000 – 16000
= 14400
10
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Example 15.2
 Machine X:
PWX = -33300 + 3.7908
-32790(P/A, 10%, 5) + 0.6209
-37380(P/A, 10%, 5)(P/F, 10%, 5) +
0.3855
6500(P/F, 10%, 10)
PWX = -33300 – 124300.33 –
87981.59 + 2505.75
PWX = -243076.17
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Example 15.2
 Machine Y:
PWY = -160000 + 6.1446
-13180(P/A, 10%, 10) +
16000(P/F, 10%, 10) 0.3855
PWY = -160000 – 80985.83 – 6168
PWY = -234817.83
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Example 15.2
 PWX > PWY, replace Machine X with
Machine Y.
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●● End of Lecture 15