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REPLACEMENT
ANALYSIS
SEMESTER JANUARY 2010
Replacement Concept
Replacement refers to
Selection of new assets to replace existing assets.
The evaluation of entirely different ways to perform an
assets function.
Example:
Old trucks can be replaced with new models that operate
similarly but have additional features that improve
performance or efficiency.
Trucks could be replaced with conveyor system,
overhead crane, subcontract for hauling, or manual
labour; that serves the needed function.
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Introduction
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INTRODUCTION
In REPLACEMENT ANALYSIS, the reference for
comparison is the existing resource --- anything that is used
in business such as machine, tools, or equipment.
The question is:
When should we replace the resource?
Or more focused question:
Should we replace the equipment now or sometime
later?
Precise question:
Should we budget now to replace the resource during
the next financial year?
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REPLACEMENT ANALYSIS
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1.
2.
3.
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PHYSICAL IMPAIRMENT
(DETERIORATION)
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ALTERED REQUIREMENTS
Significant change in demand for related
products or services
Significant change in the composition or design
of associated products or services
May be considered a form of obsolescence
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TECHNOLOGY
Impact of technological change varies with
associated industry
Technological changes typically reduce cost
per unit and improve quality of output
Results in earlier replacement of existing
assets with improved assets
May be considered a form of obsolescence
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FINANCING
Considers economic opportunity changes
external to the physical operation or use of the
asset(s)
May involve income tax considerations
(depreciation and after-tax analysis)
EG: rental of assets may become more
attractive than ownership
May be considered a form of obsolescence
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REPLACEMENT ANALYSIS
Two types of approach available [when to apply]:
1.
EUAC-BASED analysis [zone A and early part of zone B]
2.
MARGINAL-COST-BASED analysis [later part of zone B]
A
Cost
Total cost
Operating cost
EUAC min
Economic life
Age
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MARGINAL-COST
Marginal cost is the cost to keep an asset in service one
more year. This concept is applicable to mature, older
existing equipment (defender) with increasing operating
costs.
Require knowledge of the future MV of the asset.
The marginal cost is calculated for each year of the assets
life.
The marginal cost is used to compare against EUAC of the
proposed replacement.
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ECONOMIC LIFE
15
ECONOMIC LIFE
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OWNERSHIP LIFE
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PHYSICAL LIFE
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USEFUL LIFE
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Figure 9.1
$
60,000
Cumulative operating cost, COC
40,000
Cumulative capital cost =
(initial cost resale cost)
20,000
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1
2
Operating cost
2,000 3,000
Market value (MV) 15,000 11,250
3
4,620
8,500
4
5
8,000 12,000
6,500 4,700
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Table 2
From Table 1
Given
Least cost
The above tabular solution method reveals that trading-in the trucks
after 3 years for new unit is the minimum-cost replacement cycle.
This is the economic life of the challenger, where EUAC is at the
lowest.
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Least cost
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1.
2.
3.
26
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Example 9.1
1.
2.
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Example 9.2
A old pressure vessel has annual O&M expenses of
$60,000 per year and it can be kept for 5 years more at
which time it will have $0 MV. The present MV is $30,000 if
it were sold now.
A new pressure vessel cost $120,000. It will have a MV of
$50,000 in 5 years and will have O&M expenses of $30,000
per year.
Using before tax MARR of 20% per year, determine
whether or not the old pressure vessel should be replaced.
Solution:
The 1 st step is to determine the investment value of
the defender (old vessel). Using outsider viewpoint, the
investment value of the defender is $30,000, its present
MV.
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33
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Example 2:
It is desired to determine how much longer a fork lift should remain
in service before it is replaced by new unit (challenger) discussed
in Example 1.
The defender in this case is 2 years old, originally cost $13,000,
and has a present MV of $5,000. If kept, its market values and
annual expenses are as tabulated below:
EOY
k
0
1
2
3
4
MV @
EOY k
5,000
4,000
3,000
2,000
1,000
500
400
300
200
5,500
6,600
7,800
8,800
7,000
8,000
9,100
10,000
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RETENTION OF THE
DEFENDER
The defender should be kept longer than the
apparent economic life of the defender as
long as its marginal cost (total cost for an
additional year of service) is less than the
minimum EUAC for the best alternative
challenger
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Example 9.7
End of Year, $
1
2
3
4
5
6
7
Annual Rev - Exp 10,000 15,000 18,000 12,000 7,000 4,000 3,500
MV of machine 40,000 32,000 25,000 19,000 15,000 12,000 10,000
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Sample calculation:
Keep for one year
$40,000
$10,000
$50,000
PW (12%)
=
=
$32,000
$10,000
$15,000
$50,000
PW (12%)
=
=
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In the same manner, the PW (12%) for years three through seven
can be computed. The results are as follows:
Keep for three years
PW (12%) = $1,494
PW (12%) = $3,400
PW (12%) = $3,802
PW (12%) = $3,403
PW (12%) = $3,430
Conclusion:
It is obvious that PW is maximised ($3,802) by retaining the
machine for a total of 5 years.
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