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CHAPTER 11

Replacement Analysis

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.

11.1 Terminology

Defender Asset:
Currently installed asset;

Challenger Asset:
The potential replacement or challenging asset;
Under consideration to replace the defender asset.

Together Constitute mutually exclusive


alternatives;
Select one and reject the other., the Defender and
Challenger

11.1 Investment Concerns Defender

While it may seem strange to charge an investment


cost for keeping ones 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!

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.

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!

11.1 Investment Concerns-Challenger


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 known
with a fair amount of certainty.
Often a trade-in value is offered by a vendor to
take in the defender with a credit on the purchase
towards the challenger.

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.
If a trade-in is offered, what should be the proper
investment cost in the challenger?
Let PC = the 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;

Investment in the Challenger: PC (TIV MVD)

11.1 Trade-In Issues Example

Bought a system 3 years ago for $120,000

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.
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
InvestmentChallenger = $100,000($80,000-$70,000) = $90,000

11.1 Economic Service Life


Number of years for an alternative for which the AW or
EUAC is Minimum;
AW or EUAC is an analysis approach for replacement

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.
Termed The minimum cost life
Estimate the ESL for the challenger and defender.

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.

The minimum cost life is that value of n that yields the


lowest annual cost over the range of n values applied.

11.2 Typical ESL Plot


Min. Total AW of costs life

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.

Analytical Form for Total AWk:


Total AWk P ( A / P , i, k ) S k ( A / F , i, k )

AOC j ( P / F , i, j ) ( A / P, i, k )
j=1

11.2 Example

Defender Asset;
3 years old now;
Market value now $13,000;
5-year study period assumed;
Requires estimates of the future salvage values
and annual operating costs for the 5-year
period.

11.2 Example

Defender Asset: 3 years old now


Market value now $13,000
Estimated Future Market Values and AOCs: (Assume
the interest rate is 10% per year)
MktVt AOCt
t = 1:

$9,000 $-2,500

t = 2:

$8,000 -2,700

t = 3:

$6,000 -3,000

t = 4:

$2,000 -3,500

t = 5:

$0

-4,500

11.2 Example: Find the ESL

Period-by-period analysis
AW(10%)1 = (-$13,000)(A/P,10%,1) +
$9,000(A/F,10%,1) 2,500= -$7,800
AW(10%)2 = (-13,000)(A/P,10%,2) +
8,000(A/F,10%,2) -[2,500(P/F,10%,1) +
2,700(P/F,10%,2)](A/P,10%,2) = -$6,276/yr
AW(10%)3 = (-13,000)(A/P,10%,3) +6,000(A/F,10%,3)
-[2500(P/F,10%,1) + 2,700(P/F,10%,2) +
3,000(P/F,10%,3](A/P,10%,3) = -$6,132/yr

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:

-7,800

k=2:

-6,276

k=3:

-6,132

k=4:

-6,556

k=5:

-6,579

Min. Cost Year = 3 years

11.3 Overview of the two methods

Example-Defender Analysis
Input Parameters
Interrest Rate (%)
Investment Cost ($)
No of Years to Study

(1)
Mkt. Value
$12,000.00
$9,600.00
$7,680.00

Year
1
2
3
(3)
Cap. Rec. Costs
-$4,500
-$4,071
-$3,711

10.00%
15,000.00
3

(4)
AW of AOC's
-$20,000
-$14,286
-$13,595

Year
1
2
3

(2)
AOC/Yr
-$20,000.00
-$8,000.00
-$12,000.00

(5)
Total AW(i%)
-$24,500
-$18,357
-$17,307

ESL(Defender) = 3 yrs: AW = -$17,307/year

Min Life
ID

Min Life

11.3 Example: Challenger


Input Parameters
Interrest Rate (%)
Investment Cost ($)
No of Years to Study
Year
1
2
3
4
5

(3)
Cap. Rec. Costs
-$15,000
-$13,571
-$12,372
-$11,361
-$10,506

$
(1)
Mkt. Value
$40,000.00
$32,000.00
$25,600.00
$20,480.00
$16,384.00

(4)
AW of AOC's
-$5,000
-$5,952
-$6,873
-$7,762
-$8,620

10.00%
50,000.00
5

AWC = -19,123/year

(2)
AOC/Yr
-$5,000.00
-$7,000.00
-$9,000.00
-$11,000.00
-$13,000.00

Year
1
2
3
4
5

(5)
Total AW(i%)
-$20,000
-$19,524
-$19,245
-$19,123
-$19,126

Min. Cost
Life
N = 4 Years

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.

11.1 Specified Study Period


Determine the AW for both C and D over the
prescribed study period;
No need to perform an ESL analysis;
Assume equal service for both D and C
over the study period.