Replacement and Retention Decisions: Gra W Hill

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.
ENGINEERING ECONOMY Sixth

Edition
Blank and
Tarquin
CHAPTER 11
Replacement and Retention

Decisions
Mc
Gra
Hill
w
Authored by Don Smith, Texas A&M University 2004
Chapter 11 Learning Objectives

1. Basics of Replacement Study;
2. Economic Service Life;
3. Performing a Replacement Study;
4. Additional Considerations in a
Replacement Study;
5. Replacement Study over a
Specified Study Period;
6. Chapter Summary

2
CHAPTER 11
Section 11.1 Basics of

Replacement Study

11.1 Why Replace Assets

Reduced Performance:
 Wear and Tear;
 Decreasing reliability and Productivity;
 Increasing operating and maintenance costs.
Altered Requirements:
 New production needs, accuracy, speed, etc.
Obsolescence:
 Current assets may be less productive;
 Not state of the art – meet competition.

4
11.1 Terminology
Defender Asset:
 Current installed asset;
Challenger Asset:
 The potential replacement or “challenging” asset;
 Under consideration to replace the defender asset.
Together, the Defender and Challenger:
 Constitute mutually exclusive alternatives;
 Select one and reject the other.

5
11.1 Annual Worth Values
Analysis Approach for

Replacement:
 Annual Worth Approach;
 EUAC – since costs tend to
dominate the study (-) cash
flows;
 Salvage values – if any – are also
part of the analysis (+) value.

6
11.1 Economic Service Life
Economic Service Life (ESL)

 Number of years for an alternative for
which the AW or EUAC is Minimum;
 Implies that a period by period analysis
is performed;
 Computing the AW for 1 year; then 2
years; … until a minimum cost time
period is found;
 Performed manually or by spreadsheet.

7
11.1 Investment Concerns-

Defender
For a replacement analysis two
investment costs are critical:
1. The proper investment cost to
apply to keeping the defender
in service;
2. The proper investment cost to
apply to any challenger asset
that might replace the current
defender asset.

8
11.1 Investment Concerns-

Defender
While it may seem strange to
charge an investment cost for
keeping one’s own asset (the
defender) this is what must occur.
Keeping the defender is not free!
Why?
 Because the firm is giving up the
opportunity to receive a possible cash
flow from selling the current defender!

9
11.1 Investment Concerns
One must assign an investment

cost to KEEPING the defender
asset!
The appropriate investment cost
to assign to the defender asset is:
 The current fair market value of
the defender at the time the
replacement decision is being
examined.

10
11.1 Defender First Cost
Defender First Cost:

 Initial investment in the defender asset
back in time;
 This investment (cost) is considered
“sunk” for analysis purposes;
 A past cost that cannot be changed or
altered;
 The issue of the relevance of the
investment cost in the analysis will be
addressed soon.

11
11.1 Challenger First Cost
This is the total investment (Pchallenger )

required in a new (challenger) asset
that will possibly replace the current
defender.
In a replacement study this investment
is know with a fair amount of certainty.
What IF a trade in value is offered for
the defender to apply to the
challenger?

12
11.1 Trade In Concerns
Often a trade in value is offered by

a vendor to take in the defender
with a credit on the purchase
towards the challenger.
Be careful how this is handled!
Points to focus upon….

13
11.1 Basic Principles

The past investment in the defender is
“sunk” and not totally relevant to the
analysis.
Only the Fair Market Value (FMV) of the
defender is relevant.
 FMV of the defender is the net economic
worth of the current defender;
 Sale or disposal price less any costs
associated with removing the defender.

14
11.1 Basic Principles – Important

Question
At times, a “high” trade-in value
may be offered for the defender
compared to its current fair market
value.
If this is the case:
 What should be the investment cost in
the challenger for a replacement study
analysis if a trade-in value is offered?

15
11.1 Trade-In Issues

If a trade-in is offered what should be
the proper investment cost in the
challenger?
 Let PC = the cash sale price of the
challenger with no trade-in;
 Let TIV = the trade-in value for the
challenger as offered by the vendor (take in
the defender);
 Let MVD = the Fair Market Value of the
current defender;

16

For a Trade-In, the correct investment cost to assign
to the challenger is:
Investment in the Challenger:
PC – (TIV – MVD)

17
Investment in the challenger
Cash Price for the challenger less:

(Trade-in Value – Market Value of the Defender)
This represents the true investment in the

challenger to the firm!

18
Investment in the challenger
The Cash price

for
The challenger The Opportunity Cost
with Given up by not
No trade-in Selling the
Defender outright!

19
11.1 Trade-In Issues - Example

Bought a system 3 years ago for
$120,000. (Defender);
A fair market value of the current
defender is $70,000 right now;
A challenger can be purchased for
cash for $100,000 now!
The vendor selling the challenger
offers a trade-in of $80,000 on the
current defender.
20
11.1 Trade-In Issues - Example

What should be the proper
investment cost for the challenger to
the firm if the defender is traded?
 PC = $100,000;
 TIV = $80,000
 FMVD = $70,000
 InvestmentChallengernow = $100,000 –
($80,000 - $70,000) = $90,000.
 This represents the “true” investment in
the challenger with the trade.
21
11.1 Other Issues…

Investment in the challenger asset
must include:
 Actual cash price for purchase;
 Transportation costs;
 Installing/make-ready for use costs;
 Other one-time costs at time t = 0
associated with placing the challenger
in-service.

22
11.1 Warning! What Not to Do!

At times a decision maker might do
the following:
 Take the investment cost in the
challenger;
 Then add the remaining book value of the
defender to that investment;
 This is wrong!
 Overly penalizes the challenger with a
sunk cost associated with the defender
asset!
 Do not do this!
23
11.1 Sunk Costs

A “sunk” cost is any cost that has
occurred in the past and cannot be
changed or altered by a current
decision.
The past investment in any
defender or its remaining book
value is not relevant!
Unless, an after-tax replacement
analysis is being conducted!
24
11.1 Allocating Costs

Allocate only those costs
associated with:
 The Defender (opportunity cost of not
disposing – giving up a salvage value if
kept.)
 Those costs associated with obtaining
the challenger – do not penalize the
challenger with costs from the
defender!

25
11.1 The Suggested Viewpoint
It is customary to take the

following philosophical approach:
This is termed:
 The Outsider’s view or,
 The Consultant’s view.
One assumes that the analyst is an outsider to

the firm and owns neither the defender or the
challenger!

26
11.1 Outsider’s or Consultant’s

View
One assumes that you own neither of
the assets in question;
The service provided by the defender
can be “purchased” with an investment
of the firm’s money equal to the current
fair market value of the defender.
 Buy your own asset!
 Hard to comprehend? Perhaps…but this is an
objective approach to costing the defender!

27
11.1 Costing the Defender
The consultant’s view assumes:

 If the defender is retained in service,
the firm is giving up (forgone
opportunity) a potential cash inflow – IF
NOT REPLACED now!
This view attempts to minimize any bias
towards either the defender or the
challenger!

28
11.1 Replacement Approach
The traditional approach to

conducting a replacement
analysis is:
The Annual Cost or Annual
Worth approach!
 With an assumed interest rate;
 Assumed lives for each
alternative.

29
11.1 Assumptions
The traditional approach to

conducting a replacement
analysis is:
The Annual Cost or Annual
Worth approach!
 With an assumed interest rate;
 Assumed lives for each
alternative.

30
11.1 Study Period for

Replacement
The study Period for a
replacement problem may be:
Finite or,
Considered infinite.

31

Replacement
If Infinite then:
 The required services needed are
needed indefinitely;
 The challenger is the best
available and if selected will have
the same repeated cycles of costs
forever!
 Cost estimates for every future
cycle will be the same!
32

Replacement
Study Period Finite:
 The previous assumptions do not
hold!
 See Section 11.5 for a fixed study
period analysis.

33
Section 11.2
Economic Service Life (ESL)
The best value for “n” is not
known in this type of problem.
The ESL for a given asset is:
 The number of years where the AW of
the future costs is minimum;
 Using the cost estimates of all possible
years that the asset may provide a
needed service!
 Termed, “The minimum cost life”

34
11.2 ESL Analysis
One estimates the ESL for the

challenger and,
The ESL for the current defender.
Requires estimates of future
operating and maintenance costs
and any salvage value.
Apply an Annual Worth Analysis;
For assumed values of n = { 1, 2,
…}

35
11.2 ESL – General Format

Compute:
 AW(i%)t =:
 -Capital Recovery
 - AW of operating costs
 Salvage values may be incorporated into
the capital recovery term.
 Do this for n = 1 then n = 2, then n = …
and observe the min cost “n” value.

36
11.2 Minimum Cost Life
The minimum cost life is:

That value of “n” that yields the
lowest annual cost over the range
of “n” values applied.
Capital Recover topic: See
Chapter 6, section 2 to review.

37
11.2 Components of ESL

Capital Recovery Costs (CRC)
 CRS’s generally decrease with each year of
operation;
 The longer one uses an asset the costs
associated with owning the asset are spread
out over more and more time periods.
Sn
////
0 1 2 ... n-1 n
Diagram for Capital Recovery

Investment at
t = 0 (P)
38
11.2 Capital Recovery Formula
CRC Setup
Sn
////
0 1 2 ... n-1 n
$P
CRC(i%) = -P(A/P,i%,n) + S(A/F,i%,n)
CRC(i%) is the annual cost of “owing” an

asset over “n” time periods

39
11.2 Annual Operating Cost

Component
Annual Operating Costs (AOC);
End-of-year estimated costs of
operating the asset in question.
AOC’s tend to increase over time;
One wants to distribute the AOC
over a range of assumed number of
years;
“n” = {1, then 2, then 3, …. }

40
11.2 Plotting ESL
The ESL can be visualized by plotting

three curve forms:
 1. Plot the CRC’s over assumed values of “n”;
 2. Plot the AOC’s over the same assumed values
of “n”;
 Plot the sum of the CRC and AOC over the same
assumed values of “n” (Total AW of AOC’s)
 Examine the AW plot to observe the minimum
cost life of the respective asset.

41
11.2 Typical ESL Plot
Min. Total AW of costs life

42
11.2 AW over “k” Years
Notation:
 P = initial investment in the asset;
 Sk = estimated salvage value after
“k” years;
 AOCj = annual operating costs for
year j (j = 1 to k)
 “k” the number of years for the
analysis.

43
11.2 Closed Form of AWk
Analytical Form for Total AWk:
Total AWk = − P ( A / P, i, k ) + Sk ( A / F , i, k ) −
 k 
 ∑ AOC j ( P / F , i , j )  ( A / P , i , k )
 j=1 
Procedure: Year-by-year analysis for “k” years – where

“k” is given or assumed.

44
11.2 Example 11.2 - Overview
Defender Asset;
3 years old now;
Market value now: $13,000;
5-year study period assumed;
Require Estimates of the future
salvage values and annual
operating costs for the 5-year
period.

45
11.2 Example: Future Market

Values
Estimated Future Market Values
and AOC’s:
MktVt AOCt
 t = 1: $9000 Mkt. Values are
$-2500
decreasing:
 t = 2: $8000 -2700
 t = 3: $6000 AOC’s are
-3000
increasing:
 t = 4: $2000 -3500
 t = 5: $0 -4500
Assume the interest rate is 10% per year.

46
11.2 Example: Find the ESL
Period – by – period analysis

For “k” = 1 year:
S1 =
$9000
0 1
AOC1 = -2500
P=$13,000
AW(10%)1 = (-$13,000)(A/P,10%,1) + $9000(A/F,10%,1) -2500

= -$7800 ( for one year!)

47

For “k” = 2 years:
S2 = $8000
0 1 2
AOC1 = -2500
AOC2 = -$2700
P=$13,000
AW(10%)2 = (-13,000)(A/P,10%,2) + 8000(A/F,10%,2)
-[2500(P/F,10%,1) + 2700(P/F,10%,2)](A/P,10%,2)
= -$6276/yr for 2 years.
48

For “k” = 3 years: S3 = $6000
0 1 2 3
AOC1 = -2500
AOC2 = -$2700
P=$13,000 AOC3 = -$3000
AW(10%)3 = (-13,000)(A/P,10%,3) +6000(A/F,10%,3)

-[2500(P/F,10%,1) + 2700(P/F,10%,2) + 3000(P/F,10%,3](A/P,10%,3) =
-$6132/yr for 3 years.
49
11.2 Example - continued

A similar analysis for k = 4 and 5 is
conducted;
The AW(10)k, K = {1,2,3,4,5} are
tabulated as:
Total AWk
k=1: -7800
k=2: -6276 Min. Cost Year = 3 years
k=3: -6132
k=4: -6556
k=5: -6579

50
11.2 Spreadsheet Format

Input Parameters Base Input
1 Interrest Rate (%) 10.00% Parameters
2 Investment Cost ($) $ 13,000.00
3 No of Years to Study 5
(1) (2) Schedule of

Year Mkt. Value AOC/Yr Est. Mkt. Values
1 $9,000.00 -$2,500.00
2 $8,000.00 -$2,700.00 And AOC’s/year
3 $6,000.00 -$3,000.00
4 $2,000.00 -$3,500.00
5 $0.00 -$4,500.00 Tabulation of
CRS’s, AOC’s and
Total AW(i%)
(3) (4) (5) Min Life
Cap. Rec. Costs AW of AOC's Year Total AW(i%) ID
-$5,300 -$2,500 1 -$7,800
-$3,681 -$2,595 2 -$6,276
-$3,415 -$2,718 3 -$6,132 Min Life
-$3,670 -$2,886 4 -$6,556
-$3,429 -$3,150 5 -$6,580
51
11.2 Specimen Cell Formulas:

CRCk
(3) (4) (5) Min Life
-$5,300 -$2,500 1 -$7,800
-$3,681 -$2,595 2 -$6,276
-$3,415 -$2,718 3 -$6,132 Min Life
-$3,670 -$2,886 4 -$6,556
-$3,429 -$3,150 5 -$6,580
=IF($B18>$C$14,"",PMT($C$12,$B18,$C$13,-$C18))
Note: Application of the PMT financial function!

52
11.2 Specimen Cell Formulas:

AW(AOC)
(3) (4) (5) Min Life
-$5,300 -$2,500 1 -$7,800
-$3,681 -$2,595 2 -$6,276
-$3,415 -$2,718 3 -$6,132 Min Life
-$3,670 -$2,886 4 -$6,556
-$3,429 -$3,150 5 -$6,580
=IF($B18>$C$14,"",-PMT($C$12,$B18,NPV($C$12,$D$17:$D18)+0))
Note: Application of the PMT financial function in

combination with the NPV function for AW of AOC’s!

53
11.2
Specimen Cell Formulas: Total

AW(3) (4) (5) Min Life
-$5,300 -$2,500 1 -$7,800
-$3,681 -$2,595 2 -$6,276
-$3,415 -$2,718 3 -$6,132 Min Life
-$3,670 -$2,886 4 -$6,556
-$3,429 -$3,150 5 -$6,580
=IF($B18>$C$14,"",-PMT($C$12,$B18,NPV($C$12,$D$17:$D18)+0))
PMT and NPV function to compute the total AW year by

year.

54
11.2 Building a Plotting Table

Table below is used for Plotting Purposes
NO Data Entry required!
year CRC AOC AW

1 $5,300.00 $2,500 $7,800
2 $3,680.95 $0 $3,681
3 $3,414.80 $2,718 $6,132
4 $3,670.18 $2,886 $6,556
5 $3,429.37 $3,150 $6,580
Summary Table from the spreadsheet to assist in

plotting the curve forms

55
11.2 Plot of Capital Recovery

Costs
ESL
CRC
$6,000.00
$5,000.00
$4,000.00
$AW
$3,000.00
$2,000.00
$1,000.00
$0.00
0 1 2 3 4 5 6
Years

56
11.2 Plot of the AOC’s

ESL
AOC
$3,500
$3,000
$2,500
$2,000
$AW
$1,500
$1,000
$500
$0
0 1 2 3 4 5 6
Years

57
11.2 Combined Plots for Example

ESL
CRC AOC AW
$9,000.00
$8,000.00
$7,000.00
$6,000.00
$5,000.00 Min AW
$AW
$4,000.00
Year!
$3,000.00
$2,000.00
$1,000.00
$0.00
0 1 2 3 4 5 6
Years

58
11.2 ESL vs. AW Analysis
Traditional AW Analysis:
 “n” is fixed or assumed;
 First cost at t = 0;
 Est. salvage value at t = “n”;
ESL Analysis:
 “n” varies from t = 1 to t = “k:
 Year-by year analysis using AW(i%)
 Table of possible future salvage (market)
values for the asset in question.
 Table of future AOC’s, year by year.

59
11.2 ESL vs. AW

AW analysis is for a fixed time period
with a table of AOC’s and one estimated
future salvage value out at t = “n”.
ESL is a period-by-period variant of AW
where a table of estimated future salvage
values may be provided and a tabulation
of a set of AW’s for each time period
evaluated.
Seeking the min. AW life in an ESL
analysis.

60
11.2 Important Conclusions
If “n” fixed (known) then

determine the AW(i%) for “n” time
periods.
This is the ESL given “n”.
This is the correct value to use in a
replacement study!

61
11.2 “n” Not Known
For “n” of a defender or challenger

that is not known or assumed:
Compute the ESL for a range of
“n” values where n = {1, then 2, …,
then K};
From this period-by-period
analysis, determine the min cost
life and the associated AW for that
life.

62
11.2 “n” Not Known
Will need a table of future, estimated

market (salvage) values for the asset
in question and a table of the future
estimated annual operating costs.
For estimating future market values
can:
 Apply a sequence of % loss of value;
 See Chapter 15 for other cost estimating
techniques.

63
11.2 Marginal Cost Approach

Marginal Costs are year-by-year
estimates of the costs to:
 Own the asset and,
 Operate the asset,
 For the current year in question.
Three Components of Marginal Costs:
 1. Cost of ownership (loss in Mkt. Value/yr;
 2. Foregone interest of Mkt. Value at beg. Of
the year;
 3. AOC for each year.

64
11.2 Marginal Cost Analysis

Compute the marginal costs per year;
Find their equivalent annual worth;
AW of marginal costs = total AW of
costs;
Can perform either a ESL analysis or a
Marginal Cost analysis when yearly Mkt.
Values are estimated;
Same result!

65
11.2 Marginal Cost Format: Example

11.2
Loss in MV Lost Interest Est.

Year MV for Year on MV for Year AOC/Year
1 $9,000 -$4,000.00 -$1,300.00 -$2,500.00
2 $8,000 -$1,000.00 -$900.00 -$2,700.00
3 $6,000 -$2,000.00 -$800.00 -$3,000.00
4 $2,000 -$4,000.00 -$600.00 -$3,500.00
5 $0 -$2,000.00 -$200.00 -$4,500.00
Marginal Cost AW of
time For the Year Marginal Costs Min. Cost Life:
1 -$7,800.00 -$7,800 At t = 3.
2 -$4,600.00 -$6,276 Same Result as
3 -$5,800.00 -$6,132 The ESL analysis.
4 -$8,100.00 -$6,556
5 -$6,700.00 -$6,580

66
11.2 Specific Conclusions:
1. To perform an ESL analysis year-

by-year market value estimates
are made relative to the specific
asset;
Determine the “n” value with the
lowest AW of costs;
The “n” value and the associated AWn
are then used in the replacement
analysis.

67
11.2 Specific Conclusions:
2. If no estimates of future market

values are made and “n” is fixed
then:
 Fix “n”;
 Estimate Sn;
 Calculate AW over “n” years given P
and S;
 Use the “n” and AW given “n” in the
replacement analysis for the specific
asset.

68
11.2 Setting Up for a Replacement

Analysis
Conduct the ESL for the defender
and the challenger(s);
Form the following alternatives:
 Challenger Alternative (C): AWC for nC
yrs;
 Defender Alternative: (D): AWD for nD
yrs.

69
11.2 Begin the Evaluation
The next section (11.3) illustrates

how to conduct a before-tax
replacement study.

70
CHAPTER 11
Section 11.3
Performing a
Replacement Study

11.3 Two Ways to Perform the

Study
1. Without a specified study period;
2. With a specified study period

72
11.3 Overview of the two

Methods

73
11.3 New Replacement Study
Given: {(C) or (D)};

Apply:
 AWD vs. AWC
 Select the best alternative
 Stay with the Defender for nD years
or,
 Go with the challenger for nC years.

74
11.3 One-Year Later Analysis
Validate all cost and market value

estimates;
Is the current year nD?
 If “YES”, replace the defender with (C);
 If “NO”, retain defender for one more
year and re-evaluate then.
If cost estimates have changed then:
 Update all estimates
 Calculate AWC and AWD
 Initiate a new replacement study.
75
11.3 Case Problem ( Ex. 11.4) -

Defender
Defender Data
 Current Market Value: $15,000;
 Future Mkt. Values will decrease by 20%/yr;
 Keep for no more than 3 years;
 AOC’s: {$4,000,$8,000,$12,000}
 Retrofit next year = $16,000;
 AOC’sD := {$20,000, $8,000,$12,000}
(costs).

76
11.3 Case Problem: Challenger
First Cost: $50,000

Future Mkt. Values decreasing by
20%/year;
Retain for no more than 5 years;
AOC’sC :=
{$5,000,$7,000,$9,000,$11,000,$13,000}
Assume the interest rate is set at
10%/year.

77
11.3 Defender Analysis

Input Parameters
Interrest Rate (%) 10.00%
Investment Cost ($) $ 15,000.00
No of Years to Study 3
(1) (2)
Year Mkt. Value AOC/Yr
1 $12,000.00 -$20,000.00
2 $9,600.00 -$8,000.00
3 $7,680.00 -$12,000.00
(3) (4) (5) Min Life

-$4,500 -$20,000 1 -$24,500
-$4,071 -$14,286 2 -$18,357
-$3,711 -$13,595 3 -$17,307 Min Life
ESL(Defender) = 3 yrs: AW = -$17,307/year

78
11.3 Cost Plots for Defender
ESL
CRC AOC AW
$30,000.00
$25,000.00
$20,000.00
$AW
$15,000.00
$10,000.00
$5,000.00
$0.00
0 1 2 3
Years
Min AW Cost Life = 3 years

79
11.3 Example 11.4: Challenger

Input Parameters
Interrest Rate (%) 10.00%
Investment Cost ($) $ 50,000.00
No of Years to Study 5
(1) (2)
AWC = -19,123/year
Year Mkt. Value AOC/Yr
1 $40,000.00 -$5,000.00
Min Cost
2 $32,000.00 -$7,000.00
3 $25,600.00 -$9,000.00
Life
4 $20,480.00 -$11,000.00 N = 4 Years
5 $16,384.00 -$13,000.00
(3) (4) (5)

Cap. Rec. Costs AW of AOC's Year Total AW(i%)
-$15,000 -$5,000 1 -$20,000
-$13,571 -$5,952 2 -$19,524
-$12,372 -$6,873 3 -$19,245
-$11,361 -$7,762 4 -$19,123
-$10,506 -$8,620 5 -$19,126
80
11.3 Challenger Plots
AW
$20,100
$20,000
ESL: Challenger
$19,900
$19,800
$19,700 Min Cost Life = 4 years
$AW
$19,600
$19,500 At -$19,123/year
$19,400
$19,300
$19,200
$19,100
$19,000
0 1 2 3 4 5 6
Years

81
11.3 Case Problem: Summary
AWD = -$17,307/year;
nD = 3 years;
AWC = -$19,123/year;
nC = 4 years;
Conclusion:
Stay with the Defender for at least one more
year – lowest AW(10%) cost: -$17,307/yr vs. -
$19,123/yr.
82
11.3 Market Value of Defender
What minimum market value of the

defender will make the current
challenger economically attractive?
If a high enough market value (trade-
in) is possible for the defender asset,
one should do so and go with the
Challenger immediately!
Break-even or replacement value (RV)

83
11.3 Replacement Value

(Defender)
Economic Fact:
If the actual market value (trade-in)

exceed the breakeven replacement value,
the challenger is the better alternative.
If this is the case, replace now with the
challenger!

84
11.3 RV Analysis
If a spreadsheet analysis has been

conducted, one may use:
 Goal Seek to find the RV or,
 SOLVER provided the cells are properly
linked.
Build you own spreadsheet to gain the
experiences needed – replacement
problems are difficult when one applies
manual calculations.

85
CHAPTER 11
Section 11.4
Additional Considerations
in a Replacement Study

11.4 Three Additional

Considerations
1. Future-year Replacement
Decisions;
2. Opportunity-cost vs. Cash Flow
approaches;
3. Anticipation of improved future
challengers.

87
11.4 Future Replacement

Decisions
1. Future-year Replacement Decisions:
 Replace now? One year from now? Two
years from now?
 The procedure just presented does
assist with answering this question
provided:
The cost estimates for (C) and (D) do
not change!

88
11.4 Future Replacement

Decisions
1. Future-year Replacement
Decisions:
If cost estimates change for either
(D) or (C) then the analysis should
be initiated again within a
reasonable time frame.
With changing estimates the
decision to replace may be altered!

89
11.4 Opportunity Cost vs. Cash

Flow
2. The method just presented applies the
opportunity cost approach:
(D)’s investment now is the fair market
value of (D) now;
Represents the opportunity cost foregone
by not disposing of (D) now;
(C)’s investment now is the investment in
(C) now.
This is a correct approach for a
replacement analysis.

90
11.4 Cash Flow Approach
2. Cash Flow Approach:

Assumes that when the challenger
is selected and a cash inflow for the
defender is received then:
 The investment in the challenger is
immediately reduced.
 Discourage this approach;
 Works only if the lives of the (C) and
(D) are the same!

91
11.4 Anticipation of Future

Challengers
3. Assumption: At some time in the
future a worthy challenger will
appear and replace the defender.
 Always study future trends of
challengers;
 May be best to augment the defender
until such time a more worthy challenger
becomes available.
 Tax considerations should always be
involved (see Chapter 17)

92
Section 11.5
Replacement Study over a
Specified Study Period
At times, a fixed or “impressed”

study period will apply to both the
challenger and the defender.
Such a study may not be based
upon the ESL approach.
If a fixed study period then ……

93
11.5 Specified Study Period
At times, a fixed or “impressed”

study period will apply to both the
challenger and the defender.
Such a study may not be based
upon the ESL approach.
If a fixed study period then ……

94
Determine the AW for both C and D

over the prescribed study period;
No need to perform an ESL
analysis;
Assumption is that the services of
C and D are not needed beyond the
study period.
Use the AW approach.

95
Focus on the most accurate

estimates available over the fixed
study period.
Assume “equal service” for both D
and C over the study period.
What happens IF the defender’s
remaining life is shorter than the
study period?

96
11.5 Defender’s Remaining Life
If the defender’s remaining life is

shorter than the study period then:
Focus on upgrading the defender and obtain

cost estimates in order to extend the
defender out to the study period.
These costs become part of retaining the
defender out to the prescribed study period.

97
Chapter 11 Summary
Compare the best challenger to

the current defender;
“Best” is defined as the option
with the lowest AW of costs over
the specified period of time;
Apply the ESL method to find the
economic life of the defender and
challenger;

98
Chapter 11 Summary cont.
For ESL, need estimates of future

market values and annual
operating costs for both C and D.
Annual Worth is the best method
especially if the lives of each
alternative are different.
For a fixed study period for both D
and C, apply the traditional AW
method.

99
Chapter 11 Summary cont.
Always focus on the estimates of

future costs and salvage values
using sound principles of
estimation.

100
ENGINEERING ECONOMY Sixth

Edition
Blank and
Tarquin
CHAPTER 5
End of Slide Set
Mc
Gra
Hill
w

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ENGINEERING ECONOMY Sixth

Replacement and Retention

Chapter 11 Learning Objectives

Authored by Don Smith, Texas A&M University 2004

Section 11.1 Basics of

Authored by Don Smith, Texas A&M University 2004

11.1 Why Replace Assets

Authored by Don Smith, Texas A&M University 2004

Authored by Don Smith, Texas A&M University 2004

11.1 Annual Worth Values

Analysis Approach for

Authored by Don Smith, Texas A&M University 2004

11.1 Economic Service Life

Economic Service Life (ESL)

Authored by Don Smith, Texas A&M University 2004

11.1 Investment Concerns-

Authored by Don Smith, Texas A&M University 2004

11.1 Investment Concerns-

Authored by Don Smith, Texas A&M University 2004

11.1 Investment Concerns

One must assign an investment

Authored by Don Smith, Texas A&M University 2004

11.1 Defender First Cost

Defender First Cost:

Authored by Don Smith, Texas A&M University 2004

11.1 Challenger First Cost

This is the total investment (Pchallenger )

Authored by Don Smith, Texas A&M University 2004

11.1 Trade In Concerns

Often a trade in value is offered by

Authored by Don Smith, Texas A&M University 2004

11.1 Basic Principles

Authored by Don Smith, Texas A&M University 2004

11.1 Basic Principles – Important

Authored by Don Smith, Texas A&M University 2004

11.1 Trade-In Issues

Authored by Don Smith, Texas A&M University 2004

11.1 Trade-In Issues

Investment in the Challenger:

Authored by Don Smith, Texas A&M University 2004

11.1 Trade-In Issues

Investment in the challenger

Cash Price for the challenger less:

This represents the true investment in the

Authored by Don Smith, Texas A&M University 2004

11.1 Trade-In Issues

Investment in the challenger

The Cash price

Authored by Don Smith, Texas A&M University 2004

11.1 Trade-In Issues - Example

11.1 Trade-In Issues - Example

11.1 Other Issues…

Authored by Don Smith, Texas A&M University 2004

11.1 Warning! What Not to Do!

11.1 Sunk Costs

11.1 Allocating Costs

Authored by Don Smith, Texas A&M University 2004

11.1 The Suggested Viewpoint

It is customary to take the

One assumes that the analyst is an outsider to

Authored by Don Smith, Texas A&M University 2004