Engineering Economic Analysis Canadian Edition

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Engineering Economic AnalysisCanadian Edition

• Chapter 13 Replacement Analysis

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Chapter 13. . .

• recasts equipment reinvestment decisions in terms
  of defender versus challenger.
• uses the replacement analysis decision map to
  select the appropriate analysis technique.
• calculates a challengers minimum cost life.

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• uses the repeatability assumption and a
  defenders marginal cost data in replacement
  analysis.
• performs after-tax replacement analyses using the
  defender sign change procedure as required.

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Introduction

• At some point, physical assets (e.g., machinery
  and equipment)
• wear out
• cannot meet product demand
• become obsolete
• their services are no longer required

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• Must consider replacing the existing assets, the
  defender, with a new alternative (challenger)
• an identical asset
• a newer model (higher first cost but lower annual
  costs)
• At what exact time should a more efficient asset
  replace the defender to minimize costs?

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Replacement Analysis

• When should a new truck replace the existing
  truck?
• When should a process be redesigned?
• When should a product be redesigned?

The most common question asked in industry is
When should the existing be replaced?
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Replacement Analysis Terms

• Defender the existing equipment, building, or
  decision previously implemented
• Challenger the proposed replacement currently
  under consideration

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The Replacement Problem

• Engineers make replacements because of
• Obsolescence technological change
• Depletion loss of market value
• Deterioration wear that is overly expensive to
  repair

Shall the defender be replaced now or be
maintained for one or more periods?
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Aspects of Replacement Analysis

• Using available data to determine the analysis
  technique
• Determining the base comparison between
  alternatives
• Using analysis techniques when
• Defender marginal cost can be computed and is
  increasing
• Defender marginal cost can be computed and is not
  increasing
• Defender marginal cost is not available

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• Considering possible future challengers
• After-tax analysis

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Issues to Consider Before Starting

• If a unit fails, must it be removed permanently
  from service, or repaired?
• Are standby units available if the system fails?
• Do components or units fail independently of the
  failure of other components?
• If the unit can be repaired after failure, is
  there a constraint on the capacity of the repair
  facility?

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• Is there a budget constraint?
• Is only one replacement allowed over the planning
  horizon?
• Are subsequent replacements allowed at any time
  during the study period?
• Is there more than one replacement unit (price
  and quality combination) available at a given
  point in time?

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• Do future replacement units differ over time?
• Are technological improvements considered?
• Is preventative maintenance included in the
  model?
• Are periodic operating and maintenance costs
  constant or variable over time?
• Is the planning horizon finite or infinite?

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• Are consequences other than economic effects
  considered? (i.e., socio-technical issues)
• Are income tax consequences considered?
• Is inflation considered?
• Does replacement occur simultaneously with
  retirement, or are there non-zero lead times?
• Are cash flow estimates deterministic or
  stochastic?

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Replacement Analysis Decision Chart
Analysis Techniques
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What Is the Basic Comparison?

• Identify the defender and the best challenger
• Product, Machine, Process, Personnel, Mix
• Decision criteria lead to one of the following
• If the defender is more economical, it should be
  retained.
• If the challenger is more economical, it should
  be installed.

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Minimum Cost Life of the Challenger

• The period of time (years) which minimizes the
  EUAW of ownership
• Usually shorter than either physical or useful
  life because of increasing operating and
  maintenance costs as asset ages
• For defender/challenger comparisons, select the
  challenger (if more than one challenger) with the
  lowest minimum cost of life

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• Calculate the challengers EUAC for all periods
  of ownership useful life
• Select minimum EUAC

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• EUAC Equivalent Uniform Annual Cost

EUAC is the number of years at which asset cost
is minimized This example 4 years
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Example 13-12
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Marginal Costs

• The cost for any year of ownership of the
  defender which can include
• Capital recovery (interest income and market
  value losses)
• Operating and maintenance
• Taxes and insurance
• Questions about defender
• Data available and marginal cost (MC) increasing
• Data available and MC decreasing
• Data not available

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• Marginal costs are the year-by-year costs for
  keeping an asset.
• The following example illustrates the calculation
  of the marginal costs for a new item.

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Example 13-12
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Marginal Cost Data Defender

• The marginal costs are increasing.

Example 13-13
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Replacement AnalysisTechnique 1

• This technique used only when defenders MC is
  increasing.
• Replace defender when its marginal cost of
  ownership is more than the EUAC (minimum cost
  life) of the challenger.

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• Defendermarginalcosts areincreasing.

Example 13-4
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• Appropriate when replacement repeatability
  assumptions hold.
• The best challenger will be available in all
  subsequent years at the same economic cost.
• The period of needed service is infinite.

These assumptions appear to be rather restrictive.
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Relaxing the Restrictions

• This spreadsheet considers that
• The best challenger is available in subsequent
  years at the same economic cost.
• The project life is known and limited.

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Minimum Cost Life of theDefender

• Depends on when in the life of the defender the
  analysis is computed.

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Example 13-7
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Replacement AnalysisTechnique 2

• If the replacement repeatability assumption
  holds, compare EUAC of the defender asset at its
  minimum cost life against the EUAC of the
  challenger at its minimum cost life.

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• The repeatability assumptions do not hold.

Example 13-8
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Replacement AnalysisTechnique 3

• Defender marginal cost data not available
• Compare the EUAC of the defender over its stated
  life against the minimum EUAC of the challenger
• In the spreadsheet below (click the icon), the
  defining defender and challenger first costs can
  be an issue.
• Trade-in value is not a suitable value.
• Appropriate value is the market value.

Example 13-9
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Repeatability Assumptions Not Acceptable

• Study period instead of indefinite need for the
  asset
• Business wound up
• Existing production equipment inadequate to make
  new product
• Study period could be set equal to or within the
  lives of the defender or the challenger
• Decision on study period must be based on methods
  discussed earlier

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Technique 1 Incorrect Decision
Replacing the defender NOW per replacement rule 1
would not achieve a min EUAC over 5 years.
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Defender and ChallengerFirst Costs

• Dollar amounts relating to laptop
• Original cost 1600 two years ago
• Present cost 995
• Book value 800
• Trade-in value 350
• Market value 200

Relevant Cost
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Future Challengers

• Technology may generate future challengers than
  are better than current challengers (lower costs,
  higher benefits)
• How will this affect the switching decision today
  between current challengers and the defender?

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• Should the defender be kept (and the current
  challenger rejected) until a more efficient
  future challenger is available?
• Risky to select current challenger if
• Costs are high
• Current challenger has a long life (5-10 years)

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After Tax Replacement Analysis

• Adds expanded perspective as changes occur in
• Remaining economic life of defender
• Economic life of challenger
• Defender vs. Challenger comparisons
• Affected by
• Depreciation
• Assets market value over time

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After Tax Marginal Cost

• Before-tax marginal cost
• Annual loss in market value
• Annual foregone Interest
• Annual operating and maintenance cost
• After-tax marginal cost
• Loss in after-tax market value
• Foregone interest
• Tax credit from CCA deduction

After-tax OM costs (1 - t) x before-tax costs
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• Considers effects of ordinary taxes as well as
  capital gains and losses

Example 13-9
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After-Tax Cash Flows

• Challenger
• Before-tax cash flows are adjusted for
• depreciation
• taxes
• gains and losses at disposal
• Defender
• More complicated
• asset is already in service and its depreciation
  pattern has been based on its historical cost
• Use current market value ? depreciation
  recapturing or losses at disposal

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Assets Marginal Cost Before and After Taxes
Examples 13-2 and 13-10
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Defender Sign ChangeProcedure

• Used in after-tax defender/challenger comparisons
  to find the defenders time, zero ATCF
• Assume that defender is sold now (t 0)
• Find defenders ATCF now
• Change all signs of ATCF components because
  defender is being kept
• This is the defenders after-tax opportunity cost
  at t 0

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Minimum Cost Life Problems

• Minimum EUAC affected by
• depreciation method
• changes in the assets market value over time
• Shape of EUAC curve can be affected causing the
  minimum EUAC to change

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ATCF in Year of Disposal

• Initial cost 100,000
• OM 10,000 in 1st year 4,000 increase each
  year thereafter
• Assets before tax market value 50,000 at end
  of 1st year decreases by 5,000 each year
  thereafter
• CCA rate 40 (DB) Tax rate 30

Example 13-14
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Before- and After-TaxCash Flows
Example 13-12
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ATCF in Year of Disposal
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