Kathmandu University

Engineering Economy MGTS 301

Chapter-9
Replacement Analysis
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The objective of Chapter 9 is to address

the question of whether a currently owned
asset should be kept in service or
immediately replaced.
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Introduction
- Problem often faced by management: whether to buy new &
more efficient equipment or to continue to use existing
equipment.
- Failure to make such decision at appropriate time may result
in slowdown or shutdown of operations.
- This class of decision problems come under the category of
replacement problems.
- Knowledge of basic concepts & technologies related to
replacement analysis, hence is important.
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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
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Reasons for Replacement Analysis

1) Physical impairement of assets: Ageing of assets becoming less efficient

2) Altered requirement: When goods or services either increase or decrease
or change replacement analysis should be required.
3) Technology change: Obsolescence
4) Financing change: Rent become attractive than ownership
5) Depletion: Gradual loss in market value of asset
6) Inadequacy: The equipment doesn’t have sufficient capacity to meet the
present demands
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Factors that Must be considered in Replacement Studies.

1. Recognition and acceptance of past 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.
2. 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.
3. 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
 Terminologies

1) Defender and Challenger:

There are the names of two mutually exclusive alternatives. The defender is the currently
installed asset and challenger is the potential replacement asset.

Challenger Defender

Any Assets will have following cost components

i) Capital Recovery Cost – Earning back of the initial funds

ii) Average operating $ Maintenance cost
iii) Total cost
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Methods of Estimation of Cash Flow.

1. Alternative life > Study Period
• Use of implied salvage value
• Assume C/F for the deficit period (of alternative with shorter
life)
2. Alternative life ≤ Study Period
• All C/F are assumed to be reinvested until end of study period.
• FW criterion may be used & FW(i) for alternative with shorter
life has to be calculated for study period.
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Implied Salvage Value.

• It is unused capital cost of equipment or investment
alternatives at a point of time prior to its complete service
life.
• AE (i) over full service = AE(i) over study period.
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Example

Cost of equipment=$15,000, Salvage value at the end of

year=$3,000, useful life of the equipment (n) = 5 years,
MARR=12%, study period of equipment (n*)=3 years.
 $3,000

Fn*=?

0
1 2 3 4 5

$15,000

AE (i) over full service = AE(i) over study period.

$15,000 (𝐴/𝑃, 12%, 5)-$3000 (A/F, 12%, 5) = $15,000 (𝐴/𝑃, 12%, 3)- Fn* (A/F, 12%, 3)

$15,000 × 0.2774-$3000 ×0.1574 = $15,000 ×0.4163- Fn* × 0.2963

𝐹𝑛 = $8626
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Investment cost of the Defender (Existing Asset) University

The purchase price of certain new automobile (challenger) being

considered for use in your business is $21,000. Your firm’s present
automobile (defender) can be sold on the open market for $10,000. The
defender was purchased with cash three years ago, and its current BV is
$12,000. To make the defender comparable in continued service to the
challenger, your firm would need to make some repairs at an estimated
cost of $1,500.
Based on above information,
a. What is the total capital investment in the defender, using the outsider
viewpoint?
b. What is unamortized value of the defender?
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Replacement Analysis Using PW (before taxes)

A firm owns a pressure vessel that it is contemplating replacing. The
old pressure vessel has annual operating and maintenance expenses of
$60,000 per year and it can be kept for 5 years more, at which time it
will have zero MV. It is believed that $30,000 could be obtained for the
old pressure vessel if it were sold now.
A new pressure vessel can be purchased for $120,000. The new
pressure vessel will have an MV of $50,000 in 5 years and will have
annual operating and maintenance expenses of $30,000 per year. Using
a before tax MARR of 20%, determine whether or not the old pressure
vessel should be replaced. A study period of 5 years is appropriate.
 Replacement Analysis Using EUAC (before taxes)

The manager of a carpet manufacturing plant became concerned about the operation
of a critical pump in one of the processes. After discussing this situation with the
supervisor of plant engineering, they decided that a replacement study should be
done, and that a nine year study period would be appropriate for this situation. The
company that owns the plant is using a before tax MARR of 10% for its capital
investment projects.
The existing pump, Pump A, including driving motor with integrated
controls, cost $17,000 five years ago. An estimated MV of $750 could be obtained
for the pump if it were sold now. Some reliability problems have been experienced
with Pump A, including annual replacement of the impeller and bearing at a cost
$1,750.
Annual operating and maintenance expenses have been averaging $3,250. Annual
insurance and property tax expenses are 2% of the initial capital investment. It
appears that the pump will provide adequate service for another 9 years if the present
maintenance and repair practice is continued. It is estimated that if this pump is
continued in service, its final MV after nine more years will be about $200.
An alternative to keeping the existing pump in service is to sell it
immediately and to purchase a replacement pump, Pump B, for $16,000. An
estimated MV at the end of nine years study period would be 20% of the initial
capital investment. Operating and maintenance expenses for the new pump are
estimated to be $3,000 per year. Annual taxes and insurance would total 2% of the
initial investment.
Based on these data, should the defender (Pump A) be kept, or should the challenger
be purchased now?
Summary of Information
Existing Pump A (defender)
Capital Investment when purchase 5 years ago $17,000
Annual expenses:
Replacement of impeller and bearings 1,750
Operating & maintenance 3,250
Taxes & insurance: $17,000× 2% 340
Total annual expenses $5,340
Present MV $750
Estimated MV at the end of 9 additional years $200
Replacement Pump B (challenger)
Capital investment $16,000
Annual expenses:
Operating and maintenance $3,000
Taxes and insurance: $16,000 × 2% 320
Total annual expenses 3,320
Estimated MV at the end of nine years: $16000 × 20% 3,200
 Solution 1) 𝐶𝑅 𝑖% = 𝐼(𝐴Τ𝑃, 𝑖%, 𝑁) − 𝑆(𝐴Τ𝐹, 𝑖%, 𝑁)

Defender 2) 𝐶𝑅 𝑖% = (𝐼 − 𝑆)(𝐴Τ𝐹, 𝑖%, 𝑁) + 𝐼(𝑖%)

𝐸𝑈𝐴𝐶 10% = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 + 𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑋𝑝𝑒𝑛𝑠𝑒𝑠
𝑬𝑼𝑨𝑪 𝟏𝟎% = 𝟏𝟏𝟓. 𝟓𝟒 + 𝟓, 𝟑𝟒𝟎 𝐶𝑅 𝑖% = (𝐼 − 𝑆)(𝐴Τ𝑃, 𝑖%, 𝑁) + 𝑆(𝑖%)
𝐸𝑈𝐴𝐶 10% = 5455.54
𝐶𝑅 10% = (750 − 200) × 0.1736 + 200(0.1%)

𝐶𝑅 10% = 115.54

Challenger
𝐶𝑅 𝑖% = (𝐼 − 𝑆)(𝐴Τ𝑃, 𝑖%, 𝑁) + 𝑆(𝑖%)
𝐸𝑈𝐴𝐶 10% = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 + 𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑋𝑝𝑒𝑛𝑠𝑒𝑠
𝑬𝑼𝑨𝑪 𝟏𝟎% = 𝟐𝟓𝟒𝟐. 𝟎𝟖 + 𝟑, 𝟑𝟐𝟎 𝐶𝑅 10% = (16,000 − 3,200) × 0.1736 + 3,200(0.1%)
𝐸𝑈𝐴𝐶 10% = 5862.08
𝐶𝑅 10% = 2542.08
 Pause and Solve
A manufacturer produces an engine assembly consisting of Cylinder and Piston. Each part is
machined on a old lathe which was purchased 8 years ago for $400,000. It can work for another
2 years after which its SV is to be estimated to be $12,500. A new lathe is offered as a
replacement of old one. The machinery time on present & new lathe for 100 units of engine
assembly are:
Part Old lathe New lathe
Cylinder 2.92 hrs 2.39 hrs
Piston 1.84 hrs 1.45 hrs

The company sells 40,000 units of engine assembly every year. Machine Operator is paid $850
per hour. New lathe is purchased at $1,250,000 & SV after its estimated life of 10 years is
$125,000. On purchasing new lathe, old lathe is offered to be taken back by the Salesman for
$60,000 at 15% rate of interest, justify the replacement.
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Pause and Solve

Machine P was purchased by a company 4 years ago for
$220,000 with estimated life of 10 years & SV of $20,000 at the
end of its life. Operating cost on machine is $70,000 per year.
Presently a salesman has offered new machine Q for $240,000
with estimated life of 10 years, operating cost of $40,000 per
year & SV of $30,000 at the end of its life. On purchasing new
machine, supplier will take the old machine for $60,000. If
MARR=15%, whether the machine should be replaced. (assume
after 6 years, machine P will be replaced by identical machine to
Q)
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Proper Analysis Requires Knowing the Economic Life

(minimum EUAC) of the Alternatives.
• It is a question many times that how long a machine should be
used.
• Economic life of an assets is time interval that minimizes assets
total EUAC and maximizes its equivalent net income.
• 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.
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Capital cost Average Annual

Exp.
10,000 1000
5000 1500
2500 3000
 Determination of Economic Life of an Asset
Any asset will have the following cost components:
Capital recovery cost (average first cost), computed from the first cost (purchase price) of the machine.
Average operating and maintenance cost (O & M cost)
Total cost which is the sum of capital recovery cost (average first cost) and average maintenance cost.
Capital Recovery cost
Capital recovery cost has two components. (i) Initial cost or first cost (ii) Salvage value at the time of
disposal. Generally, a machine becomes older; its salvage value becomes smaller. When the salvage value
becomes less than the initial cost, the capital recovery cost is a decreasing function of the life of the
machine.
Operating cost
Operating cost of a machine includes the following cost. (i) Operating cost (ii) Maintenance cost (iii)
Labour cost (iv) Material cost (v) Energy consumption cost etc. Generally operating cost or annual
equivalent operating cost of asset is increasing with its age.
Total cost
Total cost or annual equivalent cost of an asset is the summation of capital recovery cost of the asset
and the annual equivalent operating cost of the asset.

The economic service life of an asset is defined to be the useful life period that minimizes the annual
equivalent of purchasing and operating the asset.
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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)
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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:

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𝐴𝐸1 10% = 𝐼 − 𝑆 (𝐴/𝑃, 10%, 1)+S(10%)+Annual Exp. University

Economic Life of the Assets

A new forklift truck will require an investment of $30,000 and is
expected to have year end MVs and annual expenses are shown below
in table. If the before tax MARR is 10% per year, how long should the
asset be retained in service?
EOY MV, End of year k Annual Expenses (Ek)
0 $30,000 -
1 22,500 $3,000
2 16,875 4,500
3 12,750 7,000
4 9,750 10,000
5 7,125 13,000
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Economic Life of a Laptop Computer

Determine the economic life of the $800 laptop computer. Annual
expenses and year end re-sale values are expected to be the following

EOY Resale value at EOY Software upgrades and

maintenance
1 $600 $150
2 450 200
3 200 300