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CASES
The following cases from Cases in Engineering Economy (www.oup.com/us/newnan) are suggested as matched with tbi

CASE 26 Molehill &. Mmmtain Movers


Compares depreciation methods with option for inflation.
CASE 28 Olives in Your Backyard
Emphasizes taxes and sensitivity analysis.
CASE 29 New Fangled Manufacturing
Emphasizes taxes and sensitivity analysis.
CASE 36 Brown's Nursery (Part A)
After-tax analysis of expansion opportunity.
CASE 38 West Muskegon Machining and Manufacturing
ore complex inflation and tax pro blem with sunk cost and leverage.
CASE 53 Problems in Pasta Land
Long case statement. IncJ udes taxes aad limjted uncertainty.

APPENDIX 12A
Tuxes and Personal Financial Decision Making

Key Words
adjusted gross income
buy term invest differe nee
cash value benent
death benefit
deductible
defined benefit
defined contribution
gross income
individual retirement acc ount
insurance
liability insurance
needs/savings/wants
Perkins loans
premiums
Stafford loans
taxable income
tax refund
withholding
401(k) plan
403(b) plan

In this appendix our goal is to focus on decisions involving personal income taxes and likely financial scenarios that st
first describe how taxes are computed for individuals. As is the case with corporations, individuals should consider decisions
by taxes on an after-tax basis. We detail several example applications of this knowledge to common personal finance scenar
loans and retirement acc ounts. Lastly, we provide details on decisions involving insurance and personal budgeting.

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INCQ,M E TAXES FOR INDIVIDUALS

Calculating Tuxes Due


An impmtant expense for individuals each year is federal taxes . The dollar amount due depends on both the level of tax
applicable income tax rates. Calculating annual federal taxes for individuals involves the foliowing steps:
1. CalcuJate gross income, which is the sum of all wages and income streams:

Gross income = Wages salary etc.+ Intere t income+ Dividend


Capital gains+ Unemployment compensation+ Other income

2. Determine adjusted gross inmme (AGI) from gross income. AGI includes allowable adjustments such as retirement I
Adju ted gross income = Gross income - allowable tax adjustments

3. CalcuJate taxable income from AGI and al1owab]e exemptions and deductions. Historically one exemption was allo
who depends on the gross income. Taxpayers are allowed a standard deduction to account for various expenses. Ho 1

itemize deductions if they will exceed the standard deduction. These itemized deductions (with limits) include medica
local income taxes, real estate and prope1ty taxes, home mortgage interest. charitable contributions, theft and losse
other categories.
Taxable income = Adjusted gross income - personal exemption(s)
- Jtemized deductions or standard deduction

4. Determ ine income tax from taxable income and applicable tax rates.

Income tax = L (Taxable income in bracket x (Tax rate for bracket)


or = 'fax from lower bracket + (Taxable incmne in bracket)

x (Tax rate for bracket) ('

Withholding Taxes
The federal government uses wid1bolding to collect taxpayer payments on a regular basis throughout the year. This ind
security, and edicare taxes. In most cases, employers withhold some portion of wages from each employee each pay peri
and number of dependents claimed. In the case where more taxes are withheld than are due, the taxpayer receives c1
withholdings are less than taxes due, the difference must be paid-which may involve interest and penalt1es if too large.

Tax Cuts and Jobs Act and Personal Income Tuxes


The Tax Cuts and Jobs Act (2017) simplified tax calculations by eliminating personal exemptions. It also nearly doubled th
and added limits to the itemized deduction for state and local taxes-so itemizing deductions makes sense for fewer taxpay
becomes:
Taxable incmne = Adju ted gross income - Standard deduction or itemized dednctiorrs

The standard deduction for 2018 tax returns is $12,000 for single taxpayers and $24,000 if rnmTied and filing jointly.
deductions include:
• Medical and dental expenses exceeding 7.5% of AGI
• State and local taxes (SALT) up to $5000 on single returns and $10,000 on joint returns. This includes income or salei
and property taxes.
• Horne mortgage interest (limit of $750,000 in debt)
• Charitable contributions (limit of 60% of AGO
Tables 12A- la and 12A- lb show the brackets and tax rates for single and mani ed filing jointly. Example 12A- 1 il1ustrat
these tables are constructed.

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Tobie, I2A-la 2018 Tux Rate Schedule, Filing Status Es Single


Taxable Income Tax Rate
$0 to $9525 10%
$9526 to $38, 700 $952.50 plus 12% of the amount over $9525
$38,701 to $82,500 $4453.50 plus 22% of the amount over $38,700
$82,501 to $1 7,500 $14,089.50 plus 24% of the a.mount over $82,500
$157,501 to $200,000 $32,089.50 plus 32% of the amount over $157,500
$200,001 to $500,000 $45,689.50 plus 35% of the amount over $200,000
$500,001 or more $150,689.50 plus 37% of the amount over $500,000

Tobie, l 2A-lb 2018 Tux Rate Schedule, Filing Status Is Married Filing Jointly
Taxable Income Tax Rate
$0 to $19,050 10%
$19,051 to $77,400 $1905.00 plus 12% of the amount over $19,050
$77,401 to $165,000 $8907.00 plus 22% of the amount over $77,400
$165,001 to $315,000 $28,179.00 plus 24% of the amount ove.r $165,000
$315,001 to $400,000 $64,179.00 plus 32% of the amount over $315,000
$400,001 to $600,000 $91,379.00 plus 35% of the amount over $400,000
$600,001 or more $161,379.00 plus 37% of the amount over $600,000
Note: Tob ies are also available for unmarried individual with dt>pendent re latives ("mead of household") and married taxpayers fili.ng separately.

EXAMPLE 12A-1
A young engineer earned $85,000 in wages and other income in the last tax year. She is unmarried and from company
$13,000 has been withheld for taxes. If she had $8000 in charitable donations last year, calculate if she wiU receive a refund

SO LUTION

Taxable hlcome = Adjusted Gross Income - Standard or Itemized Deductions


= 85,000 - 12;000 ( tandard deduction was greater)
= 73,000

Federal Income Tax = 4453.50 + (0.22)(73,000 - 38 700 = $1 1 999.50


The 4453.50 = 10% of 9525 + 12% of $38. 700 - $9525

Since her company withheld $13,000 in taxes, she will receive a refund of $1000.50(=13, 000 - 11,999.50) from the fe•d

Cmnbined Federal and State lncome Taxes


Individuals, like corporations, are often subject to both federal and state income taxes. However, when state taxes are dedm
be itemizing deductions) Equation 12-2 applies. If the standard deduction is used then Equation 12A-6 applies.
ombined increme ntal tax rate = .6.State tax rate + .6.Federal tax rate
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omo1nea m cremennu 1ax r a re = .n.;:,1a1e rm- ra1e + ilt<eoerru 1ax rare

EXAMPLE 12A-2
A single engineer's expected taxable income is expected to be $92,000. Instead of taking a p]anned end-of-year vacation,
accept assignment to a project with a year-end deadline. The expected overtime would increase earning~ by $8000. The mc1
income tax at either tota] income is 8%. What is the engineer's combined marginal tax rate?
1. If dedu□ions are itemized.
2. If the standard deduction is used.

SOLUTION
In either case the marginal tax rate at the federa1 level is 24%.
1. If deductions are itemized then Eq. 12-2 applies.
Combined rate = 0.08 + 0.24(1 - 0.08) = 0.08 + 0.221 = 30.1%

2. If the standard deduction is used then Eq. 12A-6 applies.


Combined rate = 0.08 + 0.24 = 32%

Capital Gains/Losses for Individuals


As with corporations, individual taxpayers incur capital gains or losses when selling houses, land, stocks, art, jewelry, an
Depending on tax bracket. type of asset, and duration of ownership, the capital gain tax rate can range from 0% to 37%.
capital gain provision for many is the exemption of up to a $500,000 gain from sale of a principal residence. Because this
introduction to personal income taxes, the regulations for the sale of a house and capital gains tax rates are not detailed here.

Tux Credits vs. Tax Deductions


This chapter and appendix have a]ready included examples of tax credits and deductions from taxable income. Comparing I
in "writing off" a pottion of college tuition expenses allows us to directly compare the value of a tax dedu□ion vs. a tax
summatizes tuition-related federal tax deductions and credits for single filers. Income leve]s are doub]ed for joint filers, ani
expense deduction . The credits are not changed.

Thll>le-12A-2 Federal tax deductions and credits for single filers (2015)
Modified Adjusted
Provision
for
Gross Income- (MAGI), Details
Education
Expenses
Education $0-65,000 100% of firs t $4000
Expenses
Deduction $65,000----60,000 100% of firs t $2000
American $0-80,000 100% of firs t $2000 25% of next $2000
Opportunity
Tax Credit $80,000-90,000 PlhaSie out bracket
Lifetime $0-57,000 20% of first $10,000
Learning
Credit $57,000-67,000 Phase out bracket

The reduction in allowable values is propmtional to percentage of phase out bracket Income levels and the Education Ex(
doubled for joint filers.

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Student Loan Interest Deduction
The interest on most consumer loans is not tax deductible, but interest on student loans (up to the Umits shown in Tabl,
mort gages is tax deductible.

EXAMPLE 12A-3
An independent first-year college student has an adj usted gross income of $18,000 in 2018 and pays $10,000 in tuit
described in Table 12A-2 is the most valuable?

SOLUTION
The student files a single return, so the limits in Table 12.A-2 apply, and the income is within the brackets where the
deduction or credit is available. The student's taxable income is $6000 (=18,000-12,000), which is in the 10% tax bracket.
Only .$4000 of the tuition payments is deductible under the education expenses deduction. Since deductions reduce t
reduction in taxes would be $400 (= 4000 x 0.10).
While deductions reduce taxable income, credits reduce income taxes. Thus, both credits are much more attractive than
American Opportunity Credit at $2500 allows $500 (= 25% of next $2000) more than the Lifetime Learning Credit, which i

Tul!Jle 12A-3 Federal tax deduction for student loan interest (2018)
Modified Adjusted Gross Income (MAGI), Details I
$ 0-65,000 (single)
$ 0-135,000 Uoint) $2500 or total paid I
$ 65,000-80,.000 (single)
$ 135,000-160,000 Ooint) Phase out bracket I

EXAMPLE 12A-4
A recent engineering graduate is single and earning $60,000 annually with a government labs group. What is the after-tax <
student loan interest that the engineer paid last year?

SOLUTION
Only $2500 of the interest is deductible from taxable income. With $60,000 in income, the engineer wnI be in a 22% tax t
is a reduced tax bill (savings) of $550 (= 2500 x 0.22). The after-tax cost of the interest is $3950 (= 4'5 00 - 550).

EXAMPLE 12A-5
Two engineers are married and filing a joint return. Last year their MAGI was $155,000. What is the amount of allowabl
paid $800 interest on their student loans? If they paid $2750 in student Joan interest?
SOLUTION
With $800 interest the deduction must be reduced because their MAGI fal]s in the $135,000 to 165,000 phase out range.

Redll e = $800 l SS,OOO - l3S,OOO = 553


C BOO X l 65 000 - 135,000
Deduction800 = 800 - 553 = 267

With $2750 in interest, first the $2500 Umit is applied and then the phase out reduction.

Reduce - = $2500 x 155,000 - 135,000 = $ 1667


'.mo 165 000 - 135,000
Deduction 2150 = 2500 - I 667 = $833

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STUDENT LOANS
If yo1.1 are borrowing money to attend college, you are part of a very large group. In 2017 neady 20 million people ,
universities in the U.S., and over 70% borrowed from the federal government or private sources. An estimated 44 milUm
students owe nearly $1.5 trillion collectively-with an average student debt of about $39,400.
This is not an overview of the different programs with the ir rates, Umits, and regulations. Instead Examp]es 12A- 6
economic anaJysis that is part of better decision making. Some of that decision making is easy. Subsidized student loans witb
are better than loans with more expensive rates. Other decisions, such as the choice between working more, borrowing less
longer to graduate, are more complex. On-the-job learning, building a resume, and balancing life and school are diffic
economic anaJysis-but they may be the decision-making drivers.

EXAMPLE 12A-6
An undergraduate is compaiing the financial aid packages offered by two institutions. Both packages include $20,000 in St
years but one is subsidized and one is not. If the student pays back the loans in 5 years after graduation, how much inte1
loan? To simplify the calcufations for an easier to follow exampJe assume annual tuition and loan payments and ignore re
income. To fu11her simplify the calculations, ignore the loan fees (see Chapter 7 to include). Assume there is one loan for 4
separate loan at a possibly different rate for each year. For 2018-19, direct subsidized and unsubsidized undergraduate St
fixed interest rate of 5.05%.

5-BUITON SOLUTION
For the subsidized Stafford loan the interest is paid by the government while the student is in school (0% compounding frn
for the subsidized loan only $20,000 is owed at the end of 4 years (the government pays the interest), and thus the paym
$4626. The total interest paid in the 5 years after graduation is $3129.

A B C D E F G H I J
1 Altemative n PMT PV
i FV Solve for Total Paid Interest Paid
2 Subsidized 5.05% 5 -20,000 0 PMT 4,626 23,129 3,129
3 begin
4 Unsubsidized 5.05% 4 5,000 0 FV -22,656
5 5.05% 5 -22,656 0 PMT 5,240 26,201 6,201

For the unsubsidized Joan the amount due at graduation is $22.,656 (over 13% higher than $20,000). The payments
$5240 are also over 13% higher than the $4626. The total interest paid is $6201, which is nearly double the interest pak
scenario.

Example 12A-6 illustrates that even if student loans are paid off quickly, rates and subsidies can dramatically change ,
Many students owe more and take much longer to repay the loan, which can interfere with their ability to buy a house., sa
even take vacations. It Is also worth noting that student loans can be discharged in bankruptcy onJy If undue hardship can be I

EXAMPLE 12A-7
Find the effective rate of interest the student pays for the subsidized loan in Example 12A-6, assuming the loan rate is 5.05(

SPREADSHEET SOLUTION
The timing of the $5000 tuition payments and the loan payment amounts and timing do not change. The future value of rl
and the present vaiue of the loan payments are equal, and the interest rate is the unknown. For visibility and convenieno
value for the subsidized Joan is entered to establish a goal. Then GOAL SEEK is used to find the effective interest rate of 2.

A B C D E F' G H I J
1 Altemative i n PMT PV FV So]ve for Total Paid
2 begin
- - . . .. - -- --- ~ - -- - - - - - -- -
~

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3 Subs.idized 2.68% 4 5,000 0 FV -21,378


4 2.68% 5 -21,378 0 p T 4,626 23,129 =C4"'H4
5 =B3 =H3 Subsidjzed Exp. 12A-6 23,129
6 difference 0

EXAMPLE 12A-8
A student has borrowed $27,500 in Perkins loans (available to students with exceptional need). The rate on the loan is 5%,
has paid the interest while the student has been in school. To simplify the cakulations assume annual tuition and loan payr
differences in the payment amount and the total paid if the student pays the Joan back in 5 years and in 20 years? Is thE
student loan interest likely to reduce the after-tax cos[ of the Joan?

5-BUITON SOLUTION
The first year the interest is 5% of the loan amount or $1375. This is less than the maximum deduction for student loan inte
be deductible. However, it is also much less rhan the standard deduction. Few smdents buy a home right out of school., and
forcing some to postpone it longer than they would like. It is mortgage interest and property taxes that often make it1
attractive.

A B C D E F G H I J
1 Alternative i n PMT PV FV Solve for Annual Payment Total Paid Inte11est Paid
2 5-year 5% 5 -27,500 0 p T 6352 31,759 4259
3 20-year 5% 20 -27,500 0 p T 2207 44,133 16,633

Using the longer repayment term reduces the payment by 65%, but it increases the total paid by 39% and the interest paii

RETIREMENT ACCOUNTS
Appendix 9A introduced defined benefit and defined contribution retirement plans. The shift to defined contribution
governments means that students graduating today must pay more attention than their parents' generation to saving en,
Examples 12A- 9 and 10 illustrate a few of the options for retirement savings. Good planning starts with understanding the
interest. It includes the analytical techniques used here . It also includes keeping up with changing investment details as yo
evolves so that you can make the best choices.
401(k) plans are available to employees of corporations. Similar retirement plans exist for employees of other types of c
for public education and some nonprofit employees, 401(a) plans for some government workers, 457(b) and (f) plans fo
nongovernment, and nonprofit employees).
These plans allow qualified employees to direct part of each paycheck into a designated relirement account Hu
depattments have staff and resources dedicated to explaining the options and establishing these accounts. When choosing a p
the employee will need to be considered. (In some cases expected returns before fees are quoted.)
Dollars are directed inm 401(k) accounts on a before-tax basis. Oeposils are subtracted from salary and wages when repo
so taxes are also reduced. In 2.018 the federal limit (the section 402(g) limit) on pre-tax dollar investments and/or expen:
Individual (up to $24,500 if over 50., via a "ca.tch-up connibution").

EXAMPLE 12A-9
A 25-year-old with a dual BS/MS engineering degree accepts employment with a national firm which has a required retire,
simplicity assume that the engineer stays through retirement and that the average annual salary over the next 40 years is
offers a $1 firm -for-$2 employee 401(k) matching plan (up to a maximum employee contribution of 6%). The choser
expected rate of return after subtracting fees . What wil1 the engjneer have in the plan at retirement?

SOLUTION

= $96,000/12 = $8000
nntlhlv rnntri hnti nn<:. fmm i>mr.lnvi>i> = <l:Mnn >< fi%
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Montl'l]y contJ.ibutions from employee = $8000 >< 6% =$480
onthly contJ.ibutions from company = $8000 >< 3% = $240 (l-for-2 match)
Total monthly contri bution =$480 240 =$720
Puture va]ue in 40 years? = $720(FIA, 0.25%, 480) 1 = $666,763
1 (F/A, 3%/12, 40 x 12)

Without the company match the accumulated amount in the account would have been 1/3 less. AH disn·ibutions fo
individua]s will be taxable income. But marginal tax rates after retirement should be much lower.

EXAMPLE 12A-10
For the data in Example 12A-9 compute the after-tax difference 1n income with and without the 401(k) deduction. Assum
and standard deduction.

SOLUTION

Choose 40 l(k) Plan No 40l(k) Plan Notes


Wages .$90,240 .$96,000 .$96, 000*. 06=.$5 760 contribution
Std. ded uction 12,000 12,000
Taxab]e income 78,240 84,000 marginal tax at 22% and 24%
Taxes (from table) 13,152 14,449
After-tax wages 77,088 81,551 = Wages - taxes Difference is $4463

Tax computations:

40l(k) $13, 152 = 44-53.50 + (0.22)(78,240 - 38,700


No 401(k) 14 44-9 = 14, 089.50 + (0.24)(84.()00 - 82,500 ,

By choosing the 401(k) plan the engineer is putting $8640 ( 5760 employee + 2880 company match) into the accm
$4463 in after-tax wages.

INSURANCE
Insurance helps individuals manage risk. Policyholders pay monthly or annual premiums to insure their life, home, vehid
Insurance may cover your possessions and your potential liability if someone is hurt in your apartment. For trip insur.
warranty, the purchase is for a trip or a product, where the insurance company pays in the event of an insured loss. With ii
payment is often reduced by a deductible that the individual is responsible for. Because the insurance company has ex{
market, and to limit fraudulent claims, the payout is on average less than the premiums collected-sometimes less than
higher than 85%. This means that for a propedy rated individual, the policy's expected value is negative.
So how do you decide which types of insurance you want? Sometimes you may not have a choice. If you finance your,
home with a mortgage, the lender wi11 require coverage to protect itself. If your employer does not offer medical insurance,
by the government to purchase it. In most states., if you license a vehicle you are required to have liability insurance.
purchase insurance, in some cases you wiU also have to choose how much coverage to catTy.
For example, most students and engineers statting out have few assets, so bankruptcy may be an alternative to higher liabi
however, they may have young children and a nonworking spouse, so life Insurance may be critical. ln contrast, an e1
retirement may have substantial assets to protect and no dependents.

Auton1obile- Insurance
Buying a vehicle usually means an insurance policy must be chosen. Coverage and deductible limits, state requirements, and
quick]y overwhelm a car buyer. Policy buyers must choose property damage and bodily injury liability levels,
protection/personal inj my protection levels, collision versus comprehensive coverage, uninsured motorist protection, roac
rental car options.

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EXAMPLE 12A-11
The state of ew Hampshire is the one state that does not require drivers to carry liability insurance. Assume you just recei'
in the Granite State. Should you purchase optional automotive insurance?

SOLUTION
The answer is that it depends! What can you afford and what is your risk tolerance? Let's start by looking at the financial
scenarios:
1. No insurance,.'.!'. no accident:
• Annual insurance premium = $0 Total Annual Expense = · 0
2. No insurance, 1 accident Assume the driver is responsible for 1 two-car accident with these costs:
• Own car is totaled = $5000 net replacement value
• Damage to other car = 4000
• Own medical bills = 2500
• Other driver, medical= 8000
• Propeny damage = 1500 replace traffic post/sig;n

Due others = $13,500


Cost to self = 7o,100
Tota] = $2 1,000

3. Insurance, 1 accident: Assume the driver has the rnin1rnum Jiability coverage policy for a driver in H,..,. and collisi
$500 deductible and causes the scenario 2 accident:
• Annual insurance premium = $150/rnonth (estimate)
• Deductible expenses = $500
Total Arut~

Scenario 2 shows the risk of not having at least minimum auto insurance. But there are other costs that are harder to quar
choosing; insurance types and levels. Scenario 2 could easily have included legal costs that are pa1t of the insurance firm's e
doing business, but that would be expensive in time and money for you to buy.
Less expensive coverage without collision insurance for the Scenario 2 accident would have meant having to replace the
you have the funds to do so? Do you need the car to get to work, or just for weekend activities? How much is the time that
spend resolving issues with the insurance company wm1h to you?
*Cu1Tently 2.0 of the 49 sta.tes that require liability minimums also require uninsured motmists coverage.
**2018 NH minimums for those electing to insure their vehicles are 25/50/25 in $1000 for bodily liability per person an
propeny per accident.

Most policyholders are willing to trade off the expense of a pe1iodic premium for the peace of mind that insurance
protection against potentially catastrophic financial circumstances. To reduce premiums: make firms compete for you
bundling different insurance coverages with the same company; make one annual payment versus monthly payments; inc11
levels; and ask for avaiJable ]ow mileage, good d1iver, and student discounts.

Life Insurance
Life insurance policies provide a death benefit that is paid to the survivors (beneficiaries) when the insured person dies. Thi
nm subject to income tax, but there may be estate taxes. Some types of life insurance also offer a cash value benefit tc
policy's cash portion can be withdrawn or bonowed against, often afte r some initial accumulation period.

EXAMPLE 12A-12
A recent enginee1ing graduate sta11ed her new job with a required session in the firm's human resources (HR) office. Sher
life insumnce options that were discussed. What should she know to assist her choice? Her options are:
( 1 \ n..-. nn t n111'V"'h !lico. !:lnu _d,H ti nn!:11 Hf'o inc1 1r!:lnr.o

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(1) Do not purchase any additional life insurance.
(2) Purchase additional term life insurance.
(3) Purchase a perm an em life insurance policy.

SOLUTION
(1) As allowed in IRS Code Section 79, her employer provides a $50,000 tenn life policy to all employees free of charg1
income tax.
(2) Term life insurance policies provide a death benefit for the specified 5-, 10-, 20-, ... year term as long as premimr
The younger and healthier the insured and the shatter the term, the lower the premium. Once the term ends, soi
renewed at a higher cost and others require a new policy.
(3) Permanent life insurance comes in many types that include whole, ordinary, variahle, universal, index-universal, an<
life. , ost have both a cash value and a death benefit. The cash value accumulation acts as a tax-free investment i
policy's life . In many cases the policyholder has the right to keep the policy for his or her whole life untiJ death, whi
is paid .
There is no one right answer. Life insurance is a complex decision based on one's life circumstances, goals, and perspec1
often influenced by number and age of dependents and one's desire to provide financial security for survivors.

Example 12A-13 (Example 12A- 12 Revisited),


The engineer in Example 12.A-12 recently retumed from an investment seminar that recommended the Buy Term and In,
(BTID) strategy. Should she use this approach?

SOLUTION
Permanent life policies offer more than death benefits for a defined term, and thus the premiums are higher than for term 1
insurance is purchased, this difference in premiums can be invested.

The main disadvantage of BTID is that the insured must actually invest the difference (versus spend it!). In additi
permanent life policies grow tax free and other BTID investments might not. Advantages of the BT D strategy ind
investment portfolio, higher potential investment gains, lower investment fees, g;reater access to funds, and the fact that the
(cash value) passes on to beneficiaries after death- rather than being kept by the insurance company, as is the case
insurance policies.
The biggest advantage of the BTID strategy may be that the amount of insurance purchased can be better matched to
(which varies over the insured's life) to provide for dependents in the case of the insured's death.

PERSONAL BUDGETING
At its essence., money management employs a simple concept: live within your means. Yet, this concept is challenged l
heavily marketed consumer choices, as well as the spending habits of many people. A simple way to organize a personal bud
into:
1. Needs: spending on the basics such as housing, groceti es, transpmt ation, insurances, energy/utiUties, clothing, and c
includes loan payments that must be made. Since income taxes are usually wi1hhe]d by the employer, it is cm
cakulations on after-tax income thal has subtracted the withho]ding.
2. Savings: building an emergency fund (target 6 months of needs), paying off high-interest loans faster, and savJ
retirement, home down payment, a new vehide, or major travel.
3. Wants: discretionary spending on entertainment, meals out, clothing beyond hasics, hobhies, recreationa] travel, and tl
A common guideline (the 50/20/30 ru]e) allocates after-tax income as 50% or less for needs, 20% or more for savings,
wants. These percentages are not always achievable. When income Is low, all spending may be on needs, but even then the g
goal as income increases.
Recognizing and naming types of spending forces individuals to be thoughtful about where their money goes each month
examples of how a few dollars here and a few dollars there add up to significant sums. Be aware of where your expenses
your spending goals. It is incredibly easy to let wants become needs. For example, taking out a loan to buy a more expensive
credit card debt on e]ectronics, meals out. or travel converts a want into a required. payment. Be intentional about your spendi

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EXAMPLE 12A-14
Dave Parish is a mid-career civil engineer with an annual after-tax income of $90,000. His monthly expenses are:

Monthly Monthly
Category expense Category expense
House payment $12 0 Groceries $400
Gasoline (automobile) 180 Utilities (gas,. water, electric) 250
Comm unications (cable, phone, Internet) 255 Car payment 535
Restaurants 350 Hobbies 175
Home essentials 230 All savings 1550
Insurance, and taxes 565 Vacations 550
CMJd suppmt 1000 Entertainment 210

What percentage of Dave's expenses fit into each of the three categories? What adjustments should he consider if his go~

SOLUTION
Categorizing Dave's annual expenses:

Category Expenses Total Sfyear Percentage ol budgE


eeds Home paymen t, groceries, gas, utili ties, car, home, insurances/taxes, child support $52,920 58.8%
Savings Retirement account 18,600 20.7
Wants Communications, restaurants, hobbies, vacations, entertainment 18,480 20.5

Like many of us, Dave's monthly budget is heavier than he' d prefer In the needs category. However, he is meeting hJ
Looking into the future, he could have more money for wants if he keeps his car after it is paid off. That removes the car
the needs category. In general, this budget could be right for Dave at this life stage.

STUDENT STUDY GUIDE


These questions are intended for self-study. Click the [solution] box to reveal a detailed solution.
12.A- A young entry-level engineer~ Kelly Green, earned $43,000 last year. Kelly is single and wilJ not itemize his tax return. How mu
1 does Kelly owe? Ass ume no othe.r income adj ustments.
Ai•j••dM§•
12.A- Tam mie pays federal income taxes at the incremental ra te of 22% and state income taxes at the incremental rate of 3.4%. \
2. incrementa.l income tax rate?

AM•Gi0ii
12.A- As a senior eng ineer for a large consulting firm, Ray ea.med $113,000 last year. Ray is maITied with two children. His wife had nc
3 not itemize their tax return. What is the effective federal tax rate the cou ple wrn pay jf they file a joint return? Assume no oti1er inco1

Affi•Giu8•
12.A.- Lexie earned $29,995 last year whi]e also attending the niversity of New London as a graduate student. She paid tuition of $41(
4 had additional educational expenses of $900. Lexie is single and wiJI not itemize her tax return. Assum in g no other income adjustrm
tax will Lexie owe?

12.A- A student pays her own tuition and fees. Her income is $45,000 and her education expenses are $5200. Using the American Opport
5 is the maximum tax credit she is d ue?

12.A- A 1-year savings certificate that pays 15% is purchased for $10,000. If the purchaser pays taxes at the 27% incremental income tax
6 of return on this investment is

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►i•1 •Gioii
UA- A newly hi11ed engineer wants to take ad vantage of the firm's generous 401k plan, where the company wm do a 1:1 match up to 3%
7 The new engine,er is mak ing $60,000 per year. If the engineer is paid twice per month, how m uch is the person putting into the '-
How much is being added each pay period in total?

►i•ll'd 0 R•
12.A- A who]e life policy worth $100,000 can be purchased for $1200 per year,. payable at the begjnning of the year. The insurance compo
B fund insurance, and the remainjng is put into a savings plan that guarantees a 1.9% rate of return. What is the cash value of the pla
there is no penalty for cashing the policy?

►ffi•Gihii

PROBLEMS
Key to icons: D = click to revea] answer; e = Green, which may include environmenta] ethics; CJ = Ethics other than gret
proble ms that are available online in Dashboard; = The icon indicates that a spreadsheet is recommended.

Income Taxes
12.A- iriam Anne is a single taxpayer. What federal taxes does she pay if her taxable income is
1 (a) $5000,
,(b) $20,000,
,(c), $95,000,
(d) $350,000,
(e) $1 m.iUion?
12.A- John Ada.ms has a $95,000 adjusted gross income from Apple Corp. and allowable itemized deductions of $7200. Mary Eve has a 1
2 income and $3000 of allowable item.ized deductions. Compute the total tax they would pay as unma:nied individuals. Then comput1
O couple filing a joint return.
llA- An unmanied taxpayer with no dependents expects an adjusted gross income of $87,000 in a given year. His nonbusiness deducti,
3 $7000,
(a) What wiJJ his federal income tax be?
(b) He .is considering an additionaJ activity expected to increase his adjusted gross income. If this increase should be $15,000 and ti
change in nonbusiness deductions or ex,emptions, what wiU be the inc11ease in his federal income tax?
12.A- Bill Jackson had a total taxable income of $3000. Bi1J 's empfoyer wants hi m w work another month during the summer, but Bill ha,
4 month hiking. If an additional month's work would increase BiU's taxable income by $2000, how much more money would he
O income tax?
12.A- Amara and her husband, Mosi, are both employed. Amara wilJ have an adjusted gross income thjs year of $130,000. Mosi has an ad.
5 $5000 a month. Amara and Mosi have agreed that Mos i shouJd continue working only until. the federal income tax on their jc
O becomes $30,700. On wha t date should osi quit his job?
12.A- A married couple filing jointly have a combined totaJ adj usted gross income of $110,000. They have com puted that their allowabl
6 are $5000. Com pute their federal income tax.
12.- An unmarried in dividual in California with a taxable income of about $75,.000 has a federal incremental. tax rate of 25% and a state
A7 9.3%. What is his combined incrementa.1 tax rate?
,(a) Assume standard deduction taken.
(b) Assume deductions a.re itemized.
12.A- Vemnica Marie has an income that places her in the 24% federal and 6.5% state incremental tax brackets. What is her coml
8 honorarium that she received recently for a speech?
I (a) Assume standard deduction taken.
,(b) Assume deductions are itemized.
llA- Given the follo,'ling data, compute your combined .income tax rate (CTR) assuming you deduct allowable expenses on your incorr
9 tax MARR of 5%, an inflation rate of 3%, a federal income tax rate of 32%, a state income tax rate of 6%, a focaJ city income ta
gains tax rate of 15%, as applicable.
Contributed .by D. P. Loucks, Cornell University
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12.A- A $10,000 commercial bond that has a 6% bond rate and matures in 5 yea:rs can be purchased for $11,000. Interest is paid at the e1
10 next 5 years. Find the annual. after-tax rate of return of this investment. Assume a 35% tax rate appJies.
O Contribmed .by D. P. Loucks, Camell University
12A- Jane Shay operates a management consulting business. The business has been successful and now produces a taxable income of $1QI
11 "ordinary and nec,essa.ry" expenses and depreciation have been deducted. At present the business is operated as a propdetors hip; thal
federaJ income tax on the entire $100,000. For tax purposes, it is as if she had a job that pays her a $100,000 salary per year.
As an aUemative, Jane is considering incorporating the business. If she does, she wrn pay hers.elf a salary of $40,000 a year fron
corporation will then pay taxes on the remaining $60,000 and retain the balance of the money as a corporate asset. Thus Jane's 1
operate the business as a propri,etorship or as a corporation. Jane is single and has $3500 of itemized pe.rsonal deductions. Which aJu
smaller total payment of taxes to the government?
12.A- Gains from non-business-related investment assets held by individuals that increase in value are subject to taxes. What distinguiS:
12 ordin ary rate from those taxes at the capital gains rate?
12.A- Juan DeBaptist purchased $10,000 in co.rporate stock on June 1 and sold the stock when its value reached $13,000 on Octot
1J transaction fees, what federal taxes did Juan pay on this stock investment .i f his taxable income is $90,000? Assume a capital gains t,
12.A- A man"ied couple (filing jointly) bought an antique armoire at an estate saJe, then sold it 6 months later or tv.rice what they paid
14 taxable in come is $80 000 and they paid $750 in taxes on this transaction, how much did they pay for the annoire? Assume capital~
O of 15%.
12.A- An investor bought investment property at the beach for $35,000 per acre. Twenty years later she sold the 100-acre lo t to a develope
15 $1.05 milUon in taxes as a resuJt of the saJe. If capital gains a11e taxed at 15% and her marginal tax bracket is 35%, what was
developer fo r the lot?
12A- You recently bought a mini-supercomputer for $10,000 to allow for tracking and analysis of real-time changes in stock and bond pr
16 on spending half your ti.me tending to the stock market with this computer and the other half as persona.I use. Also assume yo
O computer by 20% per year over 5 years (straight line rate). How much tax savings wi1J you have in each of those 5 years, if any? Usi
Contributed .by D. P. Loucks, ComeJJ Universiry
12A- Calculate the taxable income and federal taxes pajd for each of the following:
17 (a) Single filer; AGI = $65,000; itemized deductions= $2500
•(b) Single filer; AGI = $110,000; itemized deductions= $15,000
(c), Manied filing jointly; A:GI = $150,000· itemized deductions= $8000
(d) Two people are married, but they are filing as two sing]e peop]e; AGI(l ) = $80 000, AGI(2) = $70,000; itemized deductions( l )
deductions(2) = $3000; compare the combined answers here to the answer in part (c); now find the new tax brackets for "marri1
and do the same c-ompaiison.
12A- Professor . Grace has federal taxable income of $90,000 and she falls into the 5.0% state incremental income tax bracket. She rec
18 to consult in her area of technica.1 expertise. What is the after-tax amount on a stipend of $8000 for this work? Her filing status is sh
O itemize deductions, inducting her state income tax.
12.A- A royalty check arrived for $500, boosting the annual income of you and your spouse to $84, 500. You are ma11ied, £lling jointly, wi1
19 of $12,800. Your state taxes income at a marginal rate of 6.5%. How much of your check w:ilJ you be able to spend?
12.A- s. 1ma . Jinere is looking over the federal tax return that her accountant has produced for her review. Consider the analysis beJ


20 the accountant's report, or quantify the effect of any emns. Her filing status is sing]e .

Given Data:
Adjusted gross income $100,000
Itemized deductions:
Med ical expenses 12,000
Property taxes 2,000
Mortgage interest* 7,500
Cha.ritable gifts 3,500
Federal taxes withheld 14,000
•on $400,000 home mortsase debt

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A()cm.mtant Cakulati@ns:
Taxable income = 100, ooo - 12, ooo**
= $88,000
Taxes = 14, 059.50 + .24(88, 000- 82, 500)
= $15, 379.50
Due IRS = 15, 379.50 - 14, 000
= $1379.50
•• standard deduction

12.A- Two married eEigineers filing jointly, and using the standard deduction, do not want to pay more than $80,.000 in federal taxes th
21 income on their regular salaries and investment income is $380,000. What is the maximum tha t they can earn on a new venture and 1

Student Loans
12.A- An independent student has a modified adjusted gross income of $25,000 and qualifying ed ucationaJ expenses of $18,000. If the .


2.2. Tax Credh is used, what is the amount of the tax credit?

12A- Joint filing parents have $30,000 in educatio naJ expens.es as the first of their th.roe children goes off 10 college. Assuming the 1
2.3 adjusted gross income of $80,000,. what effect would each of th e education deductions/credits listed in Table 12A-3 have on the fami
12.A- A single S engineer started a new job at $70,000 and paid $3000 in interest on her student loans las t year. If she uses the fe<
2.4 student loan interest paid, what tax savings does th.is represent?
I
12.A- federal subsidized Stafford student loans historicaUy had interest caJculated at 3.4%, and the government pays the interest whJl.e tt
2.5 Using the hJstorical rates, what are a student's annual payments if she bonuws $2 00 per year in subsidized Stafford loans for 4 y
the loan in 3 yea.rs after graduation?
12.A- Referring to ProbJem 12A-25 above, compare the totaJ amount paid by the student over the term of school and repaying the Joan i


2.6 nonsubsidiz.ed 8% bank loan .

Retirement
12.A- An engineering professor has contributed $300 per month into her 403b tax-deferTed retil'ement account for the past 24 years. She i:
2.7 and wants to know her after-tax account balance (she is contem plating a lump sum distribution) if it has earned 0.5% per month ove1
that she is currently in the 24% marginal tax bracket.
12.A- A newly hired engineer signed up for the 401k plan at her new job. She decided to conuibute the maximum amount allowed (a
2.8 federal Umit is $18,000 of tax-exempted income) and to ta.ke advantage of the match offered by her rnmpany ($1 finn-for-$3 empl i
I of total monthly contribution to her retirement?
12.A- ike just changed jobs, leaving a company after 6 years. He is ful.ly vested, and thus can ke-ep the money his employer depo:
2.9 account His employer has been conuibuting $200 per month into a diversified stock fund .
{a) Using average market rates of 7.3% how much money has accumulated in the account?
,(b) If this money is "rolled over" into another reti~eme11t account with an 8% annual return today, how much will this be worth afte

Insurance
12.A- The required automobil e insurance varies by state. Investigate the laws in your state and identify the minimum required coveragi
30 person and per accident, and property per accident.
12.A- A newJy hked professional bought a us.ed car to get to the new job. Automobile insurance is expensive, so he decided to not get any.
31 drive without insurance, but he figures that he won ' t be fined if he isn't caught. If he is in an accident, he mjght get sued, but he do
G he has nothing to los.e. Comment on the ethks of th.is situation.
12.A- A $500,000 whole life policy is avai.lable for $5150 pe; year, payable at the beginnjng of the yeal'. If 10% of this amount pays for ini
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.LLH.- J-\. -1)::>Uu ,.uuv W UUll'! l l!I:! µ u rn.::y J~ dVdl.ldUH ~ 1.U[ -1)::>.l:>U pe1· yec1i-, [J i:IJiiUll'! i:I L me uegunmi g Ul me yei:IL 11. .lUo/0 U I U lJ~ dll.lU lllll !J<IY~ lUI ' t rn


3.2 into a savin gs pfan, what is the cash value of the policy after 10 years? The in surance company guarantees a rate of 2.4% per year.

12.A- A newly hired employee has a choice 11ega.rding life insuran ce. A $250,000 whole Jife policy is ava.iJable for an annual premium of
3.3 beg,innmg of each year. At the end of 10 years, the policy has a. cash value of $11,600. A term life policy fo r the same am ount is .:
premium of $140, with the premium increasing 1% each year. There js no cash value to the term policy.
(a) Which policy would you choose, and why?
(b) If the whole bfe policy were cashed in after 10 years, what is the rate of return on the savings portion of the w hole life pol.icy?

Personal Budgeting
12.A- Your neighbors have a household after-tax income of $70,000. Their monthly expenses are:
34
O Category IMcmthly expense I Category IMonthly expense I
Category Monthly expense Category Monthly expense
House payment $1500 Groceries $650
Gasoline 200 Utilities 250
Phone/lnternetffV 250 Car payment 450
Ea.ting out 200 Savings 1000
Home maintenance 233 Vacation & entertainment 500
Insurance and taxes 600

(a) What percentage of the family's expenses flt into the Needs category?
(b) What percentage of the family's expenses fit into the Sav.ings category?
(c), What percentage of the family's expenses fit into the Wants category?
(d) They are paying $1050 per year for fire insurance and $3990 per year in taxes on the house as part of their house payment Wh,
mortgage payment?
•(e), If the family pays 15% of their total income in taxes (combined federal a.nd state), wha t is their before-tax income?
12.A- Your neighbors have a household a.fter-tax income of $120,000. Their monthly expenses are:
35
Category Monthly expense Category Monthly expense
House payment $.2100 Groceries $550
Gasoline 200 Utilities 250
Phone/InternetffV 250 Car payment 750
Eating out 800 Savings 900
Home maintenance 333 Vacation & entertafornent 800
Insurance and taxes 800

,(a) What percentage of the family's expenses fit into the Needs category?
(b) What percentage of the family's expenses flt into the Savings category?
(c), What percentage of the family's expenses flt into the Wants category?
(d) They are payfog $1600 per year fo r fire insurance and $1 7,500 in mortgage payments as pa1t of their house payment What is tt
tax that is pajd a.s a part of their house payment?
•(e) If the family pays 18.5% of their total income in taxes (combined federaJ and state), what is their before-tax income?
12.A- Many people graduate fro m college with large student loan debt. What category of a personal budget does this debt fall in? Why?
36
12.A- A couple wants to purc hase a $260,000 house, and they have the required 20% dow11 payment and money fo r other dosing costs.
37 30-year mortgage at 4.625% interest, compounded monthly. The couple has an annual after-tax income of $55,000 and other d,
month. Contributed by Kate Abel, Stevens Institute of Technology
(a) If the maxjmum debt-to-income ratio (total monthly debt divided by after-tax monthly income) is 43%, can the couple afford to
•(b) If the couple Uves in the house for 30 years,. what is the total amount paid for the ho use, incl uding down payment, principal, am

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- - .J - ·- - -- ·- - - -o .c,- -- - - -- - · - ---·- - - - - , ---- -r - --·---- -------·--.J · - --- -- - ·r --· - - - --- - - ----- - - --- ---- --- ---- - - - -.-- - , - - - ---- - --- -- -
month. Contributed by Kate Abel, Stevens Institute of Technology
(a) If the maxjmum debt-to-income ratio (total monthly debt divided by after-tax monthly income) is 43%, can the couple afford to
(b) If the coupJe l.ives in the house for 30 years, what is the total amount paid for the house, ind uding down payment, principaJ, am
12.A- A rnuple wants to purchase a $170,000 house, and they have enough saved fo r a 5% down payment and money for oth er dosi
38 offe1ing a 30-year mortgage at 5.35% in terest, compounded monthly. The couple has an annual after-tax income of $85,.000 and otl
O per month. Because their down payment is less than 20%, they are required to pay for private mmtgage insurance, which costs 1
eadt year. Contributed by Kate Abel, Stevens Institute of Technology
(a) If the maxjmum debt-to-income ratio (tota] monthly debt divided by after-tax monthly income) is 43%, can the couple afford to
(b) I the couple Uves in the house for 30 years, what is the total amount paid for the house, including down payment, principal, in t
mortgage insurance?
12.A- The couple in Problem 12A-37 has only enougb money for a 10% down payment and other dosing costs. Thus the bank is offering
39 of 5.15% and requiring private mo1tgage insurance, which costs 1% of the loan amount each year. Contributed by Kate Ab~
Technology
(a) If the maxjm um debt-to-income ratio (total monthly debt divided by after-tax monthly income) is still 43%, can the couple affo
home?
(b) I the couple Uves in the house for 30 years, what is the total amount paid for the house, incl uding down payment, principal, in t
mortgage insurance?
12.A- Why is how long you expect to Jive in a house important to the choice between buying and renting a home? Contributed by Kate Al
40 Technology
(a) Can you find credible guidelines for how Jong you should expect to own a home to justify buying it? What a.re some of the cent
(b) What are the key factors that wouJd ]engthen or shorten this period?
(c), If a couple will be moving in 3 years, what wiJJ be the key factors in the decision of whether or not to buy now?

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CHAPTER 13
ECONOMIC LIFE AND REPLACEMENT
ANALYSIS

Mike Siegel/The Seattle Times. Copyright 2013, Seatlile Tirnes Company. Used with Pemiission.

Aging Bddges

On May 23, 2013, a 160-foot span of the Skagit River Bridge on I-5 north of Seattle collapsed moments after upper
bridge supports were struck by a tractor-trailer with an oversized load. The truck made it safely across, but two other
vehicles fell into the water 24 feet below. Three people were rescued without major injuries. The bridge was constmcted
in 1955 and designed for an expected life of 50 years.
The Skagit River B1idge fa rated hy the Federal Highway Administration (FHWA) as functionally obsolete- it is not
designed to today's standards, but it is not necessarily unsafe. The steel through-truss bridge has a fracture critical design,
which means that the failure of a single element could cause collapse. There are about 18,000 fracture critical bridges
throughout the United States, buiJt mostly behveen the mid-1950s and late 1970s. Modem construction methods are much
more resiUent to damage.
In 2007 the I-35W bridge carrying traffic over the Mississippi River between lvlinneapolis and St. Paul collapsed
suddenly during msh hour, killing 13 people and inj uring 145. The innesota bridge, completed in 1967, was also a
fracture critical bridge and was classified as srructurally deficiem hy the FHWA. Structural deficiency indicates that the
bridge has one or more defects in its support structure or deck and therefore requires maintenance, repair, and eventual
rehabilitation or replacement.
The nation's 615,000 b1idges have an average age of 43 years, and 8.9% are rated as structurally deficient. The FHWA
calculates that almost 40% of U.S. hridges exceed their 50-year design life. The required fiscal investment for
reconstmction and renovation poses a significant challenge for federal, state, and local governments-but some progress
is being made. ■ ■ ■
Contributed by Letitia M. Pohl, University of Arkansas

QUESTIONS T O C ONSIDER
1. Decisfons on how to allocace funding to upgrade and replace deficient bridges are influenced by both economic
and non-economic factors. List three of each.
2. The Skagit River Btidge ca1Ties an estimated 71,000 vehicles a day and is a main commercial route hetween the
United States and Canada. How would you calculate the economic impact of the catastrophic failure of the
b1idge? Compare the economic impact to commuters versus commercial traffic.
.,.. ~ ~ ~ ~

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'-" .. ;a.

What factors should be considered when engineers determine whether to either rehabilitate or replace a deficient
3 • b1idge?
4. The Federal Highway Administration released $1 million in federal emergency funding to the state of
Washington the day after the 1-5 bridge collapse and almost a month later allocated $ 15.6 million in federal
funding to help rebuild the bridge. Discuss the ethical dilemma of state and local governments that have aging
infrastructure to repair before tragedy strikes, but insufficient funding to make the repairs.
5. Both of the bridges described here were routinely inspected and deemed safe for use. Discuss how this inabiHty
to predict structural failures complicates the job of transpmtation officials.

After Completing This Chapter ...


The student should be a.ble to:
• Understand why economic life may be shorter than an asset's useful Hfe.
• Calculate the economic or minimum cost life of alternatives .
• Calculate and use marginal cost daw for an existing asset to dedde when to replace.
• Pedorm economic life and replacement analysis on an after-tax basis.

Key Words

cash flow approach


economic life
deterioration
marginal costs
minimum cost life
obsoleseence
opportunity first cost
rep1acement analysis

Examples and problems in previous chapters have assumed thar an asser's life is known. However, just because an asset
could be used for 10, 20, or 50 year~oes not mean it should be . What asset life minimizes the asset's cost of ownership
(EUAC)? Similarly, how soon should an existing asset be replaced?
Firms, agencies, and individuals aU face economic decisions with very long and indefinite horizons. For example,
firms buy robots, school and transit systems buy buses, individuals buy vehicles, and all buy computers. In each case, the
assets have lives shorter than the needs they fill. An asset's economic life minimizes the EUAC of ownership, and thus is
at the optima] replacement interval.
Dete1mining an item's economic life requires choosing between differem length lives and thus using the annua]
economic measures presented in Chapter 6. Often only costs are considered, but differences in benefits can be as well.
Near the end of an asset's life, there is another economic question: how soon will the replacemem happen? This
comparison of an aging asset with a new replacement is :replacement analysis.

ECONOMIC LIFE OF A NEW ASSET

Drivers Behind the Economic Life


Why is there an economic life that minimizes the EUAC? If assets are kept for only a few years, then the EUAC is high
because capital costs are spread over only a few years. If assets are kept for too long, then the EUAC is high because
maintenance and operating costs become large. The economic life strikes a balance that minimizes the total EUAC.
The costs to maimain and operate an asset include the costs of planned maintenance and unplanned repair or
replacement. Compare the low cost of replacing a wom tire in a scheduled appointment when the tires are on sale, versus
replacing the tire when it fails on the way to work or on a weekend trip to the moumains. Failures requiring unplanned

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repairs can shut down assembly lines, pipelines, and other processes until a key part or subassembly atTives. Failures can
be catastrophic for airplanes and nudear power plants. In some contexts a 10% chance of an unplanned repair or
replacement may be just fine; in others, a one-in-a-thousand chance may be too high.
Example 13- 1 shows that to calculate the minimum cost life of an asset, we dete1mine the EUAC for each possible life
less than or equal to the useful life. Example 13- 1 and Figure 13- 1 show that the EUAC tends to be high if the asset is
kept on]y a few years; then it decreases to some minimum va]ue, and then increases again as the asset ages. By identifying
the number of years at which the EUAC is a min1mum and then keeping the asset for that number of years, we are
minimizing the yearly cost of ownership. H is cheaper to buy another asset with the same or better costs than to continue
use of this one.
Example 13- 2 shows that even with complicated cost structures, it is still relative]y easy to find the minimum cost
EUAC with the power of spreadsheets. Example 13-3 also illustrates the assumptions common in analysis of economic
lives.
• Salvage values decline over time.
• Annual costs for operations, maintenance, risk of breakdowns, and so on increase over time.

EXAMPLE 13-1
A machine costs $6800 to buy, $700 to instaU, and has no salvage value. Maintenance costs are expected to be $0 the
first year, but will increase by $900 every year after that. Operating costs are expected to be $1200 every year. If the
machine will last 10 years and the interest rate is 8%, compute the machine's economic life that minimjzes the EUAC.

SOLUTION
In earlier chapters, when we were given a life of 10 years we would have calculated the EUAC of ownership over 10
years.

EUAC10 = 7500(A / P, 8%. 10) + 900(AJG 8%, 10 + 1200 =


= 7500(0.1490 , + 900(3.871) 1200 = 5801

Now, this cakuJation is needed for every year.

If Retirnd at the End of Year n

Year, t EUAC of Capita) EUAC of Maintenance EUAC of

Recovery Costs: and Repa ir Costs: Opera ting Costs: EUAC

$7500(A/P, 8%, t) $900(A/G, 8%, t) $1200 Total

1 $8100 $0 $1200 $9300


2 4206 433 1200 5838
3 2910 854 1200 4964
4 2264 1264 1200 4723 ....

5 1878 1661 1200 4739


6 1622 2048 1200 4870
7 1440 2425 1200 5065
8 1305 2789 1200 5294
9 1200 3142 1200 5542
10 1117 3484 1200 5801

The total EUAC data are planed In Figure 13- 1. From either the table or the figure, we see that the machinery's
minimum cost life is at 4 years, with a minimum EUAC of $4728 for each of those 4 years.

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$ lOJlOO

$'9;000

$8,000
$7;000

$6,000
Total AC
8" $5;000

$4,000
E AC of faintc-mmce
$3;000
$2;000

$1 ,000
E:UAC of Op,c.rnling
-
.. -,.••••~.,,••r •,.~"•ur,~'t•••rt"T"T't•-..,.,••rrr.~•'tn"~ .. •••...-..... •••rr.,.••••r"'T"l•••r-"•r•r••"

$0
0 2 4 6 8 10
Yc-,ar
FIGURE 13-1 Plot of costs for Example 13-1.

Looking at Figure 13-1 more closely, we see the effects of each of the individual cost components on total EUAC
(capital recovery, maintenance/repair, and operating expense EUACs) and how they behave over time. The total EUAC
curve of most assets tends to follow this concave "bathtub" shape-high for short lives due to capital recovery costs and
high for long lives due to increased maintenance/repair and operating expenses. The minimum EUAC occurs somewhere
between these high points.

Spreadsheets for Economic Life


The amount of arithmetic in computing the economic Hfe is best done with spreadsheets. The formulas are easier to build
if cash flows are separated into two groups.
• The first group includes all costs to own, operate, maintain, and repair an asset. Equatio ns 13-1 and 13-1 ' find the
present worth of these costs, PWcostt> of cash flows through year t for this group.

PWco t1 = CFo + L= 1
1 0 cost,I(l +i -
(13-1)

PWco tr = CFo + V(i, CF1 : CFr (13-1 ')


When writing Eq. ]3-1' as a spreadsheet fotmula. the cell for CF 1 should be specified with an absolute address, but
the cell for CF1 with a relative address that can change when the fommla is copied. This ensures that the range is
from year 1 to year t.
• The second group includes all cash flows linked to asset disposal. These occur in year t only if that is the year of
disposal. Equation 13-2 for St is a more precisely defined salvage value for year t.

S1 = selling pdce1 - removal costs - elling cost (13-2)


• Then Equation 13-3 or 13-3' is used to calculate the EUAC for a life oft years from a time 0 value of PWcostt and
a final value of S.
EUAC1 = PWcost1(A/ P, i t · - S,(A/ F, i t ) (13-3)
EUAC1 = - PMT(n, i, PWcost,, - Sr) (13-3')

EXAMPLE 13-2 Example 13-1 Revisited


Use the data from Example 13-1 and spreadsheets to model and solve for the minimum EUAC.

SOLUTION
The spreadsheet is a little bit simpler if the operating and maimenance costs (O&M) are combined into a single cash
fl ow <::Prii:u;: th;it <:t ::Ht'- ~t tQflfl thP fir,_t VPHr .:inrl in rrPH<::P<: h v tl~flfl nPr VPHr ThP o;:;i]v;iCJ.p v.:i h1 P rnl11mn i'- n for PVPr v
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tlow series that sta1ts at $~UU the tirst year amt increases t:ly $13UU per year. The salvage value column is O tor every
year.

A B C D E
I S7500 first 0051
2 0 salva._.l!,e value
3 SI 200 O&M
4 $900 O& M JJ;radj ent
5 lO life (years)
6 8% interest rate
7 1=SB$9+NPV(SA56,$B$ I0:B10)
8 year costr \ PWcosi. s, EUAC,
9 0 $7,500 \
10 I 1200 $8 611
I 0 19300
II 2 2,100 10,4 12 0 5. 838
12 3 3,000 12,793 0 4.694
13 4 3,900 15 660 0 4728
14 5 4800 18926 0 4 740
15 6 5,700 22,518 0 4. 8'7 1
16 7 6,600 26369 0 5.065
17 8 7,500 30.421 0 5.2(}4
18 9 8.400 34.624 0 5.543
19 lO I/ 9,300 ..- 38,931 0 ~ ... 5.802
20 / / ~ i----
21 / / - PMT($AS6,A I9.C l9.-D19)
22 / ;ses9+NPV($A$6.SB$ 1'0: B19)
23 ' =Bl8+SAS4
FIGURE 13-2 Spreadsheet for Example 13-1 and 13-2.

The EUAC values for each year match those in Example 13-1, and the economic life is still 4 years with a
minimum EUAC of $4728.

Including Salvage Values and Overhauls


Like many pieces of installed equipment, the machine in Examp]es 13-1 and 13-2 had no salvage value. To match the
specific requirements of unique processes and configurations, most industrial assets are purchased new. Unfortunately,
once instaUed the salvage value of most is near zero.
For example, a manufactming facility was once buUt to suppmt a new line of snack foods, with multiple
manufacturing lines to support the expected sales volume. Each line had equipment costing wen over $1 million.
However, the product did not sell as well as expected, and the decision was made to shut down ail but one production line
after only two years. AU unneeded equipment was sold as scrap metal-at ten cents per pound!
There are used assets, like a car, that can easily be sold for a value that depends on age and condition. evettheless,
even if the asset is easy to seU, there are still costs, and valuable time must be spent. These reduce the net salvage value of
disposing of the asset. As noted in Equation 13- 2, there may also be removal costs as well as seUing costs. The costs to
acquire and install an asset and the costs to remove and sell it increase an asset's capital cost, which may increase the
minimum cost Hfe.
Example 13- 3 has a declining selling price, which equals its salvage value, so only one column in the spreadsheet is
required. If there were removal and selling costs, then multiple columns would be used as they are for the O&M and
overhaul costs in Example 13-3.
Overhaul expenses may be required at the start of year r, so that use can continue in year t and beyond. Multiplying the
overhaul expenses by (1 + i) as in Equation 13-4 converts the overhaul expenses to an end-of-year value. Thus, the
overhaul expenses will only be incurred for service lives of r or longer.
Overhaul r = Overhaul1,eginnlng 1 1 1) (13-4)

EXAMPLE 13-3
A machine costs $18,000 to buy and install. Its operating and maintenance (O&M) costs start at $900 per year and then
climb $SOO per year. Its selling price if sold used is $5000 at the end of year 1 and then it declines 10% per year. If the
machine is to be used more than 5 vears. an overhaul mstina 3000 is needed at the end of vear 5. The machine's
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macmne IS m oe usea more man :::> years, an overnam coscrng ;)jUUU IS neeaea ac me ena or year ::,, 1 ne macnme·s
useful life is 10 years and interest is 8%. Use a spreadsheet to compute the machinery's economic life that minimizes
the EUAC.

SOLUTION
To ensure the cost calcufations are correct, the O&M costs are in column B, the overhaul cost using Equation 13-4 is in
column C, and column Dis the total of each year's costs.

A B C D I E F C
I Sl8.000 first cost
2 $5000 salvage value
3 - 10% salvage gradient
4 5900 O&M
5 ssoo O&M gradient
6 $3,000 overhaul end of y,ear 5
7 JO life (years)
8 8% interest rate
9 =$D$ l l+NPV(SASS,$D$12:D12)
10 year O&M overhaul OO!>li PWoos:t1 S1 EUAC,
II 0 S.1 8;000
12 I 5900 900 $1S,S33 $5000 $ 15.340
13 2 1,400 1.400 2-0.034 4500 9,071
14 3 1,900 1,900 21,.542 4050 7,111
15 4 2,400 2,400 23,306 3645 6.22S
16 5 2.900 2,900 25,280 3281 5.772
17 6 3.400 $3 ,240 6.640 29,464 2952 5.971
18 7 3,900 3.900 31 ,740 2657 5,799
19 8 4,400 4,400 34,117 2391 5,712
20 9 4.900 4,900 36568 2152 5,681
21 10 .,,, 5.400 :,, 5.400 39.069 ]937 5.689
22
23
24 /
/
/
/
/

';_sD$1l +N ~V($A$8,$[ 12:D2 I)


-----
-=:?Mrf(SA$S.A2 .E2L-F2 1)

25 =B20+$A! 5
FIGURE 13-3 Spreadsheet for Example 13-3.

A 5-year life has a lower cost than a 6- or 7-year life, but the lowest cost or economic life Is 9 years. Even though
the overhaul cost means that plotted curves would not be as smooth. as Figure 13--1, it is still possible to calculate the
minimum EUAC of $5681 at the asset's 9-year economic life.

Econmnic Life, Unplanned Repairs, and the Opporrunity Cost of New Alternatives
In both Example 13- 1 and 13- 3, lives close to the economic life had EUACs that were dose to the minimum cost. This is
common, but not guaranteed. The bathtub curve of EUACs like Figure 13-1 tends to be flat near the minimum cost life-
like a bathtub. This is adequate accuracy for current decision making.
Examples 13-1 and 13-3 were about unspecified machinery, but economic life problems are all around us. How long
should you keep your car? Your computer? In both cases, the probability of an unplanned repair or the capabilities of
newer cars and computers may be the critical quantity to be estimated. How could these be included?
In Example 13--3, the O&M costs climbed $500 per year. Suppose this machinery was critical to an assembly line and
an unplanned repair would cost $50,000 while the line was shut down. Then a 1% increase each year in the probability of
an unplanned repair wou]d have a $500 per year gradient.
Suppose for each year that passes, a newer car or computer has features worth $400 per year to you. Thus, using a 2-
year old asset is costing you $800 in the opportunity cost of forgone benefits. This can be included just like increasing
O&M costs.
While operating and maintenance costs may or may not have large gradients, we all know that aging vehicles and
computers are more prone to failure . We know that newer versions have newer or improved features that have value to :us.
Economic life guides the choice of how long to use an asset that may have a longer physical life.

DVDT I\ r'TI'ft.ll"'E'l\.T'T' I\ 1'.T I\ T V~ T ~


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REPLACEMENT ANALYSIS
Up to this point in our economic analysis we have considered the evaluation and selection of new alternatives. Which new
car or production machine should we buy? What js the economic life of the planned matetial handling system or vehicle?
However, economic analysis often weighs existing versus new facilities. The key choice is not which new way to perform
the desired task. Instead, we have equipment pelforming the task. and the question is: Should the existing equipment be
retained or replaced?
This question may arise because the asset is approaching the end of its economic life. In other cases, earlier
replacement may be considered because needs have changed or better alternatives have become available. In aH cases, the
answer depends on an economk analysis based on current information. This is the domain of replacement analysis.

The Replacement Problem


Replacement analysis considers the same factors that were part of finding the economic life that minimizes the EUAC-
obsolescence and deterioration due to aging.
Obsolescence: occurs when an asset's technology is surpassed by newer and/or different technologies.
Deterioration due to aging: costs for maintenance often increase as production machinery and other business
assets age. Aging equipment often has a greater risk of breakdowns. Planned replacements can be scheduled to
minimize the time and cost of dfamptions. Unplanned replacements can be very costly or even, as with an airplane
engine, potentially catastrophic.
There are variations of the replacement problem: An existing asset may be abandoned or retired, augmented by a new
asset but kept in service, or overhauled to reduce its operating and maintenance costs. These variations are most easily
considered as potential new alternatives-just as you might consider buying a used car as a "new" way to meet your
needs.
Replacement problems are normally analyzed by looking only at the costs of the existing and replacemem assets. Since
the assets typically pedorm the same function, the value of using the vehicle, machine, or other equipment can be
ignored. If the new asset has new features or better performance, these can be included as a cost savings for the new asset
or as an opportunity cost for the existing asset.
Alternatives in a replacement problem almost always have different lives. This is because an existing asset will often
be kept for at most a few years longer, while the potential replacements may have lives of any length. Because the
alternatives have differing lives, economic comparisons use annual values----annual marginal costs and EUACs. We can
calculate present wm1h of costs, but only as a step in calculating EUAC values.
Because there is an exfating asset, replacement analysis must often deal wUh sunk costs and management attitudes.
Examples include:
• This machine cost $12,000. We cannot replace it until we have gotten our money's wmth out of it.
• If it isn't broken, don't fix it. What we have now is good enough.
• We wouM rather deal with the problem we know (current aging machine) than a solution we do not understand
(new technology).
Even i.f no recommendation to replace now is made, such a recommendation may be made in a year or more. At some
point, existing equipment wiU be replaced, either when it is no fonger necessary or when better equipment is available.
Thus, the question is not if the existing asset will be replaced, but when it will be replaced. If we do decide to keep the
asset for another year, we will often reanalyze the problem next year. The operating environment and costs may change,
or new alternatives with lower costs or better performance may emerge.

Replacement Analysis C01nn1on Scenario


The most common replacement scenario for firms is one in which an existing implemented asset is aging and nearing the
end of its economic life. lls past purchase, installation, repair, and maintenance costs are all sunk costs. Its realizable
salvage value is a selling price minus removal and sales costs. This value is usual.ly only a smaJI fraction of its initial cost.
Costs for repair and maintenance are rising, as are the risks of equipment breakdowns, which can cause unscheduled
production shutdowns (and are often the largest cost). The asset may be obsolete (or becoming so).
This type of aging asset is evaluated by asking, what is the cost of using this asset for one more year? For a second
year? For a third year? How soon does a new alternative have a lower cost? In replacement analysis, such questions are
evaluated formally, with the following rule applied for decision-making purposes:
Keep the existing osset in place for the present year if and until the marginal cost of one mo,~ yeor of ownership exceeds the minimum
EUAC of o new asset ovai/a.ble ot thm time.
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The replacement rule for comparing an existing old asset with a potential new one foUows this process:
1. Calculate the marginal cost (MC) of keeping the existing old asset one more year (this year) .
2. Calculate the minimum EUAC of the best available new asset.
3. Decision ru]e:

lfMCo1d > EUACnew• replace now·


otherwis.e, keep the old asset one more year and re-evaluate next year.

Examples 13-1 to 13- 3 illustrate the common case where costs of a current old asset are 1ising each year. These
Increasing annual costs (marginal costs) are detaiJed in Examples 13---4 to 13-6. Lastly, In Example 13- 7 the replacement
rule is used to compare currently implemented old and new alternatives.

MARGINAL COSTS
Marginal costs, as opposed to an EUAC, are the year-by-year costs of keeping an asset. Therefore, the "period" of any
yearly marginal cost of ownership is always 1 year.. In our analysis, marginal cost is compared with EUAC, which is an
end-of-year cash flow. Therefore, the marginal cost is also calculated as end-of-year cash flow. The marginal cost of
ownership for any year in an asset's Ufe is the cost for that year only. Example 13-4 illustrates tota] marginal costs for al1
years of an asset.
Choosing to keep an asset for a given year ensures that the marginal cost for that year is incmred. At the beginning of
the year, the net salvage value from the previous year is "invested" by keeping the asset. Then, at the end of the year, the
new net salvage value is available. Other costs for that year are assumed to be end-of-year cash flows. This is formalized
in Equation 13-5 or the equivalent Equation 13-6.

MC, = Net SVr_ 10 + 1) - Net SV 1 + Cost, (13-5)


NetSVr

T~ ' ,_,_ l =

et SV1_ 1 Costr MCi


Examples 13-4 and 13-5 illustrate calculating marginal costs over a new asset's life using Equation 13-6. This
calculates capital costs as a loss in net salvage value plus interest on the capital tied up for the year.
MC, = (Net SV,_ , - Net SV1 + Net SV1_ 1(i ·+ Co t1 (13-6)

EXAMPLE 13-4
A new piece of production machinery has the following costs.

lnve tment co t = $25 000


Annual operating and maintenance co t = $2000 in Year l and then inc1°easing by
$500 p r year
Annual cost for risk of breakdown = $5000 per year for 3 years, then
increasing by 1500 per year
Useful life = 7 year
MARR = 15q;;
Calculate the marginal cost of keeping this asset over its useful life.

SOLUTION
From the problem data we can easilv find the mar~Jnal costs for O&M and risk of breakdowns. However. to calculate
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rrum u1e prume1u Ud la we t.:all ea:suy llllU Ute ruc1rg111dl CU:Sts IUC UO[lYl dllU n :sK Ul uredKUUWU:S. nuwever, lU t.:dlt.:llld lt'
the marginal capital recovei:y cost. we need estimates of each year's market or salvage value.
Year Salvage Value
1 $18,000
2 13,000
3 9,000
4 6,000
5 4,000
6 3,000
7 2,500

We can now calculate the machinery's margi.nal cost (year-to-year cost of ownership) over its 7-year useful life.

Year, Loss io Salvage Value in O&MCost Cost «if Breakdown Riskin Total Marginal C«ist io
Interest in Year t
t Yeart in Year t Yeart Ye-art

1
$25, 000 - 18, 000 = $25, 000(0.15} =
$2000 $5,000 $17,750
$7000 $3750

2 18, 000-13, 000 =5000 18, 000(0. 15) = 2500 5,000 1.5,200
2700

13, 000(0.15) =
3 13, 000 - 9, 000 =4000 1950
3000 5000 13,950

4 9, 000 - 6, 000 =3000


9, 000(0.15) = 3500 6,500 14,350
1350
5 6, 000 - 4, 000 = 2000 6, 000(0.15) =900 4000 8,000 1.4,900

6 4, 000 - 3, 000 = 1000 4, 000(0.15) =600 4500 9,500 1.5,600


7 3, 000 - 2, 500 =500 3, 000(0.15) =450 5000 11,000 1.6,950

Notice that each year's total marginal cost includes loss in market va]ue, interest, O&M cost. and cost for risk of
breakdowns. For example, the Year-5 marginal cost of $14,900 is calculated as :woo+ 900 + 4000 + 8000.

In each year the marginal cost is the cost to keep the asset for one more year. The pattern in Example 13-4 is typical. In
early years the marginal costs are decreasing because the capital costs are being spread over more years. In later years the
marginal costs are increasing because yearly costs are increasing. As the asset ages it will be replaced when its marginal
cost exceeds the EUAC of the best new alternative.
Example 13-5 shows how EUAC's can be calc ulated from rhe marginal cost data in Example 13-4.

EXAMPLE 13-5 Example 3-4 Revisited


Taking the machinery in Example 13-4 as a new asset, calculate the EUACt for each year from the marginal costs.

SOLUTION
The EUAC of keeping this asset for each year of its useful life is worked out as follows .

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Year, New Asset Total Marginal Cost in Present Cost if Kept Through Year t E AC if Kept Through Year
t Year t (PWrnstr) t

1 $17,750 [17, 750(P/F, 15%, 1)] x =$17,750


(NP, 1 %,. 1)

2 15,200 PC 1 + 15, 200(P/F, 15%, 2) x (NP, 15%, 2) =16,560

3 13,950 PC2 + 1.3, 950(P/F, 15%, 3) x (NP, 15% 3) =15,810


4 14,350 PC3 + 14, 350(P/F, 15%, 4) x (NP, 15%,. 4) =15,520
5 14,900 PC4 + 14, 900(P/F, 15%, 5) x (NP, 15%, 5) = 15,430 -
6 15,600 PCs 15, 600(P/F, 15%, 6) x (NP, 15%,. 6) =15,450
7 16,950 PC6 16, 950(P/F, 15%, 7) x (NP, 15%,. 7) =15,580

A minimum EUAC of $15,430 is attained for the new asset at Year 5, which is the asset's economic or minimum
cost life. As long as the marginal cost for another year is less than the EUAC, the EUAC continues to decline. When
the marginal cost in year 6 exceeds the EUAC, then the EUAC begins to increase.

We can see that marginal costs increase in each subsequent year of ownership. As before the asset is replaced when its
marginal cost exceeds the minimum EUAC of the best new alternative.
Unfortunately, the $13,250 marginal cost of keeping the 5-year old asset for one more year cannot be repeated. Even if
used assets were available the costs to find one, install it, and remove It 1 year later would far exceed the $1000 loss in
value for the existing asset.

EXAMPLE 13-6
An asset purchased 5 years ago for $75,000 can be sold today for $15,000. Operating expenses will be $10,000 this
year, but these will increase by $1500 per year. It is estimated that the asset's salvage value wil1 decrease by $1000 per
year over the next 5 years. If the MARR used by the company is 15%, calculate the total marginal cost of ownership of
this old asset (that is, the cmTe.ntly implemented asset) for each of the next 5 years.

SOLUTION
We calculate the total marginal cost of maintaining the oJd asset for the next 5-year period as foU ows:

Year, t Loss in Salvage Value in Year t Interest i:n Year t Operati:ng Cost in Year t Margina] Cost in Year t

1 $15, 000 - 14, 000 =$1000 $15, 000(0.15) =$2250 $10,000 $13,250

2 14, 000 - 13,. 000 =1000 14, 000(0. 15)=2100 11,500 14,600

3 13, 000 - 12, 000 =1000 13, 000(0.lS) =1950 13,000 15,950

4 12, 000 - 11, 000 = 1000 12, 000(0.15) = 1800 14,500 17,300
5 n , ooo - 10, ooo =1000 11, 000(0.15) =1650 16,000 18,650

EXAMPLE 13-7
The machine in Example 13-6 is the existing asset, and the machine in Examples 13-4 and 13-5 is a new alternative.
When should the existing asset be replaced.
COT IT'T'T £\ 1\J

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SOLUTION

The new asset has a minimum EU AC of $15,430 for its economic life of 5 years. vVhen that is less than the marginal
cost of the existing machine, it is time for the replacement.

Year, Exi,sting Asset Total Margi:nal Example 13-4 Alternativ e


Comparisen Result and Recommendation
t Cost in Year t Minimum EUAC

1 $13,250 $15,430 Since $13,250 is less titan $15,430, keep existing ass.et.

2 14,600 15,430 Since $14,600 is less than $15,430, keep existing ass.et.

Since $15,950 is greater than $15,430, replace with


3 15,950 15,430
alternative of Example 11.3--4.

4 17,300

5 18,650

COMPLICATIONS IN REPLACEMENT ANALYSIS

Other Scenarios for Replacen1ent Analysis


Sometimes an existing asset is evaluated for early replacement. Perhaps estimating and analysis errors were made when it
was purchased and have been discovered. Requirements may have changed, or hetter alternatives may have now become
available. In such cases., the existing alternative's ne\'!I economic life and new minimum EUAC are calculated. From this,
a comparison to available alternatives may be made. Does a new alternative have a lower minimum EUAC?
Another scenati o is when the existing asset will be replaced now or left in place until the next major plant overhaul.
The EUAC for each choice must be calculated and compared with that of newer alternatives over the same Uves. This can
also apply for the duration of a multi-year construction project.

Defining First Costs for Existing and Replacen1ent Assets


Because the existing ass et is already in service, analysts often misunderstand what first cost to assign it Example 13-8
demonstrates this prohlem.

EXAMPLE 13-8
A model SK-30 was purchased 2 years ago for $1600; it has been depreciated hy straight-line depreciation using a 4-
year life and zero salvage value. Because of recent innovations, the cun-ent price of the SK-30 is $995. An equipment
firm has offered a trade-in allowance of $350 for the SK-30 on a new $1200 model EL-40. Some discussion revealed
that without a trade-in, the EL-40 can he purchased for $1050. Thus, the otiginally quoted price of the EL-40 was
overstated to allow a larger trade-in allowance. The true current market value of the SK-30 is prohahly only $200. In a
replacement analysis, what value should be assigned to the SK-30?

SOLUTION
In the example, five different dollar amounts relating to the SK-30 have been outlined:
1. Original cost: It cost $1600 2 years ago.
2. Presenr cost: It now sells for $995.
3. Book value: The original cost less 2 years of depreciation is 1600 - 2/4(1600 - 0) = $800.
4. Trade-in value: The offer was $350.
5. Market value: The estimate was $200.
We know that an economic analysis is hased on the cmTent situation, not on the past. We refer to past costs as sunk
costs to emphasize this. These costs cannot be altered, and they are not relevant. (There is one exception: past costs
mav affect oresent or future income taxes.)
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may arrecc presem or mm.re mcome caxes.J

We want to use actual cash flows for each alternative. Here the question is, What value should be used in an
economic analysis for the SK-30? The relevant cost is the equipment's present market value of $200. either the
original cost. the present cost, the book value, nor the trade-in value is relevant.

Example 13-8 illustrated that of the several different values that can be assigned to the existing asset, the cmrect one is
the present market value less any costs to remove and to sell the asset.
Determining the first cost of a new alternative usually includes the purchase price, sales tax, installation costs, and
other items that occur initially on a one-time basis . These values are usually rather straightforvvard to obtain. One must
nm arb itratily subtract the existing asset's salvage value from the new alternative's first cost. This cash flow approach,
can lead to an incorrect analysis.
As desc1ibed in Example 13-8, the cotTect first cost to assign to the existing SK-30 is its $200 current market value.
This is the present economic benefit that we would be forgoing if we keep the SK-30. This can he called our opportunity
first cost. If we assume it is a cash benefit to the new asset, a potential error arises.
The e1rnr is using the cash flow perspective when the lives of the new and existing assets are not equal, which is
usually the case.
The opportunity cost perspective wil1 always lead to the cmTect answer, so his the one that should be used.
For example, consider the SK-30 and EL-40 from Example 13-8. It Is reasonable to assume that the 2-year-old SK-30
has 3 years of life left and that the new EL-40 would have a 5-year life. Assume that neither will have any salvage value
at the end of its life. Compare the •difference in their annual capital costs with the correct opp01iunity cost perspective and
the incorrect cash flow perspective.

SK-30 EL-40
Market value $200 First cos.t $1050
Remainjng life 3 years Useful life 5 years.

Looking at thJs from an opportunity cost perspective, the annual cost comparison of the first costs is

Annualized first cos.tsK-30 = 200(AJP 10%. 3) = 80


Anm.talized first costa40 = 1050 AJP, 10% 5 = $277
The difference in annualized first cost between the SK-30 and EL-40 is

AFCEI.AO - AFC K -30 = $277 - 80 = $197

Now using an incorrect cash flow perspective to look at the first costs, we can calculate the difference due to first cost
between the SK-30 and EL-40 .

Annllalized first costsK-30 = $0(AJP, 10 3) = 0


Annualized first costa -40 = ($1050 - 200) JP, 10%, 5 · = $224
AFC EIAo - AFCsK-30 = $224 - $0 = $224

When the existing asset's remaining life (3 years) differs from the new asset's useful life (5 years), the two perspectives
yield .different results . The conect difference of $197 is shown by using the opportunity cost approach.

A Closer Look at Future Alternatives


Over time, the best available altemative can indeed change. And given the trend in our techn ological society, it seems
likely that future alternatives wiU be better than the present ones. If so., the prospect of Improved future altematives may
affect the present decision between the existing asset and the best alternative today.
Figure 13-4 illustrates two possible estimates of future alternatives. In many technological areas it seems likely that
the equivalent uniform annual costs associated with future alternatives will decrease by a constant amount each year. In
other fields, however, a rapidly changing techn ology wiU produce a sudden and substantially improved altemative-with
decreased costs or increased benefits. The uniform decline curve of Figure 13-4 reflects the assumption that each future
.... 1.-............ ...... : ... . ..... 1.. ....... " ....,.. .: .... ~--- •--- T:, T TI\,-, +1-.. .... .- .:. ........ .t: ......... .-1 ... ~ ....... . .... ♦ 1 ........... •I.. ... ..... • h ..................... ... : ,.., ,, ... ... ......... ._,,.. .... I+-.......... ... +-: . ...... Tl..: ................................: .... .... .....t

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alternative has a minimum EUAC that is a fixed amount less than the previous year's alternative. This assumption. of
course, is on]y one of many possible assumptions that cou]d be made regarding future alternatives.
If future alternatives wiH be better what impact will this have on an analysis now? The prospect of better future
alternatives may make it more desirable to delay rep lacement.
As engineering economic analysts, we must famibaiize ourselves with potential technological advances in assets
targeted for replacement This palt of the decision process is much like the search for all available alternatives, from
which we select the best. Upon finding out more about what alternatives and technologies are emerging, we will be better
able to understand the repercussions of investing in the current best available alternative. Selecting the cmTent best
alternative can be particularly risky when (1) the costs are very high and/or (2) the useful minimum cost life is relatively
long (5-10 years or more). When one or both of these conditions exist, it may be better to keep or even augment the
existing asset until better future alternatives emerge.

Present ,
Altemat.ive

0 3 4
Yea.-
FIGURE lJ..-4 Two possible ways the EUAC of future altematives may dedine.

AFTER-TAX REPLACEMENT ANALYSIS


As described in Chapter 12, an after-tax analysis provides greater realism and insight. Tax effects can alter before-tax
recommendations. Consequently, one should always perform or check these analyses on an after-tax basis.

Econmnic or Minimu1n Cost Life Problems


Here we illustrate the effect of taxes on the calculation of the minimum mst life of the existing and new assets. The after~
tax minimum EUAC depends on both the depredation method used and changes in the asset's market value over time .
Using an accelerated depreciation method (like MACRS) tends to reduce the after-tax costs early in the asset's life. This
alters the shape of the total EUAC curve-the concave shape can be shifted and the minimum EUAC changed. Example
13-9 illustrates the effect that taxes can have.

EXAMPLE 13-9
Some new production machinery has a first cost of $100,000 and a usefu] life of 10 years. Its estimated operating and
maintenance (O&M) costs are $10,000 the first year, which will increase annually by $4000. The asset's before-tax
market value wiJI be $50,000 at the end of the first year and then will decrease by $5000 annually. This prope1ty is a 7-
year MACRS propetty. The company uses a 6% after-tax ARR and is subject to a combined federal/state tax rate of
28%.
Calcu]ate the after-tax cash flows.

SOLUTION
To find this new production machinery's minimum cost life, we first find the after-tax cash flow (ATCF) effect of the
O&M costs and depreciation {Table 13- 1). Then, we find the ATCFs of disposal if the equipment is sold in each of the
10 years (Table ]3-2). Finally in the dosing seaion on spreadsheets, we combine these two ATCFs (in Figure 13-5)
and choose the minimum cost life.
In Table 13- 1, the O&M expense starts at $10,000 and increases at $4000 per year. The depreciation entries equal
thP 7-vPr1r r . M ACR S rlPnrPr i;itinn vr1l 11 p,;; oivPn in Tr1hlP 1 1-J m 11 ltinliPrl hv t hP 'l:. 100 000 fir,;;t roo;;t ThP t;:i y;:ihlP
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U1e 7-year rt MAC.H..S depreciation values given in Table 11- 2 mumplied by the $ 1UU,UUU tJrst cost. ·_111e taxable

income, which is simply the O&M costs minus the depreciation values., is then multiplied by minus the tax rate to
determine the tax savings. The O&M expense plus the tax savings is the Table 13- 1 portion of the total ATCF.
Regarding the market value data in this problem, it should be pointed out that the initial decrease of $50,000 in Year
1 is not uncommon. This is especially tme for custom-built equipment for a particular and unique application at a
specific plant. Such equipment would not be valuable to others in the marketplace . Also, the $100,000 first cost (cost
basis) could have induded costs due lO installation, facility modifications, or removal of old equipment. The $50,000
may be optimistic for the market value of one-year-old equipment.
The next step is to dete1m ine the ATCFs that would occur in each possible year of disposal. (The ATCF for Year O is
easy; it is - $100, 000 .) For example, as shown in TaMe 13- 2, in Year 1 there is a $35,710 Joss as the book value
exceeds the market value. The tax savings from this loss are added to the salvage (market) value to detetmine the
ATCF (if the asset is disposed ofdm·ing Year 1).

Tobie 13-1 ATCF for O&M and Depreciation for Example 13- 9
Year, t O&MExpens e MACRS Depreciation, dt Tux.able Income Tax Savings (at 28%) O&M Depreciation ATCF

1 -$10,000 $14,290 -$24, 290 $6,801 -$3, 199

2 - 14,000 24,490 -38,490 10,777 -3,223

3 - 18,000 17,490 -35,490 9,937 -8,063


4 -22,000 12,490 -34,490 9,657 -12,343
5 -26,000 8,930 -34,930 9,780 -16,220

6 -30,000 8,920 -38,920 10,898 -19,102


7 -34,000 8,930 -42,930 12,020 -21,980
8 -38,000 4,460 -42,460 11,889 -26,111
9 -42,000 0 -42,000 11,760 -30,240

10 -46,000 0 -46,000 12,880 -33,120

Tobie 13~2 ATCF in Year of Disposal for Example 13-9


Year, t Market Value Book Value Gain/Loss Tux. Gain or Loss ,(at 28%) ATCF if Disposed Df

1 $50,000 $85,710 -$35,710 $9,999 $59,999


2 45,000 61,2 20 - 16,220 4,542 49,542
3 40,000 43,730 -3,730 1,044 41,044

4 35,000 31,240 3,760 - 1,053 33,947


5 30,000 22,310 7,690 -2,153 27,847
6 25,000 13,390 11,610 -3,251 21,749
7 20,000 4,460 15,540 -4,351 15,649
8 15,000 0 15,000 -4,200 10,800
9 10,000 0 10,000 -2,800 7,200
10 5,000 0 5,000 - 1,400 3,600

These tables assume that depre ciation is taken during the year of disposal and then calculates the recaptured
depreciation (gain) or Joss on the year-end book value.

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-
A B C i D E F
I Table 13-1 Table 13-2 6% Interest Rate
2 O&M&Depr. PW1 if disposed of
3 Year ATCF without S ATCF EVAC.,
4 0 --$100;000
5 I -3,200 -103;0 18 $59.999 $49,200 =PMT($ES l ,A5,C5,D5)
6 2 -3,223 -105,886 49342 33,705
7 3 - 8,062 -11-,656 41 ,044 -9,253
8 4 -1 2,341 -122,432 33.947 27~73
9 5 -16,221 -134,553 27 ,847 2:7,002
10 6 - 19',101 - 148,019 21,749 26,984 optimal life
11 7 - 21 ,981 -16-,637 15,649 2L70
12 8 - 26,111 -179,0 19 I0,800 2:7,737
l3 9 -30,240 -196,9 18 7,200 28325
14 10 -33, 120 ...- - 15,412 3,600 28.994 =PMT($ES LA J4,Cl4.D14)
15
16
17
----
; $CS4+NPV($ES l,$B$5:Bl4)
= year O + NPV(i. B column}
FIG RE ll-5 Spreadsheet for life with minimum after-tax cost.

Spreadsheets are very useful in nearly al] after-tax calculations. However, they are absolutely required for optimal life
calculations in after-tax situations, because bonus plus MACRS is the tax law, and after-tax cash flows are different in
every year. Thus, the NPV function and the PMT function are both needed to find the minimum EUAC after taxes. Figure
13-5 Illustrates the calculation of the minimum cost life for Example 13-9.
In Figure 13--5, the PV finds the present worth of the irregular cash flows from Period 1 through Period t fort= 1 to
life. Then PMT can be used to find the EUAC over each potential life. Before-tax replacement analysis was done this way
in Example 13--2. The spreadsheet block function NPV is used to find the PW of cash flows from Period 1 to Period t.
Note that the ce11 for Period 1 is an absolute address and the cell for pe1iod t is a relative address. This allows the formuJa
to be copied.

Marginal Costs on an After-Tax Basis


Marginal costs on an after-tax basis represent the cost that would be incmTed through ownership of the existing asset in
each year. On an after-tax basis we must consider the effects of ordinary taxes as well as gains and losses due to asset
disposal. Consider Example 13- 10.

EXAMPLE 13-10
Refer to Example 13-4, where we calculated the before-tax marginal costs for a new piece of production machinery.
Calculate the asset's after-tax marginal costs considering this additional information.
• Depreciation is by the straight-line method, with S = $0 and n = 5 years, so dt = ($25,000-$0)/5 = $5000.
• Ordinary income, recaptured depreciation, and fosses on sales are taxed at a combined state and federal rate of
28%.
• The after-tax MARR is 10%.
Some classes sk1p or have not yet covered Chapter lO 's expfanation of expected value. Thus, the expected cost for tisk
of breakdowns is described here as an insurance cost.

SOLUTION
The after-tax marginal cost of ownership will involve the following elements: incrnTed or forgone loss or recaptured
depreciation, interest on invested capital, tax savings due to depreciation, and annual after-tax operating/maintenance
and insurance. Figure 13--6 shows example cash flows for the marginal cost detailed i.n Table 13--3.
As a refresher of the recaptured depreciation cakulations in Chapter 12:
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The market value in Year O = 25,000.


The market value decreases to $18,000 at Year 1.
The lbook value at Year 1 = 25,000 - 5000 = $20,000.
So loss on dep reciation = 20,000 - 18,000 = $2000.
This results in a tax savings of (2000)(0.28) = $560.

f $ 560 la.'l savings from loss on sale


Keep for first year f 18,000 sah•age value

r-1
I 400 lax savi ngs on depreciation
= ($5000) (0.28)
-;040 afterAax O&M ru1d insurance
=($2000 + 55000)(1 - 0.28)
25,000
Marginal cost = Fea&-of· )'""'"
= 25,000 li + 0.1) + 5040 - 560 - 18,CHJO - 1400
= $12,580

Keep for second year t 560 lax savings f rorn loss on sale
13,000 salvag,e value

0- 1-
tt I.400 lax savings on depreciation
18,000 I t 5,400 aft r-1.aX O&M and insurance
salvage value , · = (52000 + $5500)(1 - 0.2ll)

t ;!\avings from loss on sale

Marginal cost = F ea&-of· )'~,llf


= 18,560 l U ) + 5400 - 560 - 13 000 - 1400 = to 856
FIGURE 13-G Cash flow diagrams and calculations for marginal cost

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Tobie 13-3 Marginal Costs of Ownership


Market Book Recaptured Tuxes cir After-Tax

Year Value Value Depr: or Loss Tax Savings Market Value

0 $25,000 $25,000 $25,000


1 18,000 20,000 -$2000 -$560 18,560
2 13,000 15,000 -2000 -560 13,560
3 9,000 10,000 -1000 -280 9,280
4 6,000 5,000 1000 280 5,720
5 4,000 0 4000 1120 2,880
6 3,000 3000 840 2,160
7 2,500 2500 700 1,800
Col. B Col. C Col. n Col. F' =C -t D+F-B

After 1'ax
0 Beg. Yr Tax Savings O&Mand After-Tux Marginal

Year Market Value Value >< (1 + .i) from Depr. Deduc-t. Insurance Cost Annual Expense Cost

0 $25,000
1 18,560 $27,500 -$1400 $7,000 $5,040 $12,580
2 13,560 20,416 -1400 7,500 5,400 10,856
3 9,280 14,916 -1400 8,000 5,760 9,996
4 5,720 10,208 -1400 10,000 7,200 10,288
5 2,880 6,292 -1400 12,000 8,640 10,652
6 2,160 3,168 0 14,000 10,080 11,088

7 1,800 2,376 0 16,000 11,520 12,096

The marginal cost in each year is much Jower after taxes than the pretax numbe rs shown in Example 13-4. This is tme
because depreciation and expenses can be subtracted from taxable 1ncome. However, the pattern of declining and then
increasing marginal costs is the same, and Year 3 is still the year of lowest marginal costs.

SUMMARY
This chapter has shown that an asset's economic life may be shorter than its physical life. The economic life minimizes
the EUAC of ownership that is calculated for all possible Jives. Economic life balances the dynamic of spreading capita]
costs over more years with costs that are increasing over time-operating, maintenance, risk of unplanned repair or
replacement, and the opportunity cost of not taking advantage of better alternatives.
The question in selecting new equipment is: Which alcernadve will be most economical and with what economic life?
However, when there is an existing machine, the question is: Shall we replace it now, or shall we keep it for one or more
years? When we already have equipment. a common mistake is to use past or sunk costs in the replacement analysis.
Only present and future costs are relevant.
Replacement analysis must consider th e marginaJ costs that are the year-to-year costs of ownership. These are
different from EUAC in that they represent costs as they occur in each year. In the most common case, where the existing
asset's costs are increasing year to year, the decision rule is:
Keep the existing osset in place for the present year if ond until the marginal cost of one more yeor of ownership exceeds the minimum
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J\.t::t::"p H I~ ~,AI~U rJ'~ U~·.:!J.r[. (H JJIULt::' JUI un:: JJ' t::'3~•n Yt::'UI •r Ul !U LU JUl UJ~ nnuyunu LU3l U/ U 'I I~ ururt:" yt::t.U U/ u•v•r~, ~1up t:'A.l. e'e'U~ urt::' fU IH JUfUIPl

EUAC of o new asset ovai/able ot that dme.

An important concept when calculating the EUAC of an existing or new alternative is the first cost to be assigned to
each alternative for ca]culation purposes. When the lives of the two alternatives match, either an opportunity rost or a
cash flow approach may be used. However, in the more common case of different useful lives, only the oppmtunity cost
approach accurately assigns first costs to the existing and new assets.
It is impmtant when performing engineering economic analyses to include the effects of taxes. This is much easier to
accomplish with spreadsheets. Spreadsheets also make it easy to compute the optimal economic life of vehicles and
equipment-even when this includes complex patterns of declining salvage values, wa1ranty periods, increasing repair
costs, and overhaul costs.
Replacement analyses are vastly irnpmtant, yet are often ignored by companies as they invest in equipment and
facilities. Investments in business and personal assets should not be forgotten once an initial economic evaluation has
produced a "buy" recommendation. It is important to continue to evaluate assets over their respective life cycles to ensure
that invested monies continue to yield the greatest benefit. Replacement analyses help us to ensure this.

STUDENT STUDY GUIDE


These questions are intended for self-study. Click the [solution] box to reveal a detailed solution.
13- An engineer is trying to determine the economic life of a new metal press. The press costs $10,000 initially. First-year
1 mainte11ance costs are $1000. Mainte11ance costs are forecast IO increa5e $1000 per year for each year after 1he first. Fill in the
table a11d determine the economic life of the press. Consider only maintenance and capital recovery in yom analysis. Interest is
5%.
Mai nte11a11ce C ost EUAC of Capita.I Re-cove,y EUAC of Maintenance !Total EUAC
1 $1000
2 2000
.. ...
8 8000

Ci•l••dt-ki
13- A robot's first cost is $40,000, and its market va.lue declines by 20% annually. The operating and maintenance costs start at $2000
2: per year and clim b by $1500 each year. If the. ARR is 8%, f1nd the mjn imum EUAC and lhe machine's economic life.
Ci•i••d0R1
13- A mach.i11e's firs t cost is $60,000 with salvage values over the next 5 yea.rs of are SOK, $40K, 32K, $25K, and $12K. The
3 annual opernting and mainte11ance costs are the same every year. Determine the machine's economic life and its minimum EUAC,
if the interest rate is 7%.
4i"8Git&i
13- A petroleum company, whose minimum atn.ictive rate of return is 10%, needs to paint the vessels and pipes in its refinery
4 periodically to prevent rust. Tuff-Coat, a durable paint, can be purchased for $8.05 a ga.llon, while Quick-Cover, a less durable
paint, costs $3.25 a gallon. The labor mst of applying a ganon of painl is $6.00. Both paints a11e equally easy to apply and wi.ll
cover the same area per g,allon. Quick-Cover is expected to last 5 years. How long must Tuff-Coat promise to fast to justi fy its
use?

4i•'81,ic•Ri
13- A hospital is considering the purchase of a new $40,000 diagnostic machine that will have no salvage value after installation, as
5 the cost of removal equals any resale value. Maintenance is estimated 10 be $2000 per year as Jong as the machine is owned. After
10 yea.rs the machine must be scrapped because the radioactive ion source will have caused so much damage to machine
components that safe operation .is no longer possi ble. The most economic life of this machine is
a. One year, since it wilJ have no salvage after installation.
b. Ten years, because maintenance doesn' t increase.
c. Less than 10 yea.rs, but more info rmation is needed to determine the economic life.
Ci•i•GiM§i
13- A graduate of an engineering economy course has compiled the following set of estimated costs and salvage values for a proposed
C ....... ... . ..-1.. : .... ....... ..~ ........ ,.. &:._-..................., It' 1 nnn. ·k ....... ~ ............... ~ .... lh. ...... t ..... ~ri ........... - . k ..... ~ ....... ~ ...................... ....................... ~ .-. ~ : .... l~ t .... , .r......... ..... .-1.r ~ ... ....... ............. ... . ~ a.. : ...... ~ ....... . ..

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6 machine with a fiFSt cost of $15,000; however, i:te has forgotte n how to find the most economic life. Your task is to show him how
to do this by calculating the equivalent annuaJ mst (EUAC) for n = 8, given a MARR of 12%.
Life (n) Years Estimated End-of-Year Maintenan~ Estimated Salvage if Sold in Year n

1 $0 $10,000
2 $0 9,000
3 300 8,000
4 300 7,000
5 800 6,000
6 1300 5 ,000
7 1800 4 ,000
8 2300 3,000
9 2800 2 ,000
10 3300 1,000

Remember: Cakulate only one EUAC (for n = 8). You are not expected to actual.ly find the most economicaJ life.
4i•1••dMd
13- A Ul.lck salesperson is quoted as foll ows:
7 ''Even though our list price has gone up to $42,000, I' ll sell you a new truck for the old price of $40,000, an immediate savings of
$2000, and give you a trade-in allowance of $21,000, so you.r cost is only ($40,000 - 21,000) = $19,000. Tbe book vaJue of your
oJd trnck is $12,000, so you're makin g an additionaJ ($21,000 - 12,000) = $9000 on the deal." The salesperson adds, "Actually I
am giving you more trade-in for your old Ulick than the current market value of $19,500, so you are saving an extra ($21,000 -
19,500) = $1500."
a. In a proper replacement analysis, what is the first cost of your current truck?
b. In a proper replacement analysis, what is the first cost of the new Ulick?

4i•1••dMd
13- A car was purchased 4 years ago fo r $25,000. lts estimated saJvage value after 7 years was $8000 . The car can be sold for $14,000
B now or $10,000, $7000, or $5000 in each later year. The annuaJ maintenance cost will be $1800 for this year and increasing by
$400 per year. What are the relevant cash flows for choosing how long to keep the car?
4i•l•GiM§i
13- Ten years ago Hyv,1ay Robbery in staUed a conveyor sys tem for $8000. The conveyor system has been fully depreciated to a zero
9 sa.lvage value . The company is considering replacing the conveyor because maintenance costs i:tave been increas ing. The
estimated end-of-year maimenance costs for the next 5 years are:
Year Maintenance
1 $1000
2 1250
3 1500
4 1750
5 2000
At any time, the cost of removal j ust eq uals the value of the scrap metal recovered fro m the system. The replacement the company
is considering has an EUAC of $1028 at its most economic Hfe. The company has a minimum attractive rate of return (MARR) of
10%.
a. Should the conveyor be replaced now? Show the basis used for your decision.
b. If the old conveyor could be sold at any time as scrap metal £or $500 mo~e than the cost of removal and all other data remain
the same, shouJd the conveyor be replaced now?

4i•1•GiMd
13- Ten years ago, the Cool Chemical Company installed a heat exchanger for $10,000. Maintenance costs have been increasing, and
10 they wilJ be $1000 this year. The cost of removal wiIJ be $1500 more than the heat exchanger is worth as scrap metal. The
replacement the company is considering has an EUAC of $800 at its most economic life. If the company's min im um attractive
ra~e of return (MARR) is 10%, should tile heat exchanger be replaced now?
4i•i••dM§i
13- A firm us.es a MARR of 12%. A crane was ourchased 4 vears al!o for $180.000 and it has a cunent market value of $60.000.
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Ll- A urm us.es a MAKK or lL'fu. A crane was purcnaseel 4 years ago tor :i,rnu,uuu anct u has a cunent marl<et vaJue or ~bu,uuu.
11 Expected operating and maintenance costs and market va.lues folJow. Data for a new crane have been analyzed. Its most economic
life is 8 years with a minimum EUAC of $38,000. When shouJd the existing crane be replaced?
Year O&M casts Market value
1 17,000 50,000
2 20,000 42,000
3 25,000 35,000
4 30,000 30,000
5 35,000 24,000

13- One year ago, Machine A was purchased for $15,000, to be used for 5 years. The machine has not performed as expected, and it
12 costs $750 per month for repairs, adjustments, and downtime. achjne B, designed to perform the same functions, can be
purchased for $25,000 with monthly costs of $75. The expected life of machine B is 5 years . Operating costs are substantially
equal for the two machi nes, and salvage values for both are negljgible. If 6% is used, the incremental annual net equivalent of
ach.ine B is nearest to
a. $2165
b. $2886
c. $4539
d. $5260
Ci•1•Gioii

PROBLEMS
Key to icons : D = dick to reveaI answer; e = Green, which may include environmental ethics; O= Ethics other than
green; = autograded problems that are available online in Dashboard; = The icon indicates that a spreadsheet is
recommended.

Econmnic Life
13- An injection-molding machine has a first cost of $1,050,000 and a salvage value of $225,000 in any year. The maintenance and
1 oper-ating cost is $235,000 with an annual gradient of $75,000. The ARR is 10%. What is the most economic life?

13- A machine h.as a flrst mst of $50,000. lts markcet value declines by 25% annually. Th e operating and maintenance costs start at
2. $2000 per year and dimb by $3000 per year. Th e firm's MARR is 9% . Find the mjnim um EUAC for this machine and jts
I economic life.
13- A machine has a flrst cost of $24,000. 1ts market value dedines by 20% annually. The repai.r costs are covered by the warranty in
3 Year 1, and then they increase $900 per year. The firm's MARR is 12%. Find the minimum E AC for this machfae and its
economic life.
13- A vehicle has a firs t cost of $22,500. Its market value declines by 20% annually. It is used by a firm that estimates the effect of
4 older vehides 011 the firm's image. A new car has no "image cost." But the image cost of older vehicles cUmbs by $950 per year.
I The film 's MARR is 10%. Find the minimum EUAC for thjs vehicle and its economic life.
13- The Clap Chemica) Company needs a large jnsuJated stainless steel tank to expand its plant. A recently dosed brewery has offered
5 to seU their tank for $15 000 delivered. The price is so low that Clap believes it can sell the tank at any future time and recover its
$15,000 investment.
lnstaUing the tank will cost $9000 and removing it will cost $5000. The outside of the tank is covered with heavy insulation
that requires considerable maintenance. This wiU cost $3500 in year 1 and increase by $1000 per year.
,(a) Based on a 12% before-tax MARR, what life of the insulated tank has the Jowest EUAC?
,(b) When the insulated tank is replaced by another tank is the replacement's economic life likely to be shorter or larger? Explain.
13- An electric oil pump's firs t cost is $47,500, and the in terest rate is 11%. The pump's end-of-year salvage values over the next 5


6 years are $43K, $38K, $35K, $32K, and $261<. Determine the pump's economic life.

13- A chemical process in your plant leaves !:,Ca]e deposits on the inside of pipes. The scale cannot be removed, but increasing the
7 pumping pressure maintains flow through the na1rnwer diameter. The pipe costs $35 per foot to install, and it has no salvage value
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when it is 11emoved. The pumping costs are $8 per foot of pipe init ially, and they inc:rea5e annually by $7.50 per year sta.rting in
Year 2. What is the economic life of the pipe if the inteI1est rate is 12%?
13- A $40,000 machine wilJ be purchased by a company whose· interest rate is 12%. The instaUation cost is $10K, and removaJ costs
B are insignificant. What is its economic bfe if its salvage values and O&M costs are as fo]]ows?
I {a)

Year 1 2 3 4 5

s $25K $20K $15K $10K $SK

O&M $4K $7.5K $11K $14.SK $1.5K/year

{b) For lives of 6 years or more, an overhaul costing $15 K is requil'ed of the end of year 5.
13- A $50,000 machine wiJJ be purcha5ed by a company whose interest rate is 10%. The installation cost is $BK and 11emoval costs
9 are insignificant. What is its economic life if its salvage values and O&M costs are as follows?
(a)

Year 1 2. and late,r

s $35K drop $SK per year

O&M $8K up $1.65K per year

(b) An overha ul costing $9K is needed after 5 years service.


13- A $25,000 machine will be purchased by a company whose interest rate is 12%. It will cost 5000 to install, but its removal costs


10 are in significant. What is its economic Ufe if its salvage values and O&M costs are as fo]Jows?

Year 1 2 3 4 5

s $16K $13K $UK $10K $9.51<

O&M $5K $BK $UK $14K $7K

13- ytown's street department repaves a street every 8 years. Potholes cost $15,000 per mile beginning at the end of Year 3 after
11 construction or 11epaving. The cost to fix potholes generally .increases by $15,000 each year. Repaving costs are $200,000 per mile.
ytown uses an interest rate of 8%. What is the EUAC for Mytown' s policy? What is the E AC fo r the optimal polky? What is
the optimal policy?
13- Th.e plant manager may purchase a piece of unusual machinery fo r $10,000. Its 11esale value after 1 year is estimated to be $3000.
12. Because the device is sought by antique collectors, resale value is rising $500 per year.
0 The maintenance cost is $300 per year for each of the fi rst 3 years, and then it is expected to do uble each year. Thus the fourth-
year maintenance will be $600; the flfth-yea.r maintenance, $1200, and so on. Based 0 11 a 15% before-tax MARR, what life of this
machinery has the lowest EUAC?
13- J&E Fine Wines recently purchased a new grape press for $150,000. The annual operating and maintenance rnsts for the p11ess are
13 estimated to be $4000 the firs t year. T hese costs are expected to inc11ease by $5000 each year after the first. The market vaJue is
expected to dec11ease by $25,000 each year to a value of zero. InstaUation and removal of a press each cost $3500. sing an
interest rate of 9%, detennine the economic ]ife of the press.
13- A mach.ine's initial maintenance costs are covered by a 3-year warranty. Its in itiaJ installed cost is $22,000. Salvage value in any


14 year is zero. Assume a 10% i.nte11est rate and ignore inco me taxes .

Annual maintenance Year


None 1-3
$6500 4--5
$2500 6
+ $3500/yr 7-10

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•(a) Compute the ec-onomic life with the lowest EUAC.


{b) How does the economic life and minimum E AC change if an overhau] costing $8000 at the end of year 5 is required for
lives of 6 years or greater.

13- A new $100,000 bottling machine wiU have no salvage value when it is removed. The plant man ager has asked you to estimate the
15 machi ne's economk service life, ignoring .income taxes. He estimates that the annual maintenance cost will be constant at $2500
O per year. What service life will result in the lowest eq uivaJent uniform annual cost?
13- A 2000-pound, co1mterbalanced, propane forklift can be pu.rchased for 30,000. Due to the intended service use, the forklift's
16 market value drops 20% of its prior year's value in Years 1 and 2 and then decl.ines by 15% until Year 10 when it will have a
O scrap/market val ue of $1000. aintenance of the forklift is $500 peF year during Years 1 and 2 whUe the wa.mrnty is in place. In
Year 3 it jumps to $750 and increases $750 per year thereafter. What is the optimal life of the forklift using i = 10%?
13- Demonstrate how one would calculate the eco nomic ]ife of a truck costing $40,000 initially, and at the end of this and each
17 folfowing year (y) costing O Ry in operation, maintenance and repair costs. The nuck is depreciated using the straight-line
method ov,er 4 years (Le., $40, 000/4 = Dy)- Its salvage va.Iue each year equals its boo k value. Devefop an exp ression to show how
to determ ine the truck's economic life--that is, the yea.r when the truck's uniform equivalent an nual cost is a minimum.
Contributed .by D. P. Loucks, Cornell Universiry
13- Bill 's fathe r read that each year a car's value declines by 10%. He also read that a new ca.r' s value declines by 12% as it is driven
18 off the dealer's lot. aintenance costs and the costs of "car problems" are only $200 per year during the 2-year warranty period.
Then they jump to $750 per year~ with an annuaJ increase of $500 per year.
BHJ's dad wants to keep his annual cost of car owners hip low. The car he prefers cost $30,000 new, and he uses an interest rate
of 8%. For this car, the new vehicle wananty is n·ansfem1ble.
(a) If he buys the car new, what is the minimum cost life? What is the minimum EUAC?
(b) If he buys the car after it is 2 years old, what is the minimum cost life? What is the m inimum EUAC?
(c), If he buys the car after it is 4 years old, what is the minimum cost life? What is the m inimum EUAC?
•(d) If he buys the car after it is 6 years old, what .is the minimum cost life? What is the m inimum EUAC?
(e), What strategy do you recommend? Why?

Replacement Problems
13- TypicaUy there are two alternatives in a replacement analysis. One aJtemative is to replace the existing asset now. The other
19 alternative is which one of the following?
A. Keep the existing asset for its remain ing useful Jife.
B. I<ceep the existing asset for another year and then re,exam ine the si tuation.
C. Keep th.e existing asset until there is an improved new asset that is better than the present new asset.
13- Th.e existing asset 's economic life can be found if certain esti.mates about it can be made. Assuming those estim ates prove to be
2.0 exactly correct, one can accurately predict the year when the existing asset should be repl aced, even if nothing is known about
potential new assets. True or false? Explain.
13- A proposa.1 has been made to replace a large heat exchanger (3 years ago, the initial cost was $85,000) with a new, more efficient
2.1 unit at a cost of $120,000. The existing heat exchanger is being depreciated by the MACRS method. Its present boo k value is
$20,400, but its scrap value just equals the cost to remove it from the plant. In preparing the before-tax economic analysis, shouJd
the $20,400 book value of the old heat exchanger be
A. added to the cost of the new exchanger?
B. subtracted fro m the cost of the new exchanger?
C. ignored in this befo11e-tax econom ic analysis?
13- Which o ne of the following is the proper d ollar vaJue of existing equipment to use in replacement analysis?
2.2. A. Origin al cost
B. Present market value if sold
C. Present n-ade-in value
D. Present book value
E. Present market value if sold min us remova.l and selling expenses
13- A driU press was purchased 4 years ago fo r $40,000. Its estim ated salvage value after 7 yea.rs was $5000. The press can be sold for
23 $15,000 today, or for $12,000, $9000,. or $6000 at the ends of each of the next 3 years. The annuaJ operating and maintenance cost
for the next 3 years will be $2700 for this year and then will increase by $800 per year. What are the relevant cash flows for this
machi ne?
13- Describe an example in a replacement analysis scenario where the replacement is being considered due to

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2-4 (a) reduced performance of the existing equipment.
G ,(b) altered requirements.
•(c), ohso]escence of the ,existing equipment.
,(d) risk of catastrophic failure or unplanned replacement of the existing equipment
,(e), a previous equipment choice that was incorrectly analyzed by your boss , What ethical and pragmatic challenges exist i.n this
cas,e?
13- A pulpwood-forming machine was pl.]]'Chased and installed 6 years ago fo r $50,000. The declared saJvage value was $5000, wit h a
25 useful life of 10 years. The mach ine can be replaced with a mo re efficient model that costs $90,000, incl uding instaUation. The old
machine can be sold on the open market fo r $25,000. The cost to remove the old machine is $4000. Whkh are the relevant costs
for the o]d machine?
13- A $25,000 machine that has been used for one year h.as a saJvage value of $16,000 now, which wiU drop by $4000 per year. The
2:6 maintenance costs for the next 4 years are $1250, $14 0, $1750, and $2250. When the machine is soJd, it win cost $2000 to
I remove and sell. When the machin e was purchased, the estimated salvage value in 5 years was $3500, What are the relevant costs
for the machine?

Marginal Costs
13- In Prob]em 13-23, what is the marginal cost for each year?
2.7
13- In Prob]em 13-26, what is the marginal cost for each year?
2.8
I
13- In Prob]em 13-18, what is the marginal cost for each year?
2'9
13- SHOJ Enterprises has asked you to loo k at the following data. The interest rate is 10%.
30
I Year, 11 Marginal Cost Data Existing Asset E AC i:f Kept II Years New Asset

1 $3000 $6500

2 3150 4150

3 3400 3200

4 3800 3100

5 4250 3150

6 4950 3400

,(a) What is the new asset's economic life?


•(b) When, if at all, should we replace the existing as.set wi th the new as!">et?
13- Should NewTech' s poUution testing system he replaced this year? The system has a salvage value now of $5000, which will fan to
31 $4000 by the end of the year. The cost of lower productivity linked to the older system is $3000 this year. ewTech uses an
CD imerest rate of 15%. What is the cost advantage of the best system? A potential new system costs $12,000 and has the fo]fowing
saJvage values and lost productivity fo r each year.

Year s Lost Productivity

0 $12,000

1 9,000 $0

2 7000 1000

3 5,000 2000

4 3,000 3000

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13- Five years ago, Thomas Martin installed production machinery that had a first cost of $25,000. At that ti.me initial yearly costs
32 were estimated at $1250, increasing by $500 each year. The market value of this machinery each year wouJd be 90% of the
I previous years value. There is a. new machine available now that has a first cost of $27,900 and no yearly costs over its 5-year
minimum cost life. If Thomas Martin uses an 8% before-tax ARR, when, if at all, shouJd he replace the existing machinery with
the new unit?
13- Consider Problem 13-32 involving Thomas Martin. When, if at an, should the old machinery be replaced with the new, giv,en the
33 following changes in the data. The old machine retains onJy 70% of its va]ue in the market from year to year. The yearly costs of
the old machine were $3000 in Year 1 and increase at 10% thereafter.
13- In eva.luating projects, LeadTech's engineers use a rate of 15%. One year ago a robotic n ansfer machine was installed at a cost of
34 $38,000. At the time, a. 10-yea.r life was estimated, but the machine has had a downtime rate of 28%, which is unacceptably high.
I A $12,000 upgrade should fix the problem, or a labor-intensive process costing $3500 in dfrect labor per year can be substituted.
The plant estimates indirect plant expenses at 60% of direct lab01~ and it al.locates front office overhead at 40% of plant expenses
(direct and jndi.rect). The robot has a value in other uses of $15,000. What is the difference between the E ACs for upgradjng and
switching to the labor-intens.ive process?
13- ary O' Leary's company ships fine wool garments from County Cork, Ireland. Five years ago she pu.rdtased some new
35 automated packing equipment having a first cost of $125,000. The annual costs for operating, maintenance, and insurance, as well
as market value data for each year of the equipment's 10-year useful life are as follows.

Year fl Annual Cests in Year fl for Market Value in Year n

Operating Maintenance Insurance

1 $16,000 $5,000 $17,000 $80,000


2 20,000 10,000 1-6,000 78,000

3 24,000 15,000 15,000 76,000


4 28,000 20,000 14,000 74,000

5 32,000 25,000 12,000 72,000

6 36,000 30,000 11,000 70,000


7 40,000 35,000 10,000 68,000

B 44,000 40,000 10,000 66,000

9 48,000 45,000 10,000 64,000


10 52,000 50,000 10,000 62,000

Now Mary is loo king at th,e remainjng 5 years of her investment in this eq uipment. What is the marginal cost for each of th,e
remaining 5 years? When, if at aU, shmdd Mary rep lace this packing equipment with a new asset that has a minimum EUAC of
$110,000?
13- Eight years ago, the mank Block Building Company ins talled an automated conveyor system for $38,000 . When the conveyor is
36 replaced, the net cost of removal wiU be $2500. The minimum EUAC of a new conveyor is $6500. When should the conveyor be
I replaced if BBB's MARR is 12%? The O&M costs for the next 5 years are $SK, $6K, $7K, $8K, and $9K.
13- Big-J Construction Company, Inc. is conducting a routine periodic review of existing field equipment. They use a MARR of 20%.
37 This ind udes a replacement eva]uation of a paving machine now in use. The machine was purchased 5 years ago for $200,000,
The paver's current market va.lue is $65,000, and yearly operating and maintenanc,e costs are as folJows.

Operating Maint~nance Market Value


Year, Cost i:n Cost in if Sold

rt Yearn Yearn in Yearn

1 17,000 12,000 50,000


2 20,000 18,000 40,000

3 25,000 20,000 35,000

4 30.000 25.000 30.000


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4 .:lU,UUU L'.:l,UUU .:lU,UUU

5 35,000 30,000 25,000

Data for a new paving machine have been analyzed. Its most economic life 1s at 8 years, with a minimum EUAC of $62,000.
When should the existing paving machine be replaced?
13- VMIC Corp. has as ked you to look at the following data. The interest rate is 10%.


38
Margina l EUAC if
Cost Data Kept n Years
Year.11 Existing Asset ew Asset
1 $2000 $6500

2 2200 4200
3 2300 3000
4 2550 2650
5 2900 2700
6 3400 2800
7 4000 3000

•(a) What is the new asset' s mjni.mum cost life?


,(b) When, if at alJ, should we•replace the existing asset with the new asset?
13- The existing business asset has the tabuJated totaJ marginal mst data. What is the maximum first cost for a new asset fo r it to be
39 preferred over the existing asset today? With no salvage value and no differential annual costs fro m the existing asset, the new
I asset's minimum cost life is 5 years. Use i = 20%.

Year 1 2 3 4

Total Marginal Cost ($1000s) 100 250 300 400

Coinplications in Analysis
13- You are conside1ing the purchase of a new high-efficiency machi ne to replace olde.r machines now. The new machine can replace
40 four of the older machines, each with a current market value of $600. The new machine will cost $5000 and will save the
I equivalent of 10,000 kWh of electricity per year. After a perfod of 10 years, neither option (new or old) will have any market
A value. If you use a before-tax MARR of 25% and pay $0.075 per kiJowatt-hour, wo uld you replace the old machines today with
W the new one?
13- A professor of engineering economics owns an older car. ln the past 12 months, he has paid $2000 to replace the n,msmission,
41 bougJ1t two new tires for $160, and installed a music system for $110. He wants to keep the car for 2 more years because he
G invested money 3 years ago in a 5-year certificate of deposit, which is earmarked to pay for his dream machine,. a red European
spmts car. Today the old car 's engine faUed.
The professor has two alternatives . He can hav,e the engine overhauJed at a cost of $1800 and then most Jikely have to pay
another $800 per year for the next 2 years for maintenance. The car wiJJ have no salvage value at that time.
Alternatively, a colleague offered to make· the professor a $5000 loan to buy another used car. He must pay the loan back in two
equal installments of $2500 due at the end of Year 1 and Year 2, and al the ,end of the second year he must give the colleague the
car. What interest rate is the professor paying on the loan from hJs colleague, if the v,ehide will be worth $3000 after 2 years? Is
this an ethicaJ interest rate?
The "new" used car has an expected annual maintenance cost of $300. ]f the professor selects this altemative, he can sell hi.s
current vehk le to a junkyard for $500. lnterest .is 6%. sing present worth analysis, which alternative shou]d he select and why?
13- Sacramento Cab Company owns several taxis that were purchased for $25,000 each 4 years ago. The cabs' current market value is
42 $12,000 each, and if they af\e kept for another 6 years they can be so]d for $2000 per cab. The annual maintenanc11 cost per cab is
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$1000 per year. Sacramento Cab has been approached about a leasing plan that would replace the cabs. The leasing plan calls for
payments of $6000 per year. The annual ma.intenance cost for each leased cab is $750 per year. Should the cabs be replaced if the
interest rate is 10%?
13- The local telephone company purchased four special pole hole djggers 8 years ago for $14,000 each. Owing to an increased
43 workload, additional machines will soon be required.
Recently an im proved model of the digger was an nounced. The new machines have a higher production rate and lower
maintenance expense than the old machines but will cost $32,000 each with a service life of 8 years and salvage value of $750
eaclh.. The four original diggers have an immediate salvage of $2000 each and an estimated salvage vaJue of $500 eaclh. 8 years
hence. The average annual maintenance expense of each old machine is about $1500, compared with $600 each for tlh.e new
machines.
The workload would req uire tilree additional new machfaes if the old machines continue in service. However, if the old
machines we11e aU 11etired fro m service, the workload could be canied by six new machines with an annual savings of $12,000 in
operation costs. A rraining program to prepare employees to run the machines will be necessary at an estimated cost of $1200 per
new machine. If the MARR is 8% before taxes, what should the company do?
13- JMJ Inc. bought a manufactming line 5 years ago for $35M (mimon). At that time it was estimated to have a service life of 10
44 years and salvage value at the end of its service life of $10M. JMJ's CPO recently proposed to replace the oJd line with a modem
I line expected to last 15 years and cost $95M. This line will provide $SM savings in annual O&M costs, increase T1evenues by
$2M, and have a $15M salvage va.lue. The seller of the new line is wimng to accept the old line as a trade-in for its cun"ent fajr
market value, which is $12M . The CFO estimates tlh.at if the old line is kept for 5 more yea.rs, its salvage vaJue will be $GM. If th,e
ARR is 8% per year~ should the company keep the old line or replace it with the new .line?
Contributed .by Hamed Kashani, Saei d Sadri, and Baabak Ashuri, Georgia Institute of Technology
13- A couple bought their house 10 years ago for $165,000. At the time of purchase, they made a $35,000 down payment, and the
45 balance was financed by a 30-year mortgage with monthly payments of $988.35. They exp ect to live in this house for 20 years,
after which time th,ey plan to sell the house and move to another state.
Alternatively, they can se!J the hous.e now and live in a rental unit for the next 20 years. The hous.e can be sold now for
$210,000, from whiclh. a 6% real estate commission and $110,000 remaining loan balance and miscellaneous expens.es win be
deducted. If they stay in the house, the house can be sold after 20 years for $320,.000, from which a 6% rea.l estate commjssion and
$10,000 miscellaneous expenses will be deducted. A comparable rental unit rents fo r $960 payab1e at tlh.e beginning of every
month . o secmity deposit wiU be required of them to l'ent the unit, and the rent wiJJ not increase if they maintain a good payment
record. They use an interest rate of 0.5% per month for analyz.ing this financial opportunity. hould they stay in the house or
should they sell it and move into a rental unit?
Contributed .by Hamed Kashanj, Saej d Sadri, and Baabak Ashuri, Georgia Institute of Technology
13- A used car can be kept for two more years and then sold for an estimated value of $3000, or it can be sold now for $7500. The
46 average annual maintenance cost over the past 7 years has been $500 per year. However~ if the car is kept for two more years, this
I cost is expected to be $1800 the fi.rst year and $2000 the second year. As an aJternative, a new car can be purchased for $22,000
and be used for 4 yea.rs, after which it will be sold for $8,000. The new car wiJJ be under waITanty the first 4 years, and no extra
maintenance cost will be incu11"ed during those years. If the MARR is 15% per yea1~ what is the better option?
Contributed.by Hamed Kashanj, Sm~jd Sadri, and Baabak Ashuri, Georgia Institute of Technology
13- The Quick Manufacturing Company, a large profitable corporation, may replace a production machine tooL A new machine wo ul.d
47 cost $37,000, have an 8-year useful life, and have no salvage value. For tax purposes, 3-year MACRS depredation would be us.ed
The ex.isting machine tool cost $40,000 4 years ago, and it has been mrnpletely depreciated. The tool could be soJd now to a used
equjpment dealer for $10,000 or be kept in service for another 8 years. It would then have no salvage va.lue. The new machine tool
would save about $9000 per year in operating costs compared to the existing machjne.
Assume a 20% combined state and federal tax rate. Compute the before-tax rate of return on the replacement proposal of
instalUng the new machine rather than keeping the existing machine.

After-Tax Replacement
13- Fifteen years ago the Acme Manufactming Company bought a propane-powered forklift truck for $4800. The company
48 depr"edated the forklift using straight-line depr"edation, a 12-year life, and zero sa]vage value. Estimated end-of-year maintenance
I costs for the next 10 years are as fonows:

Year Maintenance Cost

1 $ 400
2 600
3 800
4 1mm
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4 lUUU
5-10 1400/year

Th.e old forklift has no present or future net sa.lvage vaJue (scrap val ue equals disposal costs). A modern unit can be purchased
for $6500. It has an economic life equal to its 10-year dep11eciable life. Straight-line depreciation will be employed, with zero
sa.lvage value at the end of the 10-year depreciable life. Ma.intenance 011 the new forklift is estimated to be a constant $50 per year
for the next 10 years, after which maintenance is ,expected to innease sharply. Should Acme Manufacturing keep its old forklift
trllck for the present or replace it now with a new one? The firm expects an 8% after-tax rate of return on its investments. Assume
a 28% combined state-and-fede ral tax rate.
13- State the advantages and disadvantages witlh. respect to after-tax benefits of th,e foUowing optio ns for a major equipment unit:
49 A. Buy new equipment
B. Trade in and buy a simila1~ rebuj)t equipment from the manufacturer.
C. Have the manufacturer rebuild your equipment with all new available options.
D. Have the manufacturer rebuild yom equipment to the origin al specifications.
E. Buy used equipment.
13- A new employee at CLL Engineering Consulting Inc., you are asked to join a team perlonning an economic analysis for a client.
50 The client has a combined federal/state tax rate of 25% on ordinary income, depreciation recapture, and losses.
I Existing Asset: This asset was placed in service 7 years ago. At that time the $50,000 cost basis was set up on a straight-line
depredation sched ule with an estimated salvage va.lue of $15,000 over its 10-year life. This asset has a present market value
of $30,000.
New Asset: The new asset has a firs t cost of $85,000 and wrn be dep11eciated by MACRS dep11eciation over its 10-year class
life. This asset qualifies for a 10% investment tax credit.
,(a) Your task is to find the Time-0 ATCFs.
,(b) How would your calculations change if th e p11esent market value of the existing asset .is $25,500?
,(c), How would your calculations change if the present market value of the existing asset is $18,000?
13- achine A has been completely overhauled for $9000 and is expected to last another 12 years. The $9000 was treated as an
51 expense for tax purposes last year. Machine A can be sold now for $30,000 net after selling expenses, but will have no salvage
value 12 yea.rs hence . It was bought new 9 years ago for $54,000 and has been depreciated since then by straight-line depreciation
using a 12-year depreciable life.
Because less output is now req uired, Machine A can be replaced witlh. a smaUer machine: Machine B costs $42,000, has an
anticipated Jife of 12 years,. and would reduce operating costs $2500 per year. It would be depreciated by straight-line depreciation
with a 12-year depreciable life and no salvage value.
Th.e focome tax rate is 25% .. Compa.re the after-tax annua.l costs and decide whether achine A should be re·tained or replaced
by Machine B. Use a 10% after-tax rate of return.
13- A Hnn is concemed about the condition of some of its plant machinery. Bil.I James, a newly hi.red engineer, reviewed the situation
5.2 and identified fiv•e feasible, mutuaJJy exclusive alternatives.
I Alternative A: Spend $44,000 now repairing various items. The $44,000 can be charged as a cunent operating expense
(rather than cap italized) and deducted from other taxable income immediately. These repairs wiJJ keep the plant functioning
for 7 years with current operating costs.
Alternative B: Spend $49,000 to buy generaJ-pU11Jose equipment. Depreciation would be 5-year MACRS. The equjpment has
no salvage va.lue after 7 years. The new equipment wiU reduce annual operating costs by $7000.
Alternative C: Spend $56,000 to buy new specia1ized equipment. This eq uipment would be dep11eciated by 5-year MACRS.
This equipment would reduce annual operating costs by $12,000. It wiJJ have no salvage value.
Alternative D: This is the "do nothing" altemative, with annual operating costs $8000 above the present level.
This profitable film pays 28% COil)orate income taxes and uses a 10% after-tax rate of return. Whi.ch altemati ve should the firm
adopt?
13- Compute the after-tax rate of return on the replacement proposal for Problem 13-47.
53
13- BC Junction pmchased some embroidering equipment for their Denver facility 3 years ago for $15,000. This equipment quaJified
54 as MACRS 5-year property. Ma.intenance costs are estimated to be $1000 this next year and will increase by $1000 per year
I thereafter. The market (salvage) value for the equipment is $10,000 at the end of this year and declines by $1000 per year in the
future. If BC Junction has an after-tax MARR of 30%, a marginal tax rate of 28% on ordinary income, depredation recapture, and
losses, what after-tax Life of this previously purchased equipment has the lowest EUAC?

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Minicases
13- Reconsider the acqujsition of packing equipment for Mary O'Leary's business, as descri.bed in Problem 13-35. Given the data
55 tabuJated there use an after-tax ARR of 25% and a tax rate of 35% on ordin ary income to evaJuate the investment Dete1mine
the lowest after-tax EUAC of the equipment at its i.nitiaJ purchase.

13- A 2000~pound, counterbaJanced, el ectric forklift can be purchased for $25,000 plus $3000 fo r the charger and $3000 for a ba ttery.
56 The forkl.ift's market value is 15% ]ess for each of its firs t 6 years of service. After this period the market value declines at the ra te
I of 7.5% for the next 6 years.
T he battery has a life of 12 years and a salvage va]ue of $300. The charger has a 12-year me and a $100 salvage vaJue. The
charger's market value declines 20% per year of use. The battery's market value decl.ines by 15% of its purchase price each year.
aintenance of the charger and battery are minimal.. The battery will most likely not work with a replacement forklift.
MaintenanC'e of the forklift is $400 per year during Years 1 and 2 while the wa:n·anty is in place. In Year 3 it jumps to $800 and
increases $500 per year thereafter. What is the opti.m al ownershi p pol.icy usin g i = 10%?

CASES
The following cases from Cases in Engineering Economy (www.oup.com/us/newnan) are suggested as matched with
this chapter.

CASE To Use or otto Use?


27
Focus is treatment of sunk costs. More complicated than most. Some discoveries in the data gathering process. Solution
uses equation rnther than cash flow tab]e.
CASE
Freeflight Sup-erdiscs
31
Inflation and sensitivity analysis for three alternatives. lndudes taxes.
CASE
Mr. Speedy
32
Includes two memos using different inappropriate· financial rnmpa1isons. Choose optimal ]ife fo.- replaC'ement of vehicles.
CASE
Piping Plus
33
Data from case inuu, three memos, income sta.tement, and balance sheet. Computer improvement in a profession al services
film . Assumptions wiU lead to an instructive variety of results.
CASE
R&.D Device at EBP
34
Equipment replacement cost compa1ison with uneq uaJ lives. Continuing demand requires careful analysis statem ent by the
student because of detailed cost data. Before or after taxes.

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