Chapter 14 PDF

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park.
ISBN: 0-13-611848-8
2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
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Chapter 14 Replacement Decisions

Sunk Costs, Opportunity Costs, and Cash Flows
14.1
(a) Sunk cost = $12,000- $2,000 = $10,000.
(b) Opportunity cost = $2,000.
(c) PW (15%) D = $2, 000 + $10, 000( P / A,15%,3)
= $24,832
PW (15%)C = $15,000 + $3,000( P / A,15%,3) $5,000( P / F ,15%,3)
= $18,562
The net incremental benefit in present value is $6,270 associated with
replacing the old machine tools at an interest rate of 15%.
14.2
(a) Purchase cost = $15,000, market value = $6,000,
sunk cost = $15,000 - $6,000 = $9,000
(b) Opportunity cost = $6,000
(c)
PW (15%) = $6, 000 $1,500 $3, 000( P / F ,15%,1)

($3,500 $3, 000)( P / F ,15%, 2)
= $10, 486.77
AEC (15%) = $10, 486.77( A / P,15%, 2)
= $6, 450.58
(d)
PW (15%) = $7,500 $3, 000( P / F ,15%,1) $3,500( P / F ,15%, 2)

$3,800( P / F ,15%,3) $4,500( P / F ,15%, 4)
$9,800( P / F ,15%,5)
= $22, 698.98
AEC (15%) = $22, 698.98( A / P,15%,5)
= $6, 771.46
Page | 1
Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

14.3
(a) Opportunity cost = $30,000
(b) Assume that the old machines operating cost is $30,000 per year. Then the
new machines operating cost is zero per year. The cash flows associated with
retaining the defender for two more years are
n
Cash Flows: -$30,000 -$30,000 -$18,000
AECD = ($30, 000 $12, 000)( A / P,12%, 2) + $12, 000(0.12)

+$30, 000
= $42, 090.57
(c) Cash flows for the challenger:
Year 0: -$165,000; Years 1-7: 0; Year 8: $5,000
AECC = ($165, 000 $5, 000)( A / P,12%,8) + $5, 000(0.12)
= $32,808.45
(d) Since AECD > AECC , we should replace the defender now.
14.4
(a) Initial cash outlay for the new machine = $120,000
(b) Cash flows for the defender: Year 0: -$10,000 Years 1-5: 0
(c)
AEC (15%) D = $10, 000( A / P,15%,5) = $2,983
AEC (15%)C = [ ($120, 000 $30, 000)( A / P,15%, 7) + $30, 000(0.15)]
$50, 000
= $23,868
We should purchase the new machine because it has a higher annual
equivalent cash flow.
14.5
(a) Cash flows
Year:
0
Defender -$10K
Challenger -$75K
1
0
$30K
2
0
$30K
3
0
$30K
4
0
$30K
5
$5K
$30K
Page | 2

(b)
PW (15%) D = $10K + $5K( P / F,15%,5) = $7,514
PW (15%)C = $75K + $30K(P / A,15%,5) = $25,565
Replace the defender
14.6
(a) and (b) Cash flows:
Year:
0
1
2
3
4
5
Defender -$5,500 $21,000 $21,000 $22,200
Challenger -$36,500 $24,000 $24,000 $24,000 $24,000 $30,300
Revenue for defender = ($19 - $12) 3,000 = $21,000 per year

Revenue for challenger = ($19 - $11) 3,000 = $24,000 per year
(c)
AED (12%) = [($5,500 $1, 200)( A / P,12%,3) + $1, 200(0.12)]+ $21, 000
= $19, 065.70
AEC (12%) = [($36,500 $6,300)( A / P,12%,5) + $6,300(0.12)]+ $24, 000
= $14,866.23
New equipment should not be acquired now because it has a lower AE value.
Economic Service Life

14.7
Annual changes in MV
Interest rate
n
Market Value
0
1
2
3
4
5
6
7
8
$200,000
$130,000
$104,000
$83,200
$66,560
$53,248
$42,598
$34,079
$27,263
20%
12%
O&M Costs CR(12%)
$20,000
$20,000
$20,000
$20,000
$20,000
$22,000
$25,000
$28,000
$94,000
$69,283
$58,614
$51,920
$47,100
$43,396
$40,446
$38,044
OC(12%)
AEC(12%)
$20,000
$20,000
$20,000
$20,000
$20,000
$20,246
$20,718
$21,310
$114,000
$89,283
$78,614
$71,920
$67,100
$63,642
$61,163
$59,354
Page | 3

The economic life of the asset is eight years; that is,

N * = 8 years. Thus, AEC * = $59,354
14.8
(a) Interest i = 12% Defender:
Year
0
1
2
3
4
OC
MV
$7, 700
AEOC
$3, 200 $4,300 $3, 200

$3, 700 $3,300 $3, 436
$4,800 $1,100 $3,840
$5,850
0
$4, 261
CR(12%) Total AE(12%)

$4,324
$2,999
$2,880
$2,535
$7,524
$6, 435
$6, 720
$6, 796
The defenders remaining useful (economic) life is 2 more years with an AEC
value of $6,435, i.e., N D = 2, AECD = $6, 435 .
(b) N C = 10 years
AECC = $31, 000( A / P,12%,10) + $1, 000 $2,500( A / F ,12%,10)
= $6,344
Since AECD > AECC , the defender should be replaced now.
14.9
(a) Economic service life = 4 years:
Year
OR
MV
AE OR CR(12%) Total AE
0
$8,000
1
$4,000 $4,200 $4,000 $4,760
-$760
2
$3,400 $2,940 $3,717 $3,347
$370
3
$2,710 $2,058 $3,419
$2,721
$698
4
$1,917 $1,411 $3,104 $2,332
$772
5
$1,004 $1,008 $2,774
$2,061
$713
When N = 4, we have the largest AE value. The economic life of the
system is 4 years. (Note that we want to maximize our operating revenue.)
Page | 4

(b) The economic service life varies with the interest rate:
Interest rate Economic service life Maximum annual revenue
1%
3 years
$1,333
5%
4 years
$1,127
10%
4 years
$876
15%
4 years
$613
20%
4 years
$341
25%
30%
5 years
5 years
$77
-$191
40%
6 years
-$760
Maximize annual revenue at its economic service life varies inversely with
the interest rate.
Economic service life increases as the interest rate increases in our
example. As the interest rate increases, the capital cost will also increase.
However, the annual equivalent revenue will decrease. Thus, the net
effect is that the marginal increase in the capital cost is less than the
decrease in the annual equivalent revenue, resulting in extending the
service life.
14.10
(a) Interest i = 10%
n
OC
MV
AE OC
CR(10%)
AEC(10%)
$15,000
1
2
3
$2,500
$3, 200
$5,300
$12,800
$8,100
$5, 200
$2,500
$2,833
$3,579
$3,700
$4,786
$4, 461
$6, 200
$7,619
$8,039
4
5
$6,500
$7,800
$3,500
0
$4, 208
$4,796
$3,978
$3,957
$8,186
$8,753
MV
AE OC
CR(10%)
AEC(10%)
(b) Interest i = 15%

n
OC
$15,000
$2,500
$12,800
$2,500
$4, 450
$6,950
2
3
$3, 200
$5, 300
$8,100
$5, 200
$2,826
$3,538
$5, 459
$5, 072
$8, 285
$8,610
$6,500
$3,500
$4,131
$4,553
$8,684
$7,800
$4,675
$4, 475
$9,150
In both cases, the economic service life is 1 year.
Page | 5

Replacement Decision with an Infinite Planning Horizon and No

Technological Change
14.11
It is assumed that the required service period is very long.
AECD = $6, 000( A / P,12%, 6) + $2, 000 $1,500( A / F ,12%, 6)
= $3, 274.52
AECC = $21, 000( A / P,12%,12) + $1, 000 $500( A / F ,12%,12)
= $4,369.46
We should continue to use the present machine. The economic advantage is
$4,369.46-$3,274.52 = $1,094.94 per year.
14.12 (a) and (b)

n Defender Challanger
0 -$4,000
-$6,000
1 -$3,000
-$2,000
2 -$4,500
-$3,000
3
-$5,000
AECC (15%) = ($6, 000 +
-$2,000
$1, 000
)( A / P,15%,3) + $2, 000
1.152
= $4,959.04
AECD (15%) = ($4, 000 +
$3, 000 $4,500 $5, 000

)( A / P,15%,3)
+
+
1.15
1.152
1.153
= $5,824.62
Now is the time to replace the defender.
14.13
(a) Opportunity cost = $0
(b) The cash flows are:
Year:
0
1
2
3
4
5
Defender
$0
-$3K -$3K -$3K -$3K -$3K
Challenger -$10K
0
0
0
0
0
C-D
-$10K $3K $3K $3K $3K $3K
(c)
PW (i )C D = $10, 000 + $3, 000( P / A, i,5)
=0
We find i* = 15.24% . Since i* > MARR, the firm should buy the
challenger.
Page | 6

14.14
(a)
AE D = $1,000( A / P,15%,5) + $10,000 $7,000
= $2,701.68
AEC = $12,000( A / P,15%,5) + $11,500 $5,000 + $2,000( A / F,15%,5)
= $3,216.84
Yes, the new machine should be purchased now.
(b)
Let P as the current market value of the old machine
P( A / P,15%,5) + $10,000 $7,000 = $3,216.84
We find P = $726.9 .
Let P as the cost of new machine
P( A / P,15%,5) + $11,500 $5,000 + $2,000( A / F,15%,5)
= $2,701.68
We find P = $13,727 .
14.15
Assume that the old system has a current market value of P.
AECD = P( A / P,14%,5) + $20, 000
AECC = $200, 000( A / P,14%,10) + $5, 000 $18, 000( A / F ,14%,10)
= $42, 411.86
Let AECD = AECC and solve for P. We find that P = $76,941.73. If the resale
value of the defender is higher than $76,941.73, the installation of the system is
justified.
Page | 7

14.16
AEC(12%) D = $60,000( A / P,12%,10) + $18,000
= $28,619
AEC(12%)C = ($200,000 $20,000)( A / P,12%,10) + $20,000(0.12) + $4,000
= $38,257
Since AECD < AECC , do not replace the defender.
14.17
AECC = $53,500( A / P,12%,5) $12, 000( A / F ,12%,5)

+$4, 200 + $500( A / G,12%,5)
= $18, 039.80
AECD = $8,500( A / P,12%,5) + $8, 700
= $11, 057.98
Since AECC > AECD , dont purchase the challenger.
14.18
(a) Economic service life:
n
0
OR
MV
AEOR
CR(10%) AE(10%)
$20,000
1 $35,550 $17,000 $35,550
$5,000
$40,550
2 $31,013 $14,450 $33,390
$4,643
$38,033
3 $25,794 $12,283 $31,095

4 $19,794 $10,440 $28,660
$4,332
$4,060
$35,427
$32,720
The economic life of the cab is one year. These cabs should be replaced every
year.
(b) Rate of return calculation:
PW (i) = $20,000 +
$35,550 + $17,000
=0
1+ i
Solving for i yields 162.75%. The internal rate of return with one-year
replacement cycle is 162.75%.
Page | 8

14.19
For the challenger, we have:
AECC = $50, 000( A / P,14%,12) + $3, 000 $6, 000 $3, 000( A / F ,14%,12)
= $5, 724
For the defender, since salvage value at year 10 is $1,000 and the problem is
stated that if sold at the end of first year, it will bring $1,500. We assume the
market values will be declined same amount (($1,500-$1,000)/4 = $125) for the
next years.
Year
OC
MV
AE OC
CR(14%) AEC(14%)
$2,000
1
2
$3,800 $1,500 $3,800

$3,800 $1,375 $3,800
$780
$572
$4,580
$4,372
$3,800 $1,250 $3,800
$498
$4,298
4
5
$3,800 $1,125 $3,800

$3,800 $1,000 $3,800
$458
$431
$4,258
$4,231
N D = 5 years, AEC D = $4,231 with i = 14%.
Since AECC > AEC D , the new machine should not be purchased.
14.20
AECOption 1 = $15, 000 + $48, 000( A / P,15%,10) + $12, 000 $5, 000( A / F ,15%,10)
AECOption 2
= $36,317.84
= ($84, 000 $6, 000)( A / P,15%,10) + $24, 000 $9, 000( A / F ,15%,10)
= $39, 098.39
Since AECOption 1 < AECOption 2 , Option 1 should be selected.
Page | 9

Replacement Problem with a Finite Planning Horizon

14.21
(a)
AECD = $12,000( A / P,12%,1) + $3,750 $9,600( A / F,12%,1)
= $7,590
AECC = $18,000( A / P,12%,1) + $3,300 $13,500( A / F,12%,1)
= $9,960
Since AECD < AECC , the defender should not be replaced now.
(b)
Defender
Annual increases in A/T O&M
Interest rate
n
Market Value
0
1
2
3
20%
35%
12%
O&M Costs CR(12%) OC(12%) AEC(12%)
$12,000
$9,600
$7,680
$6,144
$3,750
$5,063
$6,834
$3,840
$3,478
$3,175
$3,750
$4,369
$5,100
$7,590
$7,847
$8,275
Challenger
Annual increases in A/T O&M
Interest rate
n
Market Value
0
1
2
3
$18,000
$13,500
$10,125
$7,594
AEC
1
2
3
25%
30%
12%
O&M Costs CR(12%) OC(12%) AEC(12%)
$3,300
$4,290
$5,577
$6,660
$5,875
$5,244
$3,300
$3,767
$4,303
$9,960
$9,642
$9,547
Defender Challenger
$7,590
$9,960
$7,847
$9,642
$8,275
$9,547
Page | 10

The annual equivalent cost of the defender is less than that of the challenger
for every year. Therefore, if total service life is 3 years, we should keep the
defender for 3 years in order to optimize the replacement strategy.
14.22
There are several plausible scenarios. Some of the most feasible scenarios are;
( j0 , 2), ( j ,3), ( j ,3), ( j , 2) : PW (12%) = $17, 601
( j0 ,1), ( j ,3), ( j ,3), ( j ,3) : PW (12%) = $18, 081
( j0 ,3), ( j ,3), ( j,3), ( j,1) : PW (12%) = $17,597
( j0 ,3), ( j ,3), ( j , 4) : PW (12%) = $17, 221
( j0 , 4), ( j ,3), ( j ,3) : PW (12%) = $18,384
It appears that the ( j0 ,3), ( j ,3), ( j , 4) option becomes the best strategy. Keep the
defender for 3 years; replace it with challenger j and keep it for 3 years; replace it
with another challenger and keep it for 4 years.
14.23
There are several plausible scenarios. Some of the most feasible scenarios are;
( j0 ,3), ( j,3), ( j, 2) : PW (12%) = $67,526
( j0 , 2), ( j ,3), ( j ,3) : PW (12%) = $67,390
( j0 ,1), ( j ,3), ( j ,3), ( j ,1) : PW (12%) = $66,856
( j0 , 4), ( j ,3), ( j ,1) : PW (12%) = $65,820
( j0 , 4), ( j, 4) : PW (12%) = $65,958
It appears that the ( j0 ,3), ( j ,3), ( j , 2) option becomes the best strategy. Keep the
defender for 3 years; replace it with challenger j and keep it for 3 years; replace it
with another challenger and keep it for 2 years.
Page | 11

14.24
PWD = $12, 000 + $4, 000( P / A,11%, 6) $2, 000( P / F ,11%, 6)
= $27,852.86
PWC = [$10, 000 + $2, 000( P / A,11%,3) $4, 000( P / F ,11%,3)]
[1 + ( P / F ,11%,3)]
= $20, 709.66
Since PWC < PWD , replace now.
14.25
AED = $4, 000 + $12, 000( A / P,11%, 6) $2, 000( A / F ,11%, 6)
= $6,583.77
AEC = $2, 000 + $10, 000( A / P,11%,3) $4, 000( A / F ,11%,3)
= $4,895.28
Since AEC < AED , replace now.
Replacement Analysis with Tax considerations

14.26
(a) Comments: Sunk cost can be defined as either the difference between book
value and market value or the cost that has already been expended ($).
book value = $15,000 ($3, 000 + $4,800 + $1, 440) = $5, 760
market value = $6, 000
In this example, if the sunk cost is defined as the difference between book value
and market value, there would be no sunk cost as the market value exceeds the
book value. However, the difference between the purchase cost ($15,000) and
the current market value ($6,000) may be viewed as another sunk cost that
should not be considered in the replacement analysis.
(b) Opportunity cost of not replacing the truck:

Book value = $15,000 ($3,000 + $4,800 + $1,440)
= $5,760
Market value = $6,000
Taxable gain = $6,000 $5,760 = $240

Gains tax = $240 0.40 = $96
Net proceeds from sale = $6,000 $96 = $5,904
Page | 12

The opportunity cost for not replacing the old machine now, which is $5,904,
is viewed as an investment required to keep the old machine.
Since the market value is less than the original purchase cost, there would be
no capital gains. The taxable gain in the amount of $96 in (b) is an ordinary
gain.
(c) Equivalent annual cost of operating the truck for two more years:
Cash Flow
Elements
Investment Net
proceeds 0.6(O&M) cost +
(0.40) Dn
Net cash flow
0
-$5,904
End of Period
1
-$900
-$1,800
$691
$2,491
-$2,100
$346
-$6,804
-$1,109
$737
PW (12%) = $7, 207

AEC (12%) = $4, 264
(d) Equivalent annual cost of owning and operating the truck for 5 years:
Cash Flow
Elements
Investment
Net proceeds 0.6(O&M
cost) +
(0.40) Dn
Net cash flow
0
-$5,904
-$900
-$1,800
$691
-$2,100
$691
-$2,280
$346
-$2,700
0
0
-$5,880
0
-$6,804
-$1,109
-$1,409
-$1,934
-$2,700
-$5,880
PW (12%) = $15,346.37
AEC (12%) = $4, 257.23
Page | 13

14.27
(a)
Book value = 0
Ordinary gains = $30,000 - 0 = $30,000
Gains tax = $30,000 0.4 = $12,000
Opportunity cost = $30,000 - $12,000 = $18,000
(b) , (c) and (d): Replace the defender now with the challenger.
Page | 14

Option 1: Keep the defender

n
Depreciation
Book value
Market value
0
$0
0
$30,000
Cash Flow Statement

+(.4)*(Depreciation)
Opportunity cost
(18,000)
Net Cash Flow
($18,000)
PW (10%) = ($12,050)
1
$0
0
2
$0
0
$12,000
0
7,200
$0
$7,200
AEC(10%) =
$6,943
1
$23,579
$141,422
2
$40,409
$101,013
3
$28,859
$72,155
4
$20,609
$51,546
$30,000
$30,000
$30,000
9,431
18,000
16,163
18,000
$27,431
$34,163
AEC(10%) =
$3,741
Option 2: Replace the defender

n
Depreciation
Book value
Market value
Savings in O&M cost
Cash Flow Statement
Investment
Net proceeds from sale
(1 - 0.4)*(Savings)
Net Cash Flow
0
$165,000
6
$14,718
$22,094
$0
$30,000
7
$14,735
$7,359
$0
$30,000
8
$7,359
$0
$0
$30,000
11,543
18,000
8,243
18,000
5,894
18,000
5,887
18,000
5,894
18,000
3,000
2,944
18,000
$29,543
$26,243
$23,894
$23,887
$23,894
$23,944
(165,000)
($165,000)
PW (10%) = ($19,956)
$30,000
5
$14,735
$36,812
$0
$30,000
Page | 15

storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise.16
14.28
(a) Based on the opportunity cost approach:
Cost basis = $120,000
Gains or losses at the time of disposal:
Old machine:
Total depreciation = $50,000
Book value = 0
Market value = 0
Taxable gain = $0
New machine:
Total depreciation = $109,272
Book value = $10,728
Salvage value = $30,000
Taxable gain = $19,272
Gains tax = $7,709
(b) Cash flow for the old machine:

Cash Flow
Elements
Investment Net
proceeds +
(0.40) Dn
Net cash flow
0
-$26,000
0
$4,000 $4,000 $4,000 $4,000 $4,000
-$26,000 $4,000 $4,000 $4,000 $4,000 $4,000
(c) Replacement analysis: Replace the old machine now.

PW (12%)old = $26, 000 + $4, 000( P / A,12%,5)
= $11,581
AE (12%)old = $11,581( A / P,12%,5) = $3, 213
PW (12%)new = $120, 000 + $36,859( P / F ,15%,1)
+ " + $54, 445( P / F ,12%, 7)
= $57,855
AE (12%)new = $57,855( A / P,12%, 7) = $12, 677
Page | 16

Financial Data
Depreciation
Book value
Salvage value
Savings in O&M cost
1
$17,148
($137,148)
2
$29,388
($166,536)
3
$20,988
($187,524)
4
$14,988
($202,512)
5
$10,716
($213,228)
6
$10,716
($223,944)
$50,000
$50,000
$50,000
$50,000
$50,000
$50,000
7
$5,352
($229,296)
$30,000
$50,000
6,859
30,000
11,755
30,000
8,395
30,000
5,995
30,000
4,286
30,000
4,286
30,000
22,304
2,141
30,000
($120,000)
$36,859
$41,755
$38,395
$35,995
$34,286
$34,286
$54,445
PW (12%) =
$57,855
AE (12%) =
$12,677
($120,000)
Cash Flow Statement

Investment
(1 - 0.40)*(Savings)
(120,000)
Net Cash Flow
14.29 (a) & (b): Decision - Replace the defender now.

(1) Keep the defender
Depreciation
Book value
Market value
0
$9,600
14,400
$10,000
Cash Flow Statement

Opportunity cost
(13,220)
Net Cash Flow
($13,220)
PW (12%) = ($7,251)
1
$5,760
8,640
2
$5,760
2,880
3
$2,880
0
4
$0
0
5
$0
0
5,000
2,016
2,016
1,008
0
3,250
$2,016
$2,016
$1,008
$0
$3,250
AE (12%) =
($2,012)
1
$15,000
$60,000
2
$24,000
$36,000
3
$14,400
$21,600
4
$8,640
$12,960
$30,000
$30,000
$30,000
$30,000
5
$4,320
$8,640
$0
$30,000
(2) Replace the defender

n
Depreciation
Book value
Market value
Savings in O&M cost
0
$75,000
Cash Flow Statement

Investment
(1 - 0.35)*(Savings)
Net Cash Flow
(75,000)
($75,000)
PW (12%) = $14,760
5,250
19,500
8,400
19,500
5,040
19,500
3,024
19,500
3,024
1,512
19,500
$24,750
$27,900
$24,540
$22,524
$24,036
AE (12%) =
$4,095
Page | 17

14.30 (a), (b) & (c) Decision: Do not replace the defender now.
(1) Keep the defender

n
Depreciation
Book value
Market value
Revenue
Cash Flow Statement
+(1-0.4)*(Revenue)
Opportunity cost
Net Cash Flow
$21,000
$21,000
$1,200
$21,000
$12,600
$12,600
$12,600
$12,600
$12,600
720
$13,320
AE (10%) =
$11,491
1
$7,300
$29,200
2
$11,680
$17,520
3
$7,008
$10,512
4
$4,205
$6,307
$24,000
$24,000
$24,000
$24,000
5
$2,102
$4,205
$6,300
$24,000
2,920
14,400
4,672
14,400
2,803
14,400
1,682
14,400
5,462
841
14,400
$17,320
$19,072
$17,203
$16,082
$20,703
AE (10%) =
$8,381
$5,500
(3,300)
($3,300)
PW (10%) = $28,575
(2) Replace the defender
n
Depreciation
Book value
Market value
Revenue
0
$36,500
Cash Flow Statement

Investment
(1 - 0.40)*(Savings)
Net Cash Flow
(36,500)
($36,500)
PW (10%) = $31,771
Page | 18

19
14.31
(a) Interest i = 10% Defender:
MARR
Holding
Period
0
1
2
3
4
10%
1
$1,116
$2,233
$2,233
$2,233
Permitted Annual Depreciation Amounts over the

Holding Period
2
3
4
5
$1,115
$2,230
$2,230
$1,117
$2,233
$1,116
$3,348
$5,579
$7,810
$1,115
Annual O&M Costs over the Holding Period

Holding
Period
0
1
2
3
4
$3,200
$3,200
$3,200
$3,200
Holding
Period
0
1
2
3
4
Expected
Market
Value
$7,700
$4,300
$3,300
$1,100
$0
Total
Depreciation
Book
Value
$7,810
$6,694
$4,463
$2,231
$0
Total PW
Total PW of
of A/T
O&M Costs O&M Costs
`
$3,700
$3,700
$3,700
Taxable
Gains
($2,394)
($1,163)
($1,131)
$0
$4,800
$4,800
Gains
Tax
($838)
($407)
($396)
$0
$2,909
$5,967
$9,573
$13,569
$1,891
$3,879
$6,223
$8,820
OC(10%)
CR(10%)
Total
AEC(10%)
$1,689
$1,640
$1,839
$2,086
$3,976
$3,009
$2,880
$2,614
$5,665
$4,648
$4,719
$4,699
$5,850
Net A/T
A/T Operating Costs (in PW)
Market
over the Holding Period
Value
O&M Costs Tax Shield
Total OC
$8,285
$5,138
$1,891
$355
$1,536
$3,707
$3,879
$1,033
$2,846
$1,496
$6,223
$1,649
$4,574
$0
$8,820
$2,209
$6,611
Page | 19

After-Tax Opportunity Cost of Keeping the Defender now:
Note that the cost of retaining the defender on after-tax basis is $8,285, instead of
$7,700. The scheduled depreciation amount during the fourth year of ownership
with a 7-year MACRS property is $3,122.
Period (n)
1
2
3
4
5
6
7
8
Depreciation
$3,573
$6,122
$4,373
$3,122
$2,232
$2,231
$2,231
$1,116
Book Value
$21,427
$15,305
$10,932
$7,810
$5,578
$,3347
$1,116
0
Since the asset will be disposed of during the recovery period, the allowed
depreciation amount will be (0.5) ($3,122) = $1,561. Then, the book value
becomes $9,370, instead of $7,810. With the market value of $7,700, there will be
a loss of $1,670. The tax credit on this loss will be $1,670(0.35) = $584.50.
Finally, the net proceeds from sale of old asset will be $8,285 (= $7,700 +
$584.50).
The defenders remaining useful (economic) life is 2 more years with an AEC
value of $4,648, i.e., N D = 2, AECD = $4, 648 .
Page | 20

21
(b) N C = 10 years , AECC = $4319.2

Input
Tax Rate(%) =
MARR(%) =
Output
PW(i) =
AEC(%) =
35%
10%
($26,540)
$4,319.2
10
Revenues (savings)
Expenses:
O&M
Depreciation
$1,000
$4,430
$1,000
$7,592
$1,000
$5,422
$1,000
$3,872
$1,000
$2,768
$1,000
$2,765
$1,000
$2,768
$1,000
$1,383
$1,000
$0
$1,000
$0
Taxable Income
Income Taxes (%)
($5,430)
(1,900)
($8,592)
(3,007)
($6,422)
(2,248)
($4,872)
(1,705)
($3,768)
(1,319)
($3,765)
(1,318)
($3,768)
(1,319)
($2,383)
(834)
($1,000)
(350)
($1,000)
(350)
Net Income
($3,529)
($5,585)
($4,174)
($3,167)
($2,449)
($2,447)
($2,449)
($1,549)
($650)
($650)
Income Statement
Cash Flow Statement
Operating Activities:
Net Income
Depreciation
Investment Activities:
Investment
Salvage
Gains Tax
Net Cash Flow
(3,529) $
$4,430
(5,585) $
$7,592
(4,174) $
$5,422
(3,167) $
$3,872
(2,449) $
$2,768
(2,447) $
$2,765
(2,449) $
$2,768
(1,549) $
$1,383
(650) $
$0
(650)
$0
$ (31,000)
$
2,500
($875)
$ (31,000)
$900
$2,007
$1,248
$705
$319
$318
$319
($166)
($650) $
Page | 21
975

(c) Marginal analysis:

From n = 1 to n = 2:
$4, 719(1.10) $3, 679 + $3, 700(0.65) = $3, 916.9 < $4, 319.2
From n = 2 to n = 3:
$3, 679(1.10) $1, 468 + $4,800(0.65) = $5, 698.9 > $4, 319.2
Keep the defender for two years, which happens to be the same as the economic
service life as calculated before. (In general, you should not expect this to happen
all the time.)
14.32
(a) Economic service life = 6 years with MARR of 15%
Page | 22

Tax Rate
MARR
Holding
Period
0
1
2
3
4
5
6
40%
15%
1
$2,000
$2,000
$2,000
$2,000
$2,000
$2,000
0.2
$1,600
$3,200
$3,200
$3,200
$3,200
0.32
Investmen $10,000
Book valu $10,000
Holding Period
3
4
5
6
7
8
$960
$1,920
$1,920
$1,920
$576
$1,152
$1,152
$576
$1,152
0.192
0.1152
0.1152
$576
0.0576

Holding
Period
0
1
2
3
4
5
6
Holding
Period
0
1
2
3
4
5
6
Total
Book
epreciatio Value
$10,000
$2,000 $8,000
$3,600 $6,400
$6,160 $3,840
$7,696 $2,304
$8,848 $1,152
$10,000
$0
Total PW
Total PW of of A/T
O&M Costs O&M Costs
`
$1,500
$1,500
$1,500
$1,500
$1,500
$1,500
Expected
Market
Value
$5,300
$3,900
$2,800
$1,800
$1,400
$600
$2,100
$2,100
$2,100
$2,100
$2,100
Taxable
Gains
$2,700
$2,700
$2,700
$2,700
Gains
Tax
$3,400
$3,400
$3,400
$4,200
$4,200
$1,304
$2,892
$4,668
$6,612
$8,700
$10,818
$4,900
$783
$1,735
$2,801
$3,967
$5,220
$6,491
Net A/T A/T Operating Costs (in PW)

Total
Market
over the Holding Period OC(15%) CR(15%) AEC(15%)
Value O&M CostsTax ShieldTotal OC
($2,700) ($1,080) $6,380

($2,500) ($1,000) $4,900
($1,040) ($416) $3,216
($504) ($202) $2,002
$248
$99 $1,301
$600
$240
$360
$783
$1,735
$2,801
$3,967
$5,220
$6,491
$696
$1,180
$1,916
$2,300
$2,547
$2,761
$87
$556
$885
$1,667
$2,673
$3,730
$100
$342
$387
$584
$797
$986
$5,120
$3,872
$3,454
$3,102
$2,790
$2,601
$5,220
$4,214
$3,841
$3,686
$3,588
$3,587
Page | 23

(b) Economic service life = 5 years with MARR of 10%
Tax Rate
40%
Investment
$10,000
MARR
10%
Book value
$10,000

Holding
Period
Holding Period
1
Total
5
Depreciation
Value
$10,000
$2,000
$8,000
$3,600
$6,400
$6,160
$3,840
$7,696
$2,304
$8,848
$1,152
$10,000
$0
0
1
$2,000
$2,000
$1,600
$2,000
$3,200
$960
$2,000
$3,200
$1,920
$576
$2,000
$3,200
$1,920
$1,152
$576
$2,000
$3,200
$1,920
$1,152
$1,152
$576
Total PW
Holding
Period
Total PW of
1
Book
of A/T
O&M Costs O&M Costs
0
1
$1,500
$1,500
$2,100
$1,500
$2,100
$2,700
$1,500
$2,100
$2,700
$3,400
$1,500
$2,100
$2,700
$3,400
$4,200
$1,500
$2,100
$2,700
$3,400
$4,200
Expected
$4,900
Net A/T

Holding
Market
Taxable
Gains
Market
Period
Value
Gains
Tax
Value
O&M Costs Tax Shield
$1,364
$818
$3,099
$1,860
$5,128
$3,077
$7,450
$4,470
$10,058
$6,035
$12,824
$7,694
Total
OC(10%)
CR(10%)
AEC(10%)
Total OC
0
1
$5,300
($2,700)
($1,080)
$6,380
$818
$727
$91
$100
$4,620
$4,720
$3,900
($2,500)
($1,000)
$4,900
$1,860
$1,256
$603
$348
$3,429
$3,776
3
4
$2,800
($416)
($202)
$3,216
$2,002
$3,077
$2,074
$1,003
$403
$3,050
$3,453
$1,800
($1,040)
($504)
$4,470
$2,520
$1,950
$615
$2,723
$3,339
$1,400
$248
$99
$1,301
$6,035
$2,820
$3,215
$848
$2,425
$3,273
$600
$600
$240
$360
$7,694
$3,093
$4,601
$1,056
$2,249
$3,306
Page | 24

14.33
(a) At i = 12%, the economic service life = 8 years:
Tax Rate
MARR
Holding
Period
0
1
2
3
4
5
6
7
8
9
10
40%
12%
Investment $30,000
Book value $30,000
Holding Period
3
4
5
6
7
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
10
$3,000

Holding
Period
0
1
2
3
4
5
6
7
8
9
10
Holding
Period
0
1
2
3
4
5
6
7
8
9
10
Total
Depreciation
Book
Value
$3,000
$6,000
$9,000
$12,000
$15,000
$18,000
$21,000
$24,000
$27,000
$30,000
$27,000
$24,000
$21,000
$18,000
$15,000
$12,000
$9,000
$6,000
$3,000
$0
Total PW
Total PW of of A/T
O&M Costs O&M Costs
8
`
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
Expected
Market
Value
$20,000
$18,000
$16,000
$14,000
$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$3,450
$3,450
$3,450
$3,450
$3,450
$3,450
$3,450
$3,450
$3,450
Taxable
Gains
($7,000)
($6,000)
($5,000)
($4,000)
($3,000)
($2,000)
($1,000)
$0
$1,000
$2,000
$3,968
$3,968
$3,968
$3,968
$3,968
$3,968
$3,968
$3,968
$4,563
$4,563
$4,563
$4,563
$4,563
$4,563
$4,563
Gains
Tax
Net A/T
Market
Value
($2,800)
($2,400)
($2,000)
($1,600)
($1,200)
($800)
($400)
$0
$400
$800
$22,800
$20,400
$18,000
$15,600
$13,200
$10,800
$8,400
$6,000
$3,600
$1,200
$5,247
$5,247
$5,247
$5,247
$5,247
$5,247
$6,034
$6,034
$6,034
$6,034
$6,034
$6,939
$6,939
$6,939
$6,939

O&M Costs Tax Shield Total OC
$1,607
$3,257
$4,952
$6,692
$8,478
$10,312
$12,196
$14,125
$16,110
$18,149
$1,071
$2,028
$2,882
$3,645
$4,326
$4,934
$5,477
$5,961
$5,961
$5,961
$536
$1,229
$2,070
$3,047
$4,153
$5,379
$6,719
$8,164
$10,149
$12,188
$7,960
$7,960
$7,960
$9,177
$9,177
$10,554
OC(12%)
$600
$727
$862
$1,003
$1,152
$1,308
$1,472
$1,643
$1,905
$2,157
$2,679
$5,429
$8,253
$11,153
$14,130
$17,187
$20,326
$23,541
$26,850
$30,249
CR(12%)
$1,607
$3,257
$4,952
$6,692
$8,478
$10,312
$12,196
$14,125
$16,110
$18,149
Total
AEC(12%)
$10,800
$8,128
$7,156
$6,613
$6,244
$5,966
$5,741
$5,551
$5,387
$5,241
Page | 25
$11,400
$8,856
$8,018
$7,616
$7,396
$7,274
$7,213
$7,195
$7,291
$7,398

(b) At i = 20%, the economic service life = 10 years

Tax Rate
MARR
Holding
Period
0
1
2
3
4
5
6
7
8
9
10
40%
20%
1
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
Investment $30,000
Book value $30,000
Holding Period
3
4
5
6
7
8
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$30
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
10
$3,000

Holding
Period
0
1
2
3
4
5
6
7
8
9
10
Holding
Period
0
1
2
3
4
5
6
7
8
9
10
Total
Book
Depreciation Value
$3,000
$6,000
$9,000
$12,000
$15,000
$18,000
$21,000
$21,030
$27,000
$30,000
$27,000
$24,000
$21,000
$18,000
$15,000
$12,000
$9,000
$8,970
$3,000
$0
Total PW
Total PW of of A/T
O&M Costs O&M Costs
8
`
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
$3,000
Expected
Market
Value
$3,450
$3,450
$3,450
$3,450
$3,450
$3,450
$3,450
$3,450
$3,450
Taxable
Gains
$20,000
$18,000
$16,000
$14,000
$12,000
$10,000
$8,000
$6,000
$4,000
($7,000)
($6,000)
($5,000)
($4,000)
($3,000)
($2,000)
($1,000)
($2,970)
$1,000
$2,000
$2,000
$3,968
$3,968
$3,968
$3,968
$3,968
$3,968
$3,968
$3,968
$4,563
$4,563
$4,563
$4,563
$4,563
$4,563
$4,563
$5,247
$5,247
$5,247
$5,247
$5,247
$5,247
$6,034
$6,034
$6,034
$6,034
$6,034
$6,939
$6,939
$6,939
$6,939
$7,980
$7,980
$7,980
$9,177
$9,177 $10,554
$2,500
$4,896
$7,192
$9,393
$11,501
$13,522
$15,459
$17,315
$19,093
$20,798
$1,500
$2,938
$4,315
$5,636
$6,901
$8,113
$9,275
$10,389
$11,456
$12,479
OC(20%)
CR(20%)
Total
AEC(20%)
Gains
Tax

Market
Value O&M CostsTax Shield Total OC
($2,800)
($2,400)
($2,000)
($1,600)
($1,200)
($800)
($400)
($1,188)
$400
$22,800
$20,400
$18,000
$15,600
$13,200
$10,800
$8,400
$7,188
$3,600
$1,500
$2,938
$4,315
$5,636
$6,901
$8,113
$9,275
$10,389
$11,456
$1,000
$1,833
$2,528
$3,106
$3,589
$3,991
$4,326
$4,127
$4,837
$500
$1,104
$1,788
$2,529
$3,312
$4,123
$4,950
$6,262
$6,619
$600
$723
$849
$977
$1,107
$1,240
$1,373
$1,632
$1,642
$13,200
$10,364
$9,297
$8,683
$8,258
$7,934
$7,672
$7,383
$7,269
$13,800
$11,086
$10,145
$9,660
$9,365
$9,173
$9,046
$9,014
$8,911
$1,200
$12,479
$5,031
$7,448
$1,776
$7,109
$8,886
$800
Page | 26

(c) At i = 0%, the economic service life = 5 years:
Capital recovery cost:

gain = S n Bn
gain tax = tm ( S n Bn )
net proceeds = (1 tm ) S n + tm Bn
= (1 0.40)(22, 000 2000n) + 0.40(30, 000 3, 000n)
I (1 tm ) Sn tm Bn
n
4,800 2, 400n
=
n
4,800
=
2, 400
n
CR =
Equivalent annual O&M cost:
( )
A/T O&M = (1 tm ) 3,000 1.15
( )
1,800 (1.15)
=
= 1,800 1.15
n1
n1
n1
n=1
AEO & M
(1.15)
= 1,800
n1
n=1
n
1,800 (1.15 1)
(1.15n 1)
=
= 12,000
1.15 1
n
n
n
Depreciation tax credit:
AE D
n
n=1
(tm Dn )
n
= 1,200
Minimum total annual equivalent cost:
Page | 27

4,800
(1.15n 1)
AE =
2, 400 + 12, 000
1, 200
n
n
4,800
(1.15n 1)
=
+ 12, 000
3, 600
n
n
1.15n 7, 200
= 12, 000
3, 600
n
n
Using Excel with trial and error method, we can get the n = 5 years.
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
AE (i)
3000
735
83.5
-152.98
-212.74
-173.88
-68.54
88.53
290.50
534.67
820.79
1150.25
1525.65
AE
9 10 11 12 13
Page | 28

14.34 Economic service life

With i = 12% and tax rate = 40%: Economic service life = 1 year
Tax Rate
MARR
Holding
Period
0
1
2
3
4
5
Holding
Period
0
1
2
3
4
5
Holding
Period
0
1
2
3
4
5
40%
12%
1
$3,000
$3,000
$3,000
$3,000
$3,000
0.2
Investment
$15,000
Book value
$15,000
Holding Period
3
4
5
6
7
$2,400
$4,800
$4,800
$4,800
0.32
$3,000
$5,400
$9,240
$11,544
$13,272
$1,440
$2,880
$864
$2,880
$1,728
$864
0.192
0.1152
0.1152
Total
Depreciation
Book
Value
$12,000
$9,600
$5,760
$3,456
$1,728
Total PW
Total PW of of A/T
O&M Costs O&M Costs
`
$2,500
$2,500
$2,500
$2,500
$2,500
Expected
Market
Value
$12,800
$8,100
$5,200
$3,500
$0
$3,200
$3,200
$3,200
$3,200
Taxable
Gains
$800
($1,500)
($560)
$44
($1,728)
$5,300
$5,300
$5,300
Gains
Tax
$320
($600)
($224)
$18
($691)
$6,500
$6,500
Net A/T
Market
Value
$12,480
$8,700
$5,424
$3,482
$691
$2,232
$4,783
$8,556
$12,686
$17,112
$7,800
$1,339
$2,870
$5,133
$7,612
$10,267
$1,071
$1,837
$3,012
$3,642
$4,057
$268
$1,033
$2,121
$3,970
$6,210
OC(12%)
$300
$611
$883
$1,307
$1,723
CR(12%)
$4,320
$4,772
$4,638
$4,210
$4,052
$1,339
$2,870
$5,133
$7,612
$10,267
Total
AEC(12%)
$4,620
$5,383
$5,521
$5,517
$5,775
Page | 29

14.35
(a) Challenger
Financial Data
Depreciation
Book value
Market value
Savings
Cash Flow Statement

+(1-0.40)*(Savings)
Investment
1
$21,435
$150,000 $128,565
$150,000
$30,000
2
$36,735
$91,830
3
$26,235
$65,595
4
$18,735
$46,860
5
$13,395
$33,465
6
$13,380
$20,085
7
$13,395
$6,690
8
$6,690
$0
9-10
$30,000
$30,000
$30,000
$30,000
$30,000
$30,000
$30,000
$30,000
18,000
8,574
18,000
14,694
18,000
10,494
18,000
7,494
18,000
5,358
18,000
5,352
18,000
5,358
18,000
2,676
18,000
0
($150,000) $26,574
$32,694
$28,494
$25,494
$23,358
$23,352
$23,358
$20,676
$18,000
AE (10%) =
$633
1
$12,000
$60,000
2
$12,000
$48,000
3
$12,000
$36,000
4
$12,000
$24,000
5
$12,000
$12,000
6
$12,000
$0
9-10.
4,800
4,800
4,800
4,800
4,800
4,800
$4,800
$4,800
$4,800
$4,800
$4,800
$4,800
AE (10%) =
($1,285)
$0
$0
(150,000)
Net Cash Flow

PW (10%) =
$3,889
(b) Defender
Financial Data
Depreciation
Book value
Current market value
$72,000
Cash Flow Statement

Investment
(28,800)
Net Cash Flow

PW (10%) =
($28,800)
($7,895)
Therefore, buy the callenger.
Page | 30

(c) Defender with a current market value of $ 45,000

Financial Data
Depreciation
Book value
Cash Flow Statement

Investment
1
2
3
4
5
6
$12,000 ####### ####### ###### ###### ######
$72,000 $60,000 ####### ####### ###### ######
$0
$45,000
4,800
4,800
9-10.
4,800 4,800 4,800 4,800
(55,800)
Net Cash Flow
($55,800) $4,800 $4,800 $4,800 $4,800 $4,800 $4,800
PW (10%) = ($34,895)
AE (10%) = ($5,679)
Therefore, buy the challenger.
(d) Challenger with an extended service life of 12 years

Financial Data
Depreciation
Book value
Savings
1
2
3
4
5
6
7
8
9-12
$21,435 ####### ####### ###### ###### ###### ####### $6,690
$150,000 ######## ####### ####### ###### ###### ###### $6,690
$0
$15,000 ####### ####### ###### ###### ###### ####### ###### ######
Cash Flow Statement

+(0.60)*(Savings)
Investment
(150,000)
Net Cash Flow
######## $17,574 ####### ####### ###### ###### ###### ####### ###### $9,000
PW (10%) = ($45,390)
8,574 14,694 10,494 7,494 5,358 5,352

9,000 9,000 9,000 9,000 9,000 9,000
AEC(10%) = $6,662
5,358 2,676
0
9,000 9,000 9,000
Therefore, do not buy the challenger.
Page | 31

14.36 (a) and (b):

(a) Defender (Model A)
Original Investment $150,000
n
Depreciation
Book value
Cash Flow Statement
Investment
1
$26,235
$65,601
2
$18,735
$46,866
3
$13,395
$33,471
4
$13,380
$20,091
5
$13,395
$6,696
6
$6,690
$6
10,494
7,494
5,358
5,352
5,358
2,676
$10,494
$7,494
$5,358
$5,352
$5,358
$2,676
AE (10%) =
($1,948)
1
2
3
$42,870 $73,470 $52,470
$300,000 $257,130 $183,660 $131,190
$75,000 $75,000 $75,000
4
$37,470
$93,720
$75,000
5
$26,790
$66,930
$75,000
6
$26,760
$40,170
$75,000
7
$26,790
$13,380
$75,000
8
$13,380
$0
$75,000
10
$75,000
$75,000
$91,836
$0
(36,734)
Net Cash Flow

PW (10%) =
Decision: Replace Model A with

Model B
(b) It is rather difficult to predict
what technological advances would
be made on typical equipment in the
future.If the industrial engineer had
expected a more efficient lathe to be
available in one or two years, he
could defer the replacement
decision.Since Model A was
already placed in service, the
amount of $ 150,000 expended is a
sunk cost, and it should not be
considered in future replacement decisions.
($36,734)
($8,483)
(b) Challenger (Model B)

n
Depreciation
Book value
Savings
Cash Flow Statement
+(0.60)*(Savings)
Investment
17,148
45,000
29,388
45,000
20,988
45,000
14,988
45,000
10,716
45,000
10,704
45,000
10,716
45,000
5,352
45,000
0
45,000
0
45,000
$62,148
$74,388
$65,988
$59,988
$55,716
$55,704
$55,716
$50,352
$45,000
$45,000
(300,000)
Net Cash Flow

PW (10%) =
($300,000)
$63,079
AE (10%) = $10,266
Therefore, buy the challenger.
Page | 32

14.37 Replacement Analysis

(a) Keep the defender
Financial Data
Depreciation
Book value
O&M cost
-4
$20,000
-3
$2,858
$17,142
-2
$4,898
$12,244
-1
$3,498
$8,746
Cash Flow Statement

(-0.7)*(O&M cost)
Investment
1
$1,786
$4,462
2
$1,784
$2,678
3
$1,786
$892
4
$892
$0
$2,000
$2,000
$2,000
$2,000
$2,000
$0
$1,500
$2,000
(1,400)
536
(1,400)
535
(1,400)
536
(1,400)
268
(1,400)
0
(1,400)
0
$0
(6,074)
1,050
Net Cash Flow

PW (10%) =
0
$2,498
$6,248
$6,000
$0
($10,064)
$0
AEC(10%) =
$0
$0
($6,074)
($864)
($865)
($864)
7
$1,875
$937
$1,000
8
$937
($0)
$1,000
281
(700)
($1,132)
($1,400)
($350)
10-11
$0
($0)
$1,000
12
$0
($0)
$1,000
0
(700)
0
(700)
$2,311
(b) Replace the defender

Financial Data
Depreciation
Book value
O&M cost
Cash Flow Statement
(-0.7)*(O&M cost)
Investment
Net Cash Flow
PW (10%) =
n
$21,000
1
$3,001
$17,999
$1,000
900
(700)
2
$5,143
$12,856
$1,000
1,543
(700)
3
$3,673
$9,183
$1,000
1,102
(700)
4
$2,623
$6,560
$1,000
787
(700)
5
$1,875
$4,685
$1,000
563
(700)
6
$1,873
$2,812
$1,000
562
(700)
563
(700)
$0
($0)
1000
0
(700)
(21,000)
350
($21,000)
($21,113)
$200
$843
AEC(10%) =
$402
$87
($137)
($138)
($137)
($419)
($700)
($700)
($350)
$3,099
Page | 33

14.38 (a) and (b): Replace defender now
Option 1 : Keep the defender

n
Depreciation
Book value
Expected Market value
O&M cost
$4,000
Cash Flow Statement

(-0.6)*(O&M cost)
Investment
$0
$0
$3,000
$3,000
$0
$0
$2,000
$4,500
$0
$0
$1,000
$6,000
(1,800)
0
(2,700)
0
(3,600)
0
(2,400)
600
Net Cash Flow

PW (12%) =
($2,400)
($8,295)
($1,800)
($2,700)
($3,000)
AEC(12%) =
$3,454
1
$2,000
$4,000
$2,000
2
$2,667
$1,333
$3,000
3
$444
$889
$4,000
800
(1,200)
1,067
(1,800)
178
(2,400)
Option 2 : Replace the defender

n
Depreciation
Book value
O&M cost
$6,000
Cash Flow Statement

(0.6)*(O&M cost)
Investment
(6,000)
1,556
Net Cash Flow

PW (12%) =
($6,000)
($7,416)
($400)
($733)
AEC(12%) =
$3,088
($667)
Page | 34

14.39 (a), (b), and (c):

Financial Data
Depreciation
Book value
O&M cost
Cash Flow Statement

(-0.6)*(O&M cost)
Investment
$4,000
$0
$800
$3,200
$0
$0
2
$800
$2,400
$0
$0
3
$800
$1,600
$0
$0
4
$800
$800
$0
$0
5
$800
$0
$0
$0
0
320
0
320
0
320
0
320
0
320
$320
$320
$320
$320
$320
(1,600)
Net Cash Flow
($1,600)
PW (10%) =
($387)
AEC(10%) =
$102
1
$1,429
$8,571
$0
$3,000
2
$2,449
$6,122
$0
$3,000
3
$1,749
$4,373
$0
$3,000
4
$1,249
$3,124
$0
$3,000
5
$446
$2,678
$0
$3,000
572
1,800
980
1,800
700
1,800
500
1,800
178
1,800

Financial Data
Depreciation
Book value
Savings in O&M cost
0
$10,000
$0
Cash Flow Statement

(0.6)*(Savings in O&M cost)
Investment
(10,000)
1,071
Net Cash Flow
($10,000)
PW (10%) =
Incremental cash flow
($205)
$2,372
$2,780
AEC(10%) =
$54
($8,400)
$2,052
IRR=
10.82%
Replace the defender now.
$2,460
$2,500
$2,300
$3,049
$2,180
$1,980
$2,729
Page | 35

14.40
(a) Replacement analysis
n
Financial Data
Depreciation
Book value
O&M cost
Cash Flow Statement
(-0.6)*(O&M cost)
Investment
$0
$1,000
$0
$0
$0
$7,000
$0
$0
$0
$7,000
$0
$0
$0
$7,000
$0
$0
$0
$7,000
$0
$0
$0
$7,000
($4,200)
$0
($4,200)
$0
($4,200)
$0
($4,200)
$0
($4,200)
$0
($4,200)
($4,200)
($4,200)
($4,200)
($4,200)
2
$2,939
$7,346
$5,000
$1,500
3
$2,099
$5,248
$5,000
$1,500
4
$1,499
$3,749
$5,000
$1,500
$535
$3,214
$5,000
$1,500
1,176
(3,000)
900
840
(3,000)
900
600
(3,000)
900
214
(3,000)
900
($600)
Net Cash Flow

PW (12%) =
($600)
($15,740)
AEC(12%) =
$4,366

n
Financial Data
Depreciation
Book value
O&M cost
Increased Revenue
0
$12,000
Cash Flow Statement

-(0.6)*(O&M cost)
(0.6)*(Revenue)
Investment
686
(3,000)
900
Incremental cash flow
(12,000)
2,485
Net Cash Flow

PW (12%) =
1
$1,715
$10,285
$5,000
$1,500
($12,000)
($15,510)
($1,414)
AEC(12%) =
($924)
($1,260)
($1,500)
$2,940
$2,700
$600
$4,303
($11,400)
$2,786
$3,276
IRR=
12.76% > 12%
Replace the defender.
$4,800
(b) Break-even market value: Let X denote the current market value of the old
machine. Then, the opportunity cost for not replacing the old machine now is
given by
X 0.4 X = 0.6 X
PW (12%) defender = 0.6 X $4,200( P / A,12%,5)
= 0.6 X $15,140
This present value must be the same as the present value of the challenger.
Page | 36

0.6 X $15,140 = $15,510

X = $616.67
14.41 Replacement analysis: Let X denote the current market value of the old callswitching system:
AE(10%) defender = $20,000(0.60) 0.60 X ( A / P,10%,5)
= $12,000 (0.6 X )(0.2638)
= $12,000 0.158X
AE(10%)challenger = $152,409( A / P,10%,10)
= $24,804
To justify the new call-switching system now, we must have
AE(14%) defender < AE(14%)challenger

$12,000 0.158X < $24,804
X > $81,038
Challenger:
Financial Data
Depreciation
Book value
Salvage value
O&M cost
$200,000
Cash Flow Statement

-(0.6)*(O&M cost)
Investment
($200,000)
Cash Flow Statement

-(0.6)*(Savings in O&M cost)
Investment
Net Cash Flow
PW (10%) =
AEC(10%) =
1
$40,000
$160,000
2
$64,000
$96,000
3
$38,400
$57,600
4
$23,040
$34,560
5
$23,040
$11,520
$5,000
$5,000
$5,000
$5,000
$5,000
(3,000)
16,000
(3,000)
25,600
(3,000)
15,360
(3,000)
9,216
(3,000)
9,216
$6,216
$6,216
(200,000)
Net Cash Flow
Financial Data
Depreciation
Book value
Salvage value
O&M cost
$13,000
6
$11,520
$0
$22,600
$12,360
10
$0
$0
$0
$0
$0
$0
$0
$0
$5,000
$5,000
$5,000
$5,000
$5,000
(3,000)
4,608
(3,000)
0
(3,000)
0
(3,000)
0
(3,000)
0
$1,608
($3,000)
($3,000)
($3,000)
10,800
$7,800
($152,409)
$24,804
Page | 37

14.42 Defender analysis

(a) and (b): Keep the defender for three years.
z
Defender:
Tax Rate
MARR
Holding
Period
0
1
2
3
Investment $12,725
Book value $15,000
Holding Period
3
4
5
6
7
35%
18%
1
$4,000
$4,000
$4,000
$4,000
$4,000
Total
Depreciation
$4,000
$8,000
$12,000
$4,000

Holding
Period
0
1
2
3
$4,500
$4,500
$4,500
Holding
Period
0
1
2
3
Expected
Market
Value
$11,500
$5,200
$3,500
$1,200
Total PW of
O&M Costs
Book
Value
$15,000
$11,000
$7,000
$3,000
Total PW
of A/T
O&M Costs
`
$5,300
$5,300
$6,100

Market
Value O&M CostsTax Shield Total OC
$12,725
($5,800) ($2,030) $7,230
$2,479 $1,186
$1,292
($3,500) ($1,225) $4,725
$4,953 $2,192
$2,761
($1,800)
($630) $1,830
$7,366 $3,044
$4,322
Taxable
Gains
$3,814
$7,620
$11,333
Gains
Tax
OC(18%)
$1,525
$1,764
$1,988
CR(18%)
$7,786
$5,960
$5,340
$2,479
$4,953
$7,366
Total
AEC(18%)
$9,311
$7,724
$7,328
Page | 38

Challenger:
* Challenger analysis :
n
Financial Data
Depreciation
Book value
Salvage value
O&M cost
0
$43,500
Cash Flow Statement

-(0.65)*(O&M cost)
Investment
1
$6,216
$37,284
2
$10,653
$26,631
$1,500
$1,500
(975)
2,176
3
$7,608
$19,023
4
$5,433
$13,589
5
$3,885
$9,705
$1,500
$1,500
$1,500
(975)
3,729
(975)
2,663
(975)
1,902
(975)
1,360
$927
$385
(43,500)
Net Cash Flow
($43,500)
Financial Data
Depreciation
Book value
Salvage value
O&M cost
Cash Flow Statement
-(0.65)*(O&M cost)
Investment
$1,201
$2,754
6
$3,880
$5,825
7
$3,885
$1,940
$1,500
$1,500
(975)
1,358
(975)
1,360
$1,688
9
$1,940
($0)
$1,500
(975)
679
10
$0
($0)
$1,500
(975)
0
$0
($0)
$1,500
(975)
0
2,275
Net Cash Flow
$0
PW (18%) =
AEC(18%) =
$383
$385
($296)
($975)
$1,300
($38,619)
$8,593
Page | 39

14.43 Decision: Do not replace the defender now.

(a) Keep the defender
0
Depreciation
Book value
O&M cost
$50,000
$60,000
Cash Flow Statement

(-0.6)*(O&M cost)
Opportunity cost
Net Cash Flow
2
$5,000
$40,000
3
$5,000
$35,000
4
$5,000
$30,000
5
$5,000
$25,000
6
$5,000
$20,000
7
$5,000
$15,000
8
$5,000
$10,000
9
$5,000
$5,000
10
$5,000
$0
$18,000
$18,000
$18,000
$18,000
$18,000
$18,000
$18,000
$18,000
$18,000
$18,000
($10,800)
$2,000
($10,800)
$2,000
($10,800)
$2,000
($10,800)
$2,000
($10,800)
$2,000
($10,800)
$2,000
($10,800)
$2,000
($10,800)
$2,000
($10,800)
$2,000
($10,800)
$2,000
($8,800)
($8,800)
($8,800)
($8,800)
($8,800)
($8,800)
($8,800)
($8,800)
($8,800)
($8,800)
3
$34,980
$87,460
$4,000
4
$24,980
$62,480
$4,000
5
$17,860
$44,620
$4,000
6
$17,840
$26,780
$4,000
7
$17,860
$8,920
$4,000
8
$8,920
$0
$4,000
$0
$0
$4,000
$0
$0
$4,000
$13,992
($2,400)
$9,992
($2,400)
$7,144
($2,400)
$7,136
($2,400)
$7,144
($2,400)
$3,568
($2,400)
$0
($2,400)
$0
($2,400)
($56,000)
($56,000)
PW (10%) =
1
$5,000
$45,000
($110,072)
AEC(10%) =
$17,914

0
Depreciation
Book value
O&M cost
$200,000
Cash Flow Statement

(-0.6)*(O&M cost)
Investment
Net Cash Flow
2
$48,980
$122,440
$4,000
$11,432
($2,400)
$19,592
($2,400)
10
($200,000)
$12,000
($200,000)
PW (10%) =
1
$28,580
$171,420
$4,000
($152,404)
$9,032
$17,192
AEC(10%) =
$11,592
$7,592
$4,744
$4,736
$4,744
$1,168
($2,400)
$9,600
$24,803
Page | 40

14.44 Decision: Do not replace the defender now.
Keep the defender

n
Financial Data
Depreciation
Book value
Market value
Operation Cost
0
$0
$8,500
Cash Flow Statement

Opportunity cost
-(1-0.35)*(Operation cost)
1
$0
$0
2
$0
$0
3
$0
$0
4
$0
$0
5
$0
$0
$8,700
$8,700
$8,700
$8,700
$8,700
(5,655)
(5,655)
(5,655)
(5,655)
(5,655)
($5,655)
($5,655)
($5,655) ($5,655)
($5,655)
(5,525)
Net Cash Flow
($5,525)
PW (10%) = ($26,962)
AEC(10%) = $7,112
Replace the defender

n
Financial Data
Depreciation
Book value
Market value
Operation Cost
0
$53,500
$53,500
Cash Flow Statement

Investment
Net Cash Flow
2
$13,102
$32,753
3
$9,357
$23,396
4
$6,682
$16,713
$4,200
$4,700
$5,200
$5,700
5
$2,386
$14,327
$12,000
$6,200
(53,500)
($53,500)
PW (10%) = ($47,323)
1
$7,645
$45,855
2,676
(2,730)
4,586
(3,055)
3,275
(3,380)
2,339
(3,705)
12,815
835
(4,030)
($54)
$1,531
($105)
($1,366)
$9,620
AEC(10%) = $12,484
Page | 41

14.45
Defender analysis
* Keep defender:
n
Depreciation
Book value
Market value
O&M cost
Cash Flow Statement
-(0.6)*(O&M cost)
Opportunity cost
Net Cash Flow
0
1
2
3
4
5
6
$2,873 $2,054 $2,052 $2,054 $1,026
$0
$0
$7,185 $5,131 $3,080 $1,026
($0) ($0) ($0)
$2,000 $1,500
$3,800 $3,800 $3,800 $3,800 $3,800 $3,800
($2,280) ($2,280) ($2,280) ($2,280) ($2,280) ($2,280)

$822 $821 $822 $410
$0
$0
($4,649)
$600
($4,649) ($1,458) ($1,459) ($1,458) ($1,870) ($2,280) ($1,680)
PW (10%) = ($11,917)
AEC(10%) = $2,736
Page | 42

Challenger analysis
Financial Data
Depreciation
Book value
Savings
O&M cost
Cash Flow Statement
-(0.6)*(O&M cost)
(0.6)*(Savings)
Investment
Net Cash Flow
Financial Data
Depreciation
Book value
Savings
O&M cost
Cash Flow Statement
-(0.6)*(O&M cost)
(0.6)*(Savings)
Investment
Net Cash Flow
0
$50,000
1
$7,145
$42,855
$6,000
$3,000
2
$12,245
$30,610
$6,000
$3,000
3
$8,745
$21,865
$6,000
$3,000
4
$6,245
$15,620
$6,000
$3,000
5
$4,465
$11,155
$6,000
$3,000
6
$4,465
$6,690
$6,000
$3,000
($1,800)
$3,600
$2,858
($1,800)
$3,600
$4,898
($1,800)
$3,600
$3,498
($1,800)
$3,600
$2,498
($1,800)
$3,600
$1,786
($1,800)
$3,600
$1,786
$4,658
$6,698
$5,298
$4,298
$3,586
$3,586
7
$4,460
$2,230
$6,000
$3,000
8
$2,230
$0
$6,000
$3,000
10
11
12
$0
$0
$6,000
$3,000
$0
$0
$6,000
$3,000
$0
$0
$6,000
$3,000
$0
$0
$6,000
$3,000
($1,800)
$3,600
$1,784
($1,800)
$3,600
$892
($1,800)
$3,600
$0
($1,800)
$3,600
$0
($1,800)
$3,600
$0
($1,800)
$3,600
$0
($50,000)
($50,000)
$1,800
$3,584
PW (10%) = ($22,733)
Do not buy the new machine.
$2,692
$1,800
$1,800
AEC(10%) =
$3,336
$1,800
$3,600
Page | 43

14.46 Option 1:
Financial Data
Depreciation
Book value
Current Market value
O&M cost
0
$48,000
$6,000
Cash Flow Statement

(-0.60)*(O&M cost)
Opportunity cost
Investment
2
$11,755
$29,386
3
$8,395
$20,990
4
$5,995
$14,995
5
$4,286
$10,709
$27,000
$27,000
$27,000
$27,000
$27,000
(16,200)
2,744
(16,200)
4,702
(16,200)
3,358
(16,200)
2,398
(16,200)
1,715
($13,456)
($11,498)
($12,842)
($13,802)
($14,485)
6
$4,282
$6,427
7
$4,286
$2,141
8
$2,141
$0
$27,000
$27,000
$27,000
$27,000
$0
$0
$5,000
$27,000
(16,200)
1,713
(16,200)
1,715
(16,200)
856
(16,200)
0
(16,200)
0
(3,600)
(48,000)
Net Cash Flow
($51,600)
Financial Data
Depreciation
Book value
Salvage value
O&M cost
1
$6,859
$41,141
Cash Flow Statement

-(0.40)*(O&M cost)
Investment
Net Cash Flow
PW (12%) = ($129,093)
10
$0
$0
3,000
($14,487)
($14,485)
AEC(12%) =
$22,847
($15,344)
($16,200)
($13,200)
Page | 44

Option 2:
n
Depreciation
Book value
O&M cost
0
$84,000
Cash Flow Statement

(-0.60)*(O&M cost)
Investment
1
$12,004
$71,996
$24,000
2
$20,572
$51,425
$24,000
3
$14,692
$36,733
$24,000
4
$10,492
$26,242
$24,000
5
$7,501
$18,740
$24,000
(14,400)
4,801
(14,400)
8,229
(14,400)
5,877
(14,400)
4,197
(14,400)
3,000
($9,599)
($6,171)
($8,523)
($10,203)
($11,400)
6
$7,493
$11,248
7
$7,501
$3,746
8
$3,746
($0)
$24,000
$24,000
$24,000
$24,000
$0
($0)
$9,000
$24,000
(14,400)
2,997
(14,400)
3,000
(14,400)
1,499
(14,400)
0
(14,400)
0
(84,000)
Net Cash Flow
($84,000)
n
Depreciation
Book value
Salvage value
O&M cost
Cash Flow Statement
-(0.40)*(O&M cost)
Investment
Net Cash Flow
PW (12%) = ($140,744)
Option 1 is better.
10
$0
($0)
5,400
($11,403)
($11,400)
AEC(12%) =
$24,910
($12,901)
($14,400)
($9,000)
Page | 45

14.47
The remaining useful life of the defender is 1 year. Its annual equivalent cost is $1,666.
When the defender is replaced now by the challenger, its equivalent annual cost is
$2,191, indicating that the defender should be kept for now.
(a) Economic service life = one year
Tax Rate
MARR
30%
12%
Holding
Period
0
1
2
3
4
5
Investment
$1,050
Book value
$0
Holding Period
3
4
5
6
7
Total
Depreciation
$0
$0
$0
$0
$0
Holding
Period
0
1
2
3
4
5
Holding
Period
0
1
2
3
4
5
Book
Value
$0
$0
$0
$0
$0
Total PW
Total PW of
of A/T
O&M Costs O&M Costs
8
`
$1,900
$1,900
$1,900
$1,900
$1,900
Expected
Market
Value
$1,200
$1,000
$500
$0
$0
$2,300
$2,300
$2,300
$2,300
Taxable
Gains
$1,200
$1,000
$500
$0
$0
$2,700
$2,700
$2,700
Gains
Tax
$3,100
$3,100
Net A/T
Market
Value
$360
$300
$150
$0
$0
$840
$700
$350
$0
$0
$1,696
$3,530
$5,452
$7,422
$9,351
$3,400
$1,188
$2,471
$3,816
$5,195
$6,546
$0
$0
$0
$0
$0
$1,188
$2,471
$3,816
$5,195
$6,546
OC(12%)
Total
AEC(12%)
CR(12%)
$1,330
$1,462
$1,589
$1,710
$1,816
$1,188
$2,471
$3,816
$5,195
$6,546
$336
$291
$333
$346
$291
$1,666
$1,753
$1,922
$2,056
$2,107

Financial Data
Depreciation
Book value
Salvage value
Operation Cost
$6,000
Cash Flow Statement

Investment
1
$1,200
$4,800
2
$1,920
$2,880
3
$1,152
$1,728
4
$691
$1,037
$1,100
$1,300
$1,500
$1,700
5
$346
$691
$1,000
$1,800
360
(770)
576
(910)
346
(1,050)
207
(1,190)
907
104
(1,260)
($410)
($334)
($704)
($983)
($249)
AEC(12%) =
$2,191
(6,000)
Net Cash Flow
($6,000)
PW (12%) =
($7,899)
Page | 46

14.48
n
Depreciation
Book value
Market value
Operating cost
Cash Flow Statement
-(1-0.30)*(Operating cost)
Opportunity cost
1
$3,072
$4,608
2
$1,843
$2,765
3
$1,843
$922
4
$922
$0
5
$0
$0
$4,000
$4,000
$4,000
$4,000
$4,000
$0
$0
$2,000
$4,000
$922
($2,800)
$553
($2,800)
$553
($2,800)
$276
($2,800)
$0
($2,800)
$0
($2,800)
($11,472)
$1,400
Net Cash Flow

PW (11%) =
0
$5,120
$7,680
$12,000
($11,472)
($20,703)
($1,878)
($2,247)
AEC(11%) =
$4,894
1
$2,000
$8,000
2
$3,200
$4,800
($2,247)
($2,524)
($2,800)
($1,400)

n
Depreciation (First Cycle)
Book value (First Cycle)
Depreciation (Second Cycle)
Book value (Second Cycle)
Salvage value
Operating cost
Cash Flow Statement
Investment
Net Cash Flow
PW (11%) =
0
$10,000
$2,000
$600
($1,400)
$960
($1,400)
($10,000)
($10,000)
($15,583)
$2,000
($800)
($440)
AEC(11%) =
$3,683
$2,000
$8,000
$3,200
$4,800
$2,000
$2,000
$960
$3,840
$4,000
$2,000
$288
($1,400)
($10,000)
$3,952
$600
($1,400)
$960
($1,400)
$288
($1,400)
($7,160)
($800)
$960
$3,840
$10,000
$4,000
$2,000
$3,952
($440)
$2,840
Decision: Replace the defender now with the current challenger. Then, replace the
current challenger at the end of 3 years with a similar challenger.
Page | 47

Short Case Studies

ST 14.1
(a) The following assumptions were made: (1) Depreciable life for the challenger
= 12 years (2) the challenger will be obsolete after 10 years with zero salvage
value. (3) Kazakhstans tax rate = 40%. (5) No market value for a leaky oil
system (defender). With these assumptions, the defender wins. Do not
replace the defender.
Option 1 : Upgrade the defender
Financial Data
Depreciation
Book value
Market value
Operating cost
1
$10,400
$93,600
2
$10,400
$83,200
3
$10,400
$72,800
4
$10,400
$62,400
5-9
$10,400
$52,000
10
$10,400
$0
$41,000
$41,000
$41,000
$41,000
$41,000
$41,000
4,160
4,160
4,160
4,160
4,160
4,160
(24,600)
(24,600)
(24,600)
(24,600)
(24,600)
(24,600)
($20,440)
($20,440)
($20,440)
($20,440)
($20,440) ($20,440)
AE (20%) =
($45,246)
1
$27,083
$297,917
2
$27,083
$270,833
3
$27,083
$243,750
4
$27,083
$216,667
5-9
$27,083
$189,583
$12,000
$12,000
$12,000
$12,000
$12,000
10
$27,083
$54,167
$0
$12,000
10,833
(7,200)
10,833
(7,200)
10,833
(7,200)
10,833
(7,200)
10,833
(7,200)
21,667
10,833
(7,200)
($325,000)
$3,633
$3,633
$3,633
$3,633
$3,633
$25,300
PW (20%) =
($306,268)
AE (20%) =
($73,052)
$104,000
Cash Flow Statement

Opportunity cost
(104,000)
Net Cash Flow
($104,000)
PW (20%) = ($189,694)
Financial Data
Depreciation
Book value
Salvage value
Operating cost
Cash Flow Statement

Investment
Net Cash Flow
0
$325,000
(325,000)
(b) If environmental impact is taken into account, it might be better to install the
new facility. It is also quite possible that the government of Kazakhstan
would impose some huge fines upon discovering the environmental damage
caused by the defending facility. Such issues need to be addressed before
making any final decision.
Page | 48

ST 14.2
(a) The current FMS manufacturing technology would prevail for several years with
no major cost and productivity improvement. Therefore, if the present system is
kept for the remaining useful life, it will be replaced by the current FMS
technology with the same investment and O&M costs.
(b) Decision: The challenger should be adopted.
Option1: Keep the defender

n
Operating cost
$140,000
Cash Flow Statement

-(.6)*(O&M)
Opportunity cost
($84,000)
Net Cash Flow
($84,000)
PW (15%) =
1
$105,000
2
3
4
5
$115,000 $125,000 $135,000 $145,000
($63,000) ($69,000) ($75,000) ($81,000) ($87,000)
($329,837)
($63,000) ($69,000) ($75,000) ($81,000) ($87,000)

AEC(15%) =
$98,395
1
$185,770
$1,114,230
$664,243
$45,000
2
3
4
5
$318,370 $227,370 $162,370 $116,090
$795,860 $568,490 $406,120 $290,030
$664,243 $664,243 $664,243 $664,243
$47,000 $49,000 $51,000 $53,000

n
Depreciation
Book value
Savings
Operating cost
$1,300,000
Cash Flow Statement

+(0.60)*(Savings)
-(.6)*(O&M)
Investment
Net proceeds
Net Cash Flow
PW (15%) =
$74,308 $127,348 $90,948 $64,948 $46,436 $46,384 $46,436 $23,192

$398,546 $398,546 $398,546 $398,546 $398,546 $398,546 $398,546 $398,546 $398,546 $398,546
($27,000) ($28,200) ($29,400) ($30,600) ($31,800) ($33,000) ($34,200) ($35,400) ($36,600) ($37,800)
($1,300,000)
$72,000
($1,300,000)
$888,146
6
7
8
9
10
$115,960 $116,090 $57,980
$174,070 $57,980
$664,243 $664,243 $664,243 $664,243 $664,243
$55,000 $57,000 $59,000 $61,000 $63,000
$445,854
$497,694 $460,094 $432,894 $413,182
$411,930 $410,782 $386,338 $361,946 $432,746
AEC(15%) = ($176,965)
Page | 49

ST 14.3
(a) Decision: Replace the defender now.
(b) The optimal time to replace the defender is now. If the AE cost for the
defender were smaller than that of the challenger, we would need to perform the
marginal analysis, i.e., calculating the incremental cost of operating the
defender for just 1 more year.
Option1: Keep the defender

n
Operating cost
Maintenance
1
$65,000
$2,500
2
$65,000
$2,875
3
$65,000
$3,306
4
$65,000
$3,802
5
$65,000
$4,373
Cash Flow Statement

-(.6)*(O&M)
Opportunity cost
($40,500) ($40,725) ($40,984) ($41,281) ($41,624)
Net Cash Flow
($40,500) ($40,725) ($40,984) ($41,281) ($41,624)
PW (16%) =
($134,052)
AEC(16%) =
$40,941
1
$1,160
$46,040
$18,777
$112,623
$57,895
$35,000
2
$1,210
$44,830
$32,180
$80,443
$57,895
$35,000

n
Depreciation(Building)
Book value (Building)
Depreciation(Equipment)
Book value (Equipment)
Savings
O&M cost
Cash Flow Statement
+(0.60)*(Savings)
-(.6)*(O&M)
Investment
Net proceeds
$47,200
$131,400
3
$1,210
$43,620
$22,982
$57,461
$57,895
$35,000
4
$1,210
$42,410
$16,412
$41,049
$57,895
$35,000
5
$1,210
$41,200
$11,734
$29,315
$57,895
$35,000
6
$1,210
$39,990
$11,721
$17,594
$57,895
$35,000
7
$1,210
$38,780
$11,734
$5,860
$57,895
$35,000
8
$1,210
$37,570
$5,860
9
$1,210
$36,360
10
$1,160
$35,200
$57,895
$35,000
$57,895
$35,000
$57,895
$35,000
$7,975 $13,356 $9,677 $7,049 $5,178 $5,172 $5,178 $2,828

$484
$464
$34,737 $34,737 $34,737 $34,737 $34,737 $34,737 $34,737 $34,737 $34,737 $34,737
($21,000) ($21,000) ($21,000) ($21,000) ($21,000) ($21,000) ($21,000) ($21,000) ($21,000) ($21,000)
($178,600)
$21,964
Net Cash Flow

PW (16%) =
($178,600)
($72,819)
$21,712
$27,093
AEC(16%) =
$15,066
$23,414
$20,786
$18,915
$18,909
$18,915
$16,565
$14,221
$36,165
Page | 50

ST 14.4
(a) Development of a combined productivity index: Combined productivity
means inherent productivity relative hours for challenger.
Operating hours
(b)
Ratio Combined productivity index
Defender
Challenger
1,800
2,500
1.389
1.667
1,800
2,400
1.333
1.600
1,700
2,300
1.353
1.624
1,700
2,100
1.235
1.482
1,600
2,000
1.250
1.500
Adjusted annual O&M costs for Defender

n
Operating HR Maintenance
Wages
Fuel
Total
1,800
$46,800
$42,120
$24,408
$113,328
1,800
$46,800
$42,120
$24,408
$113,328
1,700
$46,800
$39,780
$23,052
$109,632
1,700
$46,800
$39,780
$23,052
$109,632
1,600
$46,800
$37,440
$21,696
$105,936
Adjusted annual O&M costs for Challenger

n
Operating
HR
Combined
Productivity
index
Adjusted
L
Total
2,500
$35,000 $58,500 $48,000
1.667
$21,000
$35,100 $28,800 $84,900
2,400
$38,400 $56,160 $46,080
1.600
$24,000
$35,100 $28,800 $87,900
2,300
$43,700 $53,820 $44,160
1.624
$26,917
$33,150 $27,200 $87,267
2,100
$48,300 $49,140 $40,320
1.482
$32,583
$33,150 $27,200 $92,933
2,000
$58,000 $46,800 $38,400
1.500
$38,667
$31,200 $25,600 $95,467
Page | 51

(c) Replacement analysis

Defender analysis
Market
Dep.
n
value
0
1
2
3
4
5
n
0
1
2
3
4
5
$75,000
$60,000
$50,000
$30,000
$30,000
$10,000
0
0
0
0
0
After tax
Salvage
Dep.
Tax credit
A/T
O&M cost
$113,328
$113,328
$109,632
$109,632
$105,936
$36,000
$30,000
$18,000
$18,000
$6,000
0
0
0
0
0
$67,997
$67,997
$65,779
$65,779
$63,562
Equivalent Annual Cost

Net
Cumulative
Net
O&M cost O&M cost Investment Capital cost Operating
Total
cost
$67,997
$67,997
$65,779
$65,779
$63,562
$59,128
$110,543
$153,794
$191,403
$223,005
Challenger analysis
Market
Dep.
n
value
0
1
2
3
4
5
O&M Cost
$400,000
$300,000
$240,000
$190,000
$150,000
$115,000
$80,000
$128,000
$76,800
$46,080
$46,080
$13,696
$22,316
$33,165
$34,708
$42,017
$15,750
$13,726
$14,526
$12,158
$12,534
$67,997
$67,995
$67,362
$67,049
$66,522
$83,747
$81,721
$81,888
$79,207
$79,056
O&M Cost
After tax
Salvage
Dep.
Tax credit
A/T
O&M cost
$84,900
$87,900
$87,267
$92,933
$95,467
$308,000
$220,800
$160,080
$117,648
$78,216
$32,000
$51,200
$30,720
$18,432
$18,432
$50,940
$52,740
$52,360
$55,760
$57,280

Net
Cumulative
Net
n
Total
cost
0
1
2
3
4
5
$18,940
$1,540
$21,640
$37,328
$38,848
$16,470
$17,634
$31,863
$53,205
$72,519
$132,174
$233,043
$294,745
$332,734
$361,113
$152,000
$143,345
$129,098
$116,557
$107,720
$18,940
$10,847
$13,956
$18,638
$21,633
$170,940
$154,192
$143,054
$135,195
$129,352
Decision: The economic service life for the defender is 5 years with AE(15%) =
$79,060. On the other hand, the economic service life for the challenger is 5
years with AE(15%) = $129,352. Even though the challenger is a better
Page | 52

machine in terms of operating efficiency, its initial cost is too high to justify its
purchase at this point.
(d) Replacement analysis under inflation
Adjusted operating and maintenance cost by inflation: Sample calculation
for fuel cost Defender for Year 2:
Fuel cost before inflation = $24,408
Price index for fuel for year 2 = 120
Fuel cost after inflation = $24,408(1.2) = $29,290
Other inflation-adjusted operating and maintenance cost elements can be
calculated in a manner similar to the fuel cost. The following table summarizes
these calculations. All cost figures are in actual dollars.
Defender
Maintenance
Wage
Fuel
Total
$50,544
$48,438
$26,849
$125,831
$54,288
$52,650
$29,290
$136,228
$58,032
$51,714
$29,968
$139,714
$58,968
$53,703
$32,273
$144,944
$59,904
$52,416
$32,544
$144,864
Challenger
Maintenance
Wage
Fuel
Total
$22,680
$40,365
$31,680
$94,725
$27,840
$43,875
$34,560
$106,275
$33,377
$43,095
$35,360
$111,832
$41,055
$44,753
$38,080
$123,888
$49,493
$43,680
$38,400
$131,573
Page | 53

Replacement analysis: Keep the defender for now
n
0
1
2
3
4
5
n
0
1
2
3
4
5
n
0
1
2
3
4
5
n
0
1
2
3
4
5
Defender
Market
value
$75,000
$60,000
$50,000
$30,000
$30,000
$10,000
Dep.
O&M Cost
After tax
Salvage
Dep.
Tax credit
A/T
O&M cost
$0
$0
$0
$0
$0
$125,831
$136,228
$139,714
$144,944
$144,864
$36,000
$30,000
$18,000
$18,000
$6,000
$0
$0
$0
$0
$0
$75,498
$81,737
$83,828
$86,966
$86,918

Net
Cumulative
Net
Total
cost
$75,498
$81,737
$83,828
$86,966
$86,918
$65,651
$127,455
$182,574
$232,297
$275,511
$13,696
$22,316
$33,165
$34,708
$42,017
Challenger
Market
Dep.
O&M Cost
value
$400,000
$300,000 $80,000
$94,725
$240,000 $128,000 $106,275
$190,000 $76,800
$111,832
$150,000 $46,080
$123,888
$115,000 $46,080
$131,573
$15,750
$13,726
$14,526
$12,158
$12,534
After tax
Salvage
$308,000
$220,800
$160,080
$117,648
$78,216
$75,498
$78,398
$79,967
$81,374
$82,185
$91,248
$92,124
$94,493
$93,532
$94,719
Dep.
A/T
Tax credit O&M cost
$32,000
$51,200
$30,720
$18,432
$18,432
$56,835
$63,765
$67,099
$74,333
$78,944

Net
Cumulative
Net
Operating
O&M cost O&M cost Investment Capital cost
Total
cost
$24,835
$12,565
$36,379
$55,901
$60,512
$21,596
$31,097
$55,016
$86,978
$117,063
$132,174
$233,043
$294,745
$332,734
$361,113
$152,000
$143,345
$129,098
$116,557
$107,720
$24,835
$19,128
$24,097
$30,468
$34,920
$176,835
$162,473
$153,195
$147,025
$142,640
Page | 54

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Contemporary Engineering Economics, Fifth Edition, by Chan S. Park.

Chapter 14 Replacement Decisions

PW (15%) = $6, 000 $1,500 $3, 000( P / F ,15%,1)

PW (15%) = $7,500 $3, 000( P / F ,15%,1) $3,500( P / F ,15%, 2)

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Cash Flows: -$30,000 -$30,000 -$18,000

AECD = ($30, 000 $12, 000)( A / P,12%, 2) + $12, 000(0.12)

AEC (15%) D = $10, 000( A / P,15%,5) = $2,983

AEC (15%)C = [ ($120, 000 $30, 000)( A / P,15%, 7) + $30, 000(0.15)]

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Revenue for defender = ($19 - $12) 3,000 = $21,000 per year

Economic Service Life

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

The economic life of the asset is eight years; that is,

$3, 200 $4,300 $3, 200

CR(12%) Total AE(12%)

Since AECD > AECC , the defender should be replaced now.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

(b) Interest i = 15%

In both cases, the economic service life is 1 year.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Replacement Decision with an Infinite Planning Horizon and No

14.12 (a) and (b)

AECC (15%) = ($6, 000 +

$3, 000 $4,500 $5, 000

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

AECC = $53,500( A / P,12%,5) $12, 000( A / F ,12%,5)

1 $35,550 $17,000 $35,550

2 $31,013 $14,450 $33,390

3 $25,794 $12,283 $31,095

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

$3,800 $1,500 $3,800

$3,800 $1,250 $3,800

$3,800 $1,125 $3,800

N D = 5 years, AEC D = $4,231 with i = 14%.

Since AECOption 1 < AECOption 2 , Option 1 should be selected.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Replacement Problem with a Finite Planning Horizon

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Since AEC < AED , replace now.

Replacement Analysis with Tax considerations

(b) Opportunity cost of not replacing the truck:

Taxable gain = $6,000 $5,760 = $240

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

PW (12%) = $7, 207

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Option 1: Keep the defender

Cash Flow Statement

Net Cash Flow

Option 2: Replace the defender

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

(b) Cash flow for the old machine:

(c) Replacement analysis: Replace the old machine now.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Cash Flow Statement

Net Cash Flow

14.29 (a) & (b): Decision - Replace the defender now.

Cash Flow Statement

Net Cash Flow

(2) Replace the defender