REPLACEMENT ANALYSIS

Prof. Mercedes S. Ferrer-Alameda

DEFINITIONS

Defender: Actual Equipment

been evaluated

Challenger: New equipment
meant to be the replacement of the
defender
DEFINITIONS

Marginal Cost: The cost of keeping the defender
for one more year. This cost includes:

Operation & Maintenance (O & M)

Insurance

Capital Recovery Cost (cost of opportunity)

Includes: loss in market value + lost interests
DEFINITIONS

Minimum Cost Life (Economic Life): Number
of years at which the EUAC is minimized. The
minimum cost life is usually shorter that the
useful life due to increasing O & M costs
EXAMPLE #1

An in-used equipment has a current market value of $5000.
For the next 3 years, the market value will be $3000, $1000
and $500 respectively.

A challenger can be purchased for $7500 with no salvage value
at the end of three years. Operating and maintenance costs for
the defender are $1700, $2000 and $2500 for the next three
years. For the challenger, the O & M costs are $500, $ 1100
and $1300. Use MARR = 10%

Determine Marginal Cost of the defender

Costo marginal año 1:

2000 + 2000*(.10) + 1700

Costo marginal año 2

2000 + 2000*(.10) + 2000

Costo marginal año 3

500 + 500*(.10) + 2500
EXAMPLE #2: CALCULATING ECONOMIC
LIFE

The purchase price of a challenger is $15,000.

Determine the economic life at 10%. The
schedule of future operating costs and salvage
values is:

Year 1 2 3 4 5 6
O&M 4500 4800 5700 6900 8400 10200

S 9000 6900 5100 3900 3300 2700

 Annualized Annualized Annualized Capital
Year O&M Costs O&M Costs SV SV Investment ($15,000) EUAC
1 $4,500.00 4500 9000 ($9,000.00) $16,500.00 $12,000.00
2 $4,800.00 $4,642.86 6900 ($3,285.71) $8,642.86 $10,000.00
3 $5,700.00 $4,962.24 5100 ($1,540.79) $6,031.72 $9,453.17
4 $6,900.00 $5,379.77 3900 ($840.34) $4,732.06 $9,271.49
5 $8,400.00 $5,874.47 3300 ($540.53) $3,956.96 $9,290.90
6 $10,200.00 $6,435.09 2700 ($349.94) $3,444.11 $9,529.26
OPPORTUNITY COST APPROACH

Salvage value is considered as an opportunity cost
for keeping the defender. Is a foregone
opportunity…

It only answer the question on whether or not it is
justifiable to replace the defender NOW

Steps:

Identify the planning horizon: Usually taken as the
remaining useful life for the defender

If the planning horizon is finite, identify cash-flow for
both: defender and challenger. Remember to consider
salvage value for the defender as an initial investment

Perform incremental PW analysis
EXAMPLE #3

Evaluate Example 1 assuming three years
planning horizon
Cash Flow Cash Flow
Year Defender Challenger Incremental
0 -$5,000.00 -$7,500.00 -$2,500.00
1 -$1,700.00 -$500.00 $1,200.00
2 -$2,000.00 -$1,100.00 $900.00
3 -$2,500.00 -$1,300.00 $1,200.00

Incremental
PW(12%) $143.04

Incremental analysis results in a

positive PW, the defender should
be replaced NOW
REPLACEMENT STRATEGIES UNDER THE INFINITE
PLANNING HORIZON

Answer the question about WHEN should the

defender be replaced

Steps:

Compute and compare the cost at economic lives for
both: the defender (AECD* ) and the challenger (AECc* )

If AECD* < AECC* , the defender should be kept, at least
until the economic is reached. Otherwise, the defender
should be replaced now

If the defender should be kept, determine when should
it be replaced, after the economic live is finished.

Calculate the marginal cost and compare to the AECC*

If MC< AECC*, keep the defender for one more year

Repeat procedure until MC > AECC*
EXAMPLE #4

A grinder was purchased 3 years ago for $40,000. It
has provided adequate service but an improved
version is now available for $35,000 which will
reduce operating costs and cut inspection expenses.
Costs and salvage values for the two machines are
shown below. Should the replacement be made at a
MARR = 15%?

If the service will be needed for only 4 more years,
will your decision change?
Year Defender Challenger

O&M S O&M S
0 12000 35000
1 3400 7000 200 30000
2 3900 4000 1000 27000
3 4600 2500 1200 24000
4 6500 1000 1500 20000
5 2000 19000
6 2000 18000
 Economic Life Analysis for the Defender

Annualized
Annualized Opportunity Cost
Year O&M Costs O&M Costs SV Annualized SV ($12,000) EUAC
1 $3,400.00 $3,400.00 7000 ($7,000.00) $13,800.00 $10,200.00
2 $3,900.00 $3,883.87 4000 ($1,860.47) $7,381.40 $9,404.80
3 $4,600.00 $4,279.08 2500 ($719.94) $5,255.72 $8,814.86
4 $6,500.00 $4,977.16 1000 ($200.27) $4,203.18 $8,980.08
5
6
 Economic Life Analysis for the Challenger

Annualized Capital
Annualized Investment
Year O&M Costs O&M Costs SV Annualized SV ($35,000) EUAC
1 $200.00 200 30000 ($30,000.00) $40,250.00 $10,450.00
2 $1,000.00 $572.09 27000 ($12,558.14) $21,529.07 $9,543.02
3 $1,200.00 $752.92 24000 ($6,911.45) $15,329.19 $9,170.66
4 $1,500.00 $902.53 20000 ($4,005.31) $12,259.29 $9,156.51
5 $2,000.00 $1,065.30 19000 ($2,818.00) $10,441.04 $8,688.35
6 $2,000.00 $1,172.08 18000 ($2,056.26) $9,248.29 $8,364.11

EUAC at Economic Life for the Challenger is lower

than EUAC at Economic Life for the Defender.
The Defender should be replaced NOW
EXAMPLE #5

Assume defender in example #1 can be replaced
with challenger in example #2. Should the in-
used equipment be replaced now?

Steps:

Planning horizon? – No planning horizon

Calculate cost at Economic Life for the defender
 Economic Life Analysis for the Defender

Annualized
Annualized Annualized Opportunity
Year O&M Costs O&M Costs SV SV Cost ($5,000) EUAC
1 $1,700.00 $1,700.00 3000 $3,000.00 $5,500.00 $10,200.00
2 $2,000.00 $1,842.86 1000 $476.19 $2,880.95 $5,200.00
3 $2,500.00 $2,041.39 500 $151.06 $2,010.57 $4,203.02

Economic Life Analysis for the Challenger

Annualized Annualized Annualized Capital

Year O&M Costs O&M Costs SV SV Investment ($15,000) EUAC
1 $4,500.00 4500 9000 ($9,000.00) $16,500.00 $12,000.00
2 $4,800.00 $4,642.86 6900 ($3,285.71) $8,642.86 $10,000.00
3 $5,700.00 $4,962.24 5100 ($1,540.79) $6,031.72 $9,453.17
4 $6,900.00 $5,379.77 3900 ($840.34) $4,732.06 $9,271.49
5 $8,400.00 $5,874.47 3300 ($540.53) $3,956.96 $9,290.90
6 $10,200.00 $6,435.09 2700 ($349.94) $3,444.11 $9,529.26
OTHER CONSIDERATIONS: TRADE IN

A second challenger competes with the defender in
example 1. This challenger has a purchase price of
$12000, but $6000 is offered for the defender as trade-
in and the seller guarantees that operating costs will
be no more than $800/year, for the first 5 years.

Should the offer be accepted when the required rate of
return is 10% and a salvage value of $2000 at the end
of the challenger’s 5-years economic life?

Use a No-Planning Horizon approach

OTHER CONSIDERATIONS: TRADE IN

The initial investment for the challenger must be
reduced on $1000, that represents the real trade-in
advantage

EUAC (challenger) = (12,000-1000) (A/P, 10%,5)
- $2000 (A/F, 10%, 5) + $800

EUAC(Challenger) = $3,374.18

Challenger should be selected

PRACTICE

Current in-use equipment can be sold in the market for
$5,000, however to keep it in service it will require an
immediate overhaul for $1,200. Operating costs are
estimated in $2,000 for the next year, expected to increase
in $2,500 per year thereafter. Future market values are
expected to decline in $1000 per year

New machine cost $10,000 and will have operating costs of
1,800 on the first year, increasing by $800/year thereafter.
The expected salvage value is $6000 for the first year, and
will decline 15% each year

Using an MARR = 15%, determine when the defender
should be replaced
OTHER CONSIDERATIONS: TAXES

To perform a Replacement-After Tax Analysis,
several considerations are important:

For the defender:

Current opportunity cost will be affected (positively or
negatively) by the gains or losses at the selling transaction

If the in-used machine is sold by a value under the current
book-value, a loss may be claim, resulting in tax savings (a
benefit). This will have the effect of reducing the
Opportunity Cost

If the in-used machine is sold by a value over the current
book-value, a loss may be claim, resulting in additional tax
expense. This will have the effect of increasing the
Opportunity Cost

Perform an After-Tax cash flow including the above
considerations:
EXAMPLE #6

Machintosh Printing, Inc., purchased a $20,000 printing
machine two years ago. The company expected this
machine to have five-year useful life and salvage value of
$5000. The company spent $5000 last year on repairs, and
current operating costs are running at a rate of $8000/yr.
Furthermore, the anticipated salvage value has been
reduced to $2500 at the end of the remaining useful life. In
addition, the company has found that the current machine
has a market value of $10,000 today.

Suppose that initial $20,000 in capital expenditure was
setup to be depreciated using seven-years MACRS. If the
company’s marginal income tax rate is 40%, determine the
after-tax cash flow, assumig you keep the defender

Calculate Opportunity Cost: Benefit losses if the
defender in kept

Current selling price + Tax impact

Current market value: $10,000

Tax savings or tax expenses on disposal

Determine taxable income or loss from disposal

Selling price – Book Value

Book value: Initial investment – up to date depreciation

$20,000 – ($2858 + 4898/2) = $14,693

Depreciation for second year was divided by two because

MACRS requires the assumption that ALL
TRANSACTIONS occur at the mid of the year