Replacement Analysis

• The objective of this topic is to address the question of
whether a currently owned asset should be kept in service

or immediately replaced.
• The objective of this topic is to address the question of
whether a currently owned asset should be kept in service
or immediately replaced.
What to do with an existing asset?
• Keep it
• Abandon it (do not replace)
• Replace it, but keep it for backup purposes
• Augment the capacity of the asset
• Dispose of it, and replace it with another
Three reasons to consider a
change.
• Physical impairment (deterioration)
• Altered requirements
• New and improved technology is now available.
The second and third reasons are sometimes

referred to as different categories of obsolescence.
Some important terms for replacement analysis
• Economic life: the period of time (years) that yields the
minimum equivalent uniform annual cost (EUAC) of
owning and operating as asset.
• Ownership life: the period between acquisition and disposal
by a specific owner.
• Physical life: period between original acquisition and final
disposal over the entire life of an asset.
• Useful life: the time period an asset is kept in productive
service (primary or backup).
Replacement: past estimation errors
• Any study today is about the future—past estimation

“errors” related to the defender are irrelevant.
• The only exception to the above is if there are income tax
implications forthcoming that were not foreseen.
Replacement: watch out for the sunk-cost trap
• Only present and future cash flows are considered in

replacement studies.
• Past decisions are relevant only to the extent that they
resulted in the current situation.
• Sunk costs—used here as the difference between an asset’s
BV and MV at a particular point in time—have no
relevance except to the extent they affect income taxes.
• Replacement: the outsider viewpoint
• The outsider viewpoint is the perspective taken by
an impartial third party to establish the fair MV of
the defender. Also called the opportunity cost
approach.
• The opportunity cost is the opportunity foregone by
deciding to keep an asset.
• If an upgrade of the defender is required to have a
competitive service level with the challenger, this
should be added to the present realizable MV.
Replacement: economic lives of the challenger and
defender
• The economic life of the challenger minimizes the

EUAC.
• The economic life of the defender is often one year,
so a proper analysis may be between different-lived
alternatives.
• The defender may be kept longer than it’s apparent
economic life as long as it’s marginal cost is less
than the minimum EUAC of the challenger over
it’s economic life.
Acme owns a CNC machine that it is considering
replacing. Its current market value is $25,000, but it can
be productively used for four more years at which time
its market value will be zero. Operating and maintenance
expenses are $50,000 per year
Acme can purchase a new CNC machine, with the same
functionality as the current machine, for $90,000. In four
years the market value of the new machine is estimated to
be $45,000. Annual operating and maintenance costs will
be $35,000 per year.
Should the old CNC machine be replaced using a before-
tax MARR of 15% and a study period of four years?
Example solution
Defender
Challenger
PW of the challenger is greater than PW of the

defender (but it is close).
Proper analysis requires knowing the economic life
(minimum EUAC) of the alternatives.
• The EUAC of a new asset can be computed if the

capital investment, annual expenses, and year-by-
year market values are known or can be estimated.
• The difficulties in estimating these values are
encountered in most engineering economy studies,
and can be overcome in most cases.
Finding the EUAC of the challenger requires
finding the total marginal cost of the challenger,
for each year. The minimum such value
identifies the economic life.
This equation represents the present worth, through

year k, of total costs. (Although the sign is
positive, it is a cost. Eq. 9-1.)
Total marginal cost formula
The total marginal cost is the equivalent worth,
at the end of year k, of the increase in PW of
total cost from year k-1 to year k.
This can be simplified to (eq. 9-2)

Finding the economic life of the new CNC machine.
Year 1 Year 2 Year 3 Year 4
O&M costs $35,000 $35,000 $35,000 $35,000
Market value $75,000 $60,000 $50,000 $45,000
Marginal
costs:
O&M $35,000 $35,000 $35,000 $35,000
Depreciation $15,000 $15,000 $10,000 $5,000
Int. on capital $13,500 $11,250 $9,000 $7,500
TC $63,500 $61,250 $54,000 $47,500
The economic life of the defender
• If a major overhaul is needed, the life yielding the
minimum EUAC is likely the time to the next
major overhaul.
• If the MV is zero (and will be so later), and
operating expenses are expected to increase, the
economic life will the one year.
• The defender should be kept as long as its marginal
cost is less than the minimum EUAC of the best
challenger.
Abandonment is retirement without replacement.
• For projects having positive net cash flows
(following an initial investment) and a finite period
of required service.
• Should the project be undertaken? If so, and given
market (abandonment) values for each year, what is
the best year to abandon the project? What is its
economic life?
• These are similar to determining the economic life
of an asset, but where benefits instead of costs
dominate.
• Abandon the year PW is a maximum.
Abandonment example
A machine lathe has a current market value of

$60,000 and can be kept in service for 4 more
years. With an MARR of 12%/year, when
should it be abandoned? The following data are
projected for future years.

Net receipts $50,000 $40,000 $15,000 $10,000
Market value $35,000 $20,000 $15,000 $5,000
Abandonment solution
Keep for one year
Keep for two years
Keep for three years (BEST!) Keep for four years

Replacement Analysis

Uploaded by

Copyright:

Available Formats

Replacement Analysis

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Replacement Analysis

Uploaded by

Copyright:

Available Formats

• The objective of this topic is to address the question of

whether a currently owned asset should be kept in service

The second and third reasons are sometimes

• Any study today is about the future—past estimation

• Only present and future cash flows are considered in

• The economic life of the challenger minimizes the

PW of the challenger is greater than PW of the

• The EUAC of a new asset can be computed if the

This equation represents the present worth, through

This can be simplified to (eq. 9-2)

A machine lathe has a current market value of

Year 1 Year 2 Year 3 Year 4

Keep for one year

Keep for two years

Keep for three years (BEST!) Keep for four years

You might also like