Replacement Analysis

Dr. Hassan Ashraf

Engineering Economics _ CU Islamabad _ Wah Campus _ BS Program in
1
Civil Engineering_ Class of 2020 _ FA16 Session
 Introduction
The rationale of replacement analysis is same as that of increment
analysis.

In increment analysis we are interested in knowing whether the extra

costs associated with the alternative get offset by its extra benefits
when compared with the referenced alternative.

Similarly, in replacement analysis we are interested in knowing

whether an existing asset should be replaced considering the
associated expected benefits of the proposed asset with which the
existing asset is to be replaced.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 2
 Basic Terminology
Some of the basic terminology is same which we have used in
incremental analysis.

Old asset which will be compared against different alternatives is

called Defender

Proposed asset(s) that will be compared against the old asset is/are
called Challenger(s)
Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 3
 Reasons of Replacement
• Physical impairment ( Deterioration) of an asset

 Reduced efficiency
 Increased frequency of maintenance costs

• Altered Requirements of the market

 Reduced relevance of an asset with respect to the demands

of the market

• Changes in Technology

 Reduced operational efficiency when compared with

competitors

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 4
Different Categories of Obsolescence

Altered
Technology
Requirements

Categories
of
obsolescence

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 5
 Types of Asset life
• Economic life
 Period of time that results in minimum EUAC of owning and
operating an asset.

 Therefore, if an asset is maintained properly, the economic life

should match with the time period extending from the date of
acquisition of an asset to the date of abandonment, demotion in
use, or replacement from the primary intended service.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 6
 Types of Asset life
• Ownership life
 The period extending from the date of acquisition of an asset to its
disposal by a specific owner.

• Physical Life
 The period extending from the date of an acquisition of an asset
until the final disposal of an asset .

• Useful life
 The time period that an asset is kept in productive service either
primary or backup. It is an estimate of how long an asset is
expected to be used in a trade or business to produce income.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 7
 Factors in replacement analysis
• Recognition and acceptance of past errors

• Sunk costs

• Existing asset value and the outsider viewpoint

• Economic life of the proposed replacement asset

(challenger).

• Remaining (economic) life of the old asset (defender)

• Income tax considerations

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 8
 Past Estimation Errors
• The focus of replacement analysis is “FUTURE”.
Therefore any past estimation errors related to the
defender are not relevant.

• One type of an error in estimation is realized when:

Asset’s Book Value (BV) > Asset’s Market value (MV)

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 9
 Past Estimation Errors
With the error made, and the book value of an asset is
greater than its Market value, the question we have to
answer is :

“ What will be the costs of my competitor who has no

past errors to consider? In other words, we must decide
whether we wish to live in the past, with its errors and
discrepancies, or to be in a sound competitive position in
the future.”

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 10
 Past Estimation Errors
“ A common reaction is, I cant afford to take the loss in
the value of the existing asset that will result if the
replacement is made. The fact is that the loss already
had occurred, whether or not it could be afforded, and it
exists whether or not the replacement is made.”

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 11
 The sunk-cost trap
One way of understanding sunk cost is by looking at the
difference between asset’s market value and its book
value.

The difference when the Book value is greater than

market value of an asset represents sunk cost.

Sunk costs have no relevance to the replacement

decisions that must be made ( except to the extent that
they affect income taxes). When income taxes are
involved, we must include the sunk cost in the
engineering economy study.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 12
 Investment value and outsider’s viewpoint
As we have seen the importance of the relationship
between BV and MV of an asset, it is important that MV
of an asset is determined fairly and impartially.

Determining the incorrect MV would lead to

replacement decisions which will defy the spirit of
replacement analysis using the principles of engineering
economics.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 13
 Economic life of the challenger
It is essential to know a challenger’s economic life, in
view of the principle that new and existing assets should
be compared over their economic (optimum) lives.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 14
 Economic life of the Defender
Care must be taken when comparing defender and
challenger with different economic lives.

“ We shall see that the defender should be kept longer

than its apparent economic life as far as its marginal
cost is less than the minimum EUAC of the challenger
over its economic life.”

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 15
 Importance of Income Tax consequences
The replacement of assets often results in gains or losses
from the sale of depreciable property. Consequently, to
perform an accurate economic analysis in such cases, the
studies must be made on an after-tax basis. It is evident that
the existence of a taxable gain or loss, in connection with
replacement, can have a considerable effect on the results of
an engineering study. A prospective gain from the
disposal of assets can be reduced by as much as 40% or
50%, depending on the effective income tax rate used in
a particular study. Hence, the decision to dispose of or
retain an existing asset can be influenced by income tax
considerations.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 16
 Thank you !!!

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