Chapter 9 Replacement Analysis

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Chapter 9Replacement Analysis
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Replacement Analysis

• Should the existing equipment be retained or
  replaced?
• The Defender is the existing equipment.
• The Challenger is the best available
  replacement equipment.
• If the defender proves more economical, it will
  be retained. If the challenger proves more
  economical, it will be installed.

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The Replacement Problem

• Obsolescence occurs when an assets technology is
  surpassed by newer and/or different technologies
  (PC)
• Depletion is the gradual loss of market value of
  an asset as it is being consumed or exhausted
  (Oil well, Timber)
• Deterioration is the general loss in value of an
  asset due to aging process (Production machinery)

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The Replacement Problem

• Planned replacements can be scheduled to minimize
  the time and cost of disruptions.
• Variations of replacement problems, such as
  abandonment, retirement, improvements of defender
  or keeping defender as spare, can be considered
  as potential new challenger.
• Since replacement problems usually are considered
  with fixed output, only costs of defender and
  challengers are analyzed.
• Due to the lives of the defender and challengers
  are usually different, most calculations focus on
  annual marginal costs or on EUAC.

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Replacement Analysis Decision Map
Identify Alternatives
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Minimum Cost Life of a New Asset

• The minimum cost life of any new asset is the
  number of years at which the EUAC of ownership is
  minimized.
• Because of increasing operating and maintenance
  costs, the minimum cost life is often shorter
  than the assets useful life.
• EUAC for each possible life, less than or equal
  to the useful life, is determined. The number of
  years at which the EUAC is minimum can then be
  identified.

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Example 9AMinimum Cost Life of a New Asset
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Example 9AMinimum Cost Life of a New Asset
Total EUAC
OM
Capital Recovery
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Replacement Analysis Decision Map
Identify Alternatives
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Defenders Marginal Cost Data

• Are the Defender marginal cost data available?
• Are the Defender marginal cost increasing?
• The total marginal cost for any year can include
• Capital Recovery Cost (loss in market value and
  loss interest for the year)
• Yearly operating and maintenance costs
• Yearly taxes and insurance
• Any other expenses that occurs during that year
• The marginal cost is calculated as an equivalent
  end-of-year cash flow

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Example 9B Marginal Cost Calculation
Capital Recovery Cost MVN-1(A/P, 15, 1)
MVN(A/F, 15, 1) MVN-1(115) MVN(1)
(MVN-1 MVN) MVN-1(15)
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Example 9C Marginal Cost Calculation
Capital Recovery Cost MVN-1(A/P, 15, 1)
MVN(A/F, 15, 1) MVN-1(115) MVN(1)
(MVN-1 MVN) MVN-1(15)
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Replacement Analysis Technique 1Defender
Marginal Cost Increasing

• Maintain the Defender as long as the marginal
  cost of ownership for one more year is less than
  the Challengers minimum EUAC.
• When the Defenders marginal cost becomes greater
  than the Challengers minimum EUAC, then replace
  the Defender with the Challenger.

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Example 9D Replacement Analysis Technique 1
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Replacement Repeatability Assumption

• Currently available best Challenger will continue
  to be available in subsequent years and will be
  unchanged in its economic costs. When the
  Defender is ultimately replaced, it will be
  replaced with this Challenger.
• The period of needed services of the asset is
  indefinitely long.

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Replacement Analysis Technique 2Defender
Marginal Cost Not Increasing

• Calculate the Defenders minimum EUAC.
• If the Defenders minimum EUAC exceeds the
  Challengers minimum EUAC, then replace
  immediately.
• If the Defenders minimum EUAC is lower than the
  Challengers minimum EUAC, then the Defender will
  be kept at least the minimum cost life.
• After the minimum cost life, then replace when
  the Defenders increasing marginal cost exceeds
  the Challengers minimum EUAC.

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Example 9E Replacement Analysis Technique 2
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Example 9FFinding Minimum Cost Life
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Example 9G Replacement Analysis Technique 2
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Replacement Analysis Technique 3Defender
Marginal Cost Not Available

• Calculate the Defenders EUAC over its stated
  useful life.
• If the Defenders EUAC exceeds the Challengers
  minimum EUAC, then replace immediately.
• If the Defenders EUAC is lower than the
  Challengers minimum EUAC, then the Defender will
  be kept.

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Defining First Costs of Defender and Challenger

• Present market value, not the trade-in value,
  should be assigned as the first cost of the
  Defender.
• The first cost of the Challenger should include
  the purchase price, sales tax, installation cost,
  and other items that occur initially on a
  one-time basis if the Challenger is selected.
• The Defenders potential market (or salvage)
  value should not be subtracted from the
  Challengers first cost.

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Example 9H Defining Defender First Cost

• Defender SK-30, purchased 2 years ago for 1600,
  was depreciated with SL using 4-year life and 0
  salvage.
• Challenger EL-40, 1200 with a trade-in
  allowance of 350 for the SK-30 1050 without a
  trade-in.
• Current price for new SK-30 is 995.

• Defender SK-30,
• Original cost 1600 (Basis for SL depreciation)
• Present cost 995 (Irrelevant)
• Book value 800 (Useful in determining
  depreciation
• recapture or loss)
• Trade-in value 350 (Irrelevant)
• Market value 200 (First cost assigned to
  Defender)

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Repeatability Assumption Not Acceptable

• Circumstances that Repeatability Assumption may
  not apply
• When there is a specific study period instead of
  an indefinite need for the asset
• When future Challengers are not assumed to be
  identical to the current best Challenger

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A Closer Look at Future Challengers

• It seems likely that future challengers will be
  better than the present Challenger
• The prospect of better future challengers may
  make it more desirable to retain the Defender and
  to reject the present Challenger
• Selecting the current best Challenger could be
  risky if 1) high cost and/or 2) long economic
  life

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After-Tax Replacement Analysis

• Ordinary taxes
• Gains and losses due to asset disposal

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Example 9IMarginal Costs on After-Tax Basis
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Example 9IMarginal Costs on After-Tax Basis
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Example 9JAfter-tax Minimum Cost Life
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Example 9JAfter-tax Minimum Cost Life
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Example 9KBefore-tax Minimum Cost Life
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Example 9KBefore-tax Minimum Cost Life