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ENS191 Chapter 9 Replacement Studies

This document provides information about replacement studies from two chapters: 1. It discusses the major reasons for replacing an existing asset including physical impairment, inadequacy, obsolescence, and rental/lease possibilities. 2. It defines important terms used in replacement analysis like economic life, ownership life, physical life, and useful life. 3. It notes that replacement studies should only consider present and future cash flows and not sunk costs from past decisions, with the exception of income tax implications.

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Karl Pepon Ayala
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1K views15 pages

ENS191 Chapter 9 Replacement Studies

This document provides information about replacement studies from two chapters: 1. It discusses the major reasons for replacing an existing asset including physical impairment, inadequacy, obsolescence, and rental/lease possibilities. 2. It defines important terms used in replacement analysis like economic life, ownership life, physical life, and useful life. 3. It notes that replacement studies should only consider present and future cash flows and not sunk costs from past decisions, with the exception of income tax implications.

Uploaded by

Karl Pepon Ayala
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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ENS191: Engineering Economy

Replacement Studies
Chapter 9 (Sta. Maria)
Replacement Analysis
Chapter 9 (Sullivan)

Engr. Adrian Keith R. Caamiño


Engr. Maria Cristina P. Vegafria, PhD
College of Engineering & Technology
MSU-Iligan Institute of Technology
Replacement Studies

Should a currently owned asset be kept in


service or immediately replaced?

Chapter 9 Replacement Studies


What to do with an existing asset?

1. Keep it
2. Abandon it
3. Replace it, but keep it for backup purposes
4. Augment the capacity of the asset
5. Dispose of it, and replace it with another

Chapter 9 Replacement Studies


Major Reasons for Replacement
1. Physical Impairment (Deterioration)
➢ The existing asset is completely or partially worn out and will no
longer function satisfactorily without extensive repairs

2. Inadequacy
➢ The existing asset does not have sufficient capacity to meet the
present demands that are placed on it

Chapter 9 Replacement Studies


Major Reasons for Replacement
3. Obsolescence
➢ This may be caused either by lessening in the demand for the
service rendered by the asset or the availability of more efficient
assets which will operate with lower out-of-pocket costs
➢ A new and improved technology is now available

2. Rental or Lease Possibilities


➢ It is possible to rent identical or comparable asset or property,
thus freeing capital for other and more profitable use.

Chapter 9 Replacement Studies


Sunk Cost Due to Unamortized Value

Unamortized Value of an Equipment or Property


➢ The difference between its book value and its resale value when
replaced
➢ Should be considered as a sunk cost or a loss.

Chapter 9 Replacement Studies


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
➢ The 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)
Chapter 9 Replacement Studies
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.

Chapter 9 Replacement Studies


Replacement: Watch Our for the Sunk-Cost Trap
➢ Only the 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
book value and market value at a particular point in time – have
no relevance except to the extent they affect income taxes.

Chapter 9 Replacement Studies


Replacement: The Outsider Viewpoint
Outsider Viewpoint
➢ The perspective taken by an impartial third party to establish the
fair market value of the defender
➢ Also called the opportunity cost approach

Opportunity Cost
➢ 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 market value.

Chapter 9 Replacement Studies


Replacement: Economic Lives of the Challenger and Defender
➢ The economic life of the challenger minimizes the equivalent
uniform annual cost (EUAC)
➢ The economic life of the defender is often one year, so 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 then the minimum EUAC
of the challenger over it’s economic life.

Chapter 9 Replacement Studies


Replacement: Income Taxes

➢ Replacement often results in gains or losses from the sale of


depreciable property
➢ Studies must be made on an after-tax basis for an accurate
economic analysis since this can have a considerable effect on
the resulting decision

Chapter 9 Replacement Studies


Before-Tax PW Example
Example 1 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?

Solution: 0 1 2 3 4
For the Defender
𝑃𝑊𝐷 = −$25,000 − $50,000(𝑃/𝐴, 15%, 4) $50k $50k $50k $50k
= −$𝟏𝟔𝟕, 𝟕𝟒𝟗 $50k(P/A,15%,4)
$25,000 (outsider viewpoint)
For the Challenger – New CNC Machine
𝑃𝑊𝐶 = −$90,000 − $35,000(𝑃/𝐴, 15%, 4) + $45,000(𝑃/𝐹, 15%, 4) $45k

= −$𝟏𝟔𝟒, 𝟏𝟗𝟓 $45k(P/F,15%,4)


0 1 2 3 4
Since PWC > PWD (but it is close), the old CNC
machine can be replaced. $35k $35k $35k $35k
$35k(P/A,15%,4)
Chapter 9 Replacement Studies $90,000
Example 2 Solution:
A decision must be made whether to replace a For the Reconditioned Engine
certain engine with a new one, or to rebore the Annual Costs:
cylinder of the old engine and thoroughly ₱2 8 ,000 ₱2 8 ,000
Depreciation = = ₱4,071
reconditioning it. 𝐹/𝐴,16%,5 6.877

The original cost of the old engine 10 years ago was Fuel and Lubricants 20,000
₱70,000; to rebore and recondition it now will cost Repairs (Excess) 2,500
₱28,000, but would extend its useful life for 5 years. Interest on Capital = (₱28,000)(0.16) 4,480
A new engine will have a first cost of ₱62,000 and Total Annual Cost, ACRE ₱31,051
will have an estimated life of 10 years. It is expected
that the annual cost of fuel and lubricants with the For the New Engine
reconditioned engine will be about ₱20,000 and that
₱6 2 ,000 ₱6 2 ,000
this cost will be 15% less with the new engine. It is Depreciation = = ₱2,908
𝐹/𝐴,16%,10 21.32
also believed that repairs will be ₱2,500 a year less
with the new engine than with the reconditioned one. Fuel and Lubricants = ₱20,000 (0.85) 17,000
Interest on Capital = ₱62,000(0.16) 9,920
Assume that neither engine has any realizable value
when retires. If the money if worth 16%, what would Total Annual Cost, ACNE ₱29,828
you recommend?
Since ACNE < ACRE, the old engine should be replaced.
Chapter 9 Replacement Studies
Solution:
For the Augmentation Annual Costs:
Old Unit
Example 3 ₱2 6 ,000−₱8 1 ,000(0.12) ₱1 6 ,280 ₱1,639
Depreciation = =
𝐹/𝐴,20%,6 9.9299
Four years ago, an ore-crushing unit was installed at a
Operation 3,540
mine which cost ₱81,000. Annual operating costs for
this unit are ₱3,540. This unit was estimated to have a Taxes & insurance = (₱81,000)(0.025) 2,025
life of 10 years. The quantity or ore to be handled is to New Small Unit
be doubled and is expected to continue at this higher Depreciation =
₱7 5 ,000−₱7 5 ,000(0.12) ₱6 6 ,000
= ₱6,647
rate for at least 10 years. A unit that will handle the 𝐹/𝐴,20%,6 9.9299

same quantity of ore and have the same operating Operation 3,540
costs as the one now in service can be installed for Taxes & insurance = (₱75,000)(0.025) 1,875
₱75,000. This unit will have a useful life of 6 years.
Total Annual Cost ₱19,266
A unit with double the capacity of the one now in use For the Replacement
can be installed for ₱112,000. Its life is estimated at 6 New Big Unit
years and its annual operating costs are estimated at ₱1 1 2 ,000−₱1 1 2 ,000(0.12) ₱9 8 ,560 ₱9,926
Depreciation = =
₱4,950. The present realizable value of the unit now in 𝐹/𝐴,20%,6 9.9299

use is ₱26,000. Operation 4,950


All units under consideration will have an estimated Taxes & insurance = (₱112,000)(0.025) 2,800
salvage value at retirement age of 12% of the original Total Annual Cost ₱17,676
cost. Interest rate is 20%. Annual taxes and insurance 𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠
are 2.5% of the original cost. 𝑅𝑜𝑅 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
𝑎𝑑𝑑𝑖𝑡𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
What would you recommend? ₱1 9 ,266−₱1 7 ,676 ₱1 ,590
= = 𝑥100 = 𝟏𝟒. 𝟓%
₱1 1 2 ,000−₱7 5 ,000−₱2 6 ,000 ₱1 1 ,000

Chapter 9 Replacement Studies Since 14.5% < 20%, buy the new small unit to augment the old unit.

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