IE 343 Engineering Economics

Lecture 35: Chapter 9 Replacement Analysis Instructor: Tian Ni

Nov.21, 2011

IE 343 Fall 2011

Terminology

IE 343 Fall 2011

Terminologies in Replacement Studies

Defender:
is the old asset that is being considered for replacement.

Challenger:
is the new asset that is considered for replacing the defender.

IE 343 Fall 2011

Terminologies in Replacement Studies

AW values:
are used for both the defender and challenger.

BV:
Book value of an asset.

MV:
Market value of an asset.

IE 343 Fall 2011

Terminologies in Replacement Studies

Life Terminologies: Useful Life*:
the length of time that we anticipate using the asset

Ownership Life:
Period between date of acquisition and date of disposal by a specific owner.

Physical Life:
Period between original acquisition and final disposal

IE 343 Fall 2011

Terminologies in Replacement Studies

Tax Life:
the length of time that we can depreciate the asset.

Economic Life*:
the length of time during which keeping the asset is economically justifiable. The ESL establish the life n for the challenger and defender.

IE 343 Fall 2011

Terminologies in Replacement Studies

EUAC*:
EUAC(Equivalent Uniform Annual Cost) is frequently used instead of AW values since often only the cost are used in the evaluation.

IE 343 Fall 2011

Terminologies in Replacement Studies

Outsider viewpoint:
We use the so-called outsider viewpoint for approximating the investment worth of an exiting asset(defender). Outsider viewpoint is the perspective that would be taken by an impartial third party to establish the fair MV of a used(secondhand) asset.

Present Realizable MV:

Is the correct capital investment amount to be assigned to an existing asset in replacement studies Good way to reason is to use the opportunity cost or opportunity forgone principle
IE 343 Fall 2011 8

Before-Tax Replacement Analysis

IE 343 Fall 2011

Example 9.1-Before Tax Replacement Analysis

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 five more years, at which time it will have zero market value. It is believed that $30,000 could be obtained for the old pressure vessel if it were sold now. (Defender)

IE 343 Fall 2011

10

Example 9.1-Before Tax Replacement Analysis

A new pressure vessel can be purchased for $120,000. The new pressure vessel will have a market value of $50,000 in five years and will have annual operating and maintenance expenses of $30,000 per year. Using a (before-tax) MARR of 20% per year, determine whether or not the old pressure vessel should be replaced. A study period of five years is appropriate. (Challenger)

IE 343 Fall 2011

11

Example 9.1
From outsider viewpoint: Invest the old pressure vessel(Defender) VS Invest the new pressure vessel(Challenger)
Before-Tax MARR = Study Period = 20.00% 5

IE 343 Fall 2011

12

Example 9.1
From outsider viewpoint: Invest the old pressure vessel(Defender) VS Invest the new pressure vessel(Challenger)
EOY, k 0 1 2 3 4 5 5(MV)
IE 343 Fall 2011

Defender -30000 -60000 -60000 -60000 -60000 -60000 0

Challenger -120000 -30000 -30000 -30000 -30000 -30000 50000

13

Example 9.1 Solution(PW)

Solution 1: (PW) Defender: PW(20%) = -$30,000 - $60,000(P/A, 20%, 5) = -$209,436 Challenger: PW(20%) = -$120,000 - $30,000(P/A, 20%, 5) + $50,000(P/F, 20%, 5) = -$189,624 Select the Challenger Replace the old pressure vessel with the new one.
IE 343 Fall 2011 14

Example 9.1 Solution(EUAC)

Solution 2: (EUAC) In Example 9.1 only cost is considered, EUAC is equivalent to the negation of AW Defender: EUAC(20%) = $30,000(A/P, 20%, 5) + $60,000= $70,031 Challenger: EUAC(20%) = $120,000(A/P, 20%, 5) + $30,000 $50,000(A/F, 20%, 5) = $63,407 Select the Challenger.
IE 343 Fall 2011 15

Example 9.2
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. The company that owns the plant is using a before-tax MARR of 10% per year for its capital investment projects.

IE 343 Fall 2011

16

Example 9.2
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 bearings at a cost of $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 nine 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. (Defender: Pump A)
IE 343 Fall 2011 17

Example 9.2
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 the nine-year 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 capital investment. (Challenger: Pump B)

IE 343 Fall 2011

18

Example 9.2
Based on these data, should the defender (Pump A) be kept [and the challenger (Pump B) not purchased], or should the challenger be purchased now (and the defender sold)? Use a before-tax analysis and the outsider viewpoint in the evaluation.
Before-Tax MARR = Study Period = 10.00% 9

IE 343 Fall 2011

19

Example 9.2 Defender

Pump A (Defender)

Capital Investment when purchased 5 years ago Annual expenses: Replacement of impeller and bearings Operating and maintenance Taxes and insurance: $17,0000.02 Total annual expenses: Present MV Estimated market value at the end of nine additional years
IE 343 Fall 2011

$17,000 $1,750 $3,250 $340 $5,340 $750

$200
20

Example 9.2 Challenger

Pump B (Challenger) Capital Investment Annual expenses: Operating and maintenance Taxes and insurance: $16,0000.02 Total annual expenses: Estimated market value at the end of nine additional years:$16,0000.2
IE 343 Fall 2011

$16,000

$3,000 $320 $3,320 $3,200

21

Example 9.2 Note

Note: 1. Pump A Capital investment $17,000 when purchased five years ago is the SUNK cost, so ignore. 2. From outsiders viewpoint, invest Pump A costs the present MV = $750

IE 343 Fall 2011

22

Example 9.2 Cash Flow

EOY, k 0 1 2 3 4 5 6 7 8 9 9(MV)
IE 343 Fall 2011

Defender -750 -5340 -5340 -5340 -5340 -5340 -5340 -5340 -5340 -5340 200

Challenger -16000 -3320 -3320 -3320 -3320 -3320 -3320 -3320 -3320 -3320 3200
23

Example 9.2 Solution(PW)

Solution 1: (PW) Defender: PW(10%) = -$750 - $5,340(P/A, 10%, 9) + $200(P/F, 10%, 9) = -$31,418 Challenger: PW(10%) = -$16,000 - $3,320(P/A, 10%, 9) + $3,200(P/F, 10%, 9) = -$33,763 Select the Defender Pump A

IE 343 Fall 2011

24

Example 9.2 Solution(EUAC)

Solution 2: (EUAC) Defender: EUAC(10%) = $750(A/P, 10%, 9) + $5,340 - $200(A/F, 10%, 9) = $5,455 Challenger: EUAC(10%) = $16,000(A/P, 10%, 9) + $3,320 - $3,200(A/F, 10%, 9) = $5,862 Select the Defender - Pump A.

IE 343 Fall 2011

25

Determining Economic Life

IE 343 Fall 2011

26

Why Determining Economic Life?

Sometimes the useful lives of assets (both defender and challenger) are not known and cannot be reasonably estimated. It is important to know the Economic Life, minimum EUAC, and total year-by-year (marginal) costs for both the best challenger and the defender so that they can be compared on the basis of an evaluation of their economic lives and the costs most favorable to each

IE 343 Fall 2011

27

Determining Economic Life Factors

Economic Life:
Economic life of an asset minimizes the EUAC of owning and operating the asset Economic life of the defender VS Economic life of the challenger Economic life is often shorter than useful life.

Minimum EUAC:
The lowest Equivalent Uniform Annual Cost

Total year-by-year (marginal) costs:

Marginal cost is total cost for an additional year of service
IE 343 Fall 2011 28

Determining Economic Life Notations

Economic life can be estimated if the capital investment, annual expenses, and year-by-year MVs are known or can be estimated. PWk : the present worth of total costs through year k I : sum of the initial capital investment (PW of the initial
investment amounts, if any, occur after time Zero) MVk : Market Value at the end of year k

Ek : Annual expenses through year k * N C : Economic life of an asset

IE 343 Fall 2011 29

Determining Economic Life

So the Present Worth of total costs through year k is
PWk = I MVk ( P / F , i %, k ) + E j ( P / F , i %, j )
j =1 k

The total marginal cost for each year k (TCk)is calculated from the equation above by finding the increase in the PW of total cost from year k-1 to year k and then determine the equivalent worth of this increase at the end of year k.
30

IE 343 Fall 2011

Determining Economic Life

That is,
TCk = ( PWk PWk 1 )( F / P, i %, k )

By algebraic simplification,
TCk (i %) = ( PWk PWk 1 )(1 + i ) k = [ I MVk ( P / F , i, k ) + E j ( P / F , i, j )
j =1 k

( I MVk 1 ( P / F , i, k ) + E j ( P / F , i, j ))](1 + i ) k
j =1

k 1

= ( MVk 1 /(1 + i ) k 1 MVk /(1 + i ) k + Ek /(1 + i ) k )(1 + i ) k = MVk 1 MVk + iMVk 1 + Ek

IE 343 Fall 2011 31

Determining Economic Life

So equivalently,
TCk (i %) = MVk 1 MVk + iMVk 1 + Ek

MVk-1 MVk : sum of the loss in MV during the year of service iMVk-1: the opportunity cost of capital invested in the asset at the beginning of year k Ek: Annual expenses incurred in year k

IE 343 Fall 2011

32

Determining Economic Life

Finally, we can determine the EUAC through year k
k EUACk = TC j ( P / F , i %, j ) ( A / P, i %, k ) j =1

to determine the economic life NC*

IE 343 Fall 2011

33

Determining the Economic Life of a New Asset (Challenger)

IE 343 Fall 2011

34

Example 9.3
A new manufacturing process asset is being considered. Its current market value is $13,000. Estimated future market values and annual operating costs for the next 5 years are given. What is the economic life of the challenger if the before-tax MARR is 10% per year?
Year j 1 2 3 4 5
IE 343 Fall 2011

MVj 9000 8000 6000 2000 0

Annual Expenses 2500 2700 3000 3500 4500

35

Example 9.3 Solution

MV Loss j = MV j 1 MV j

Cost of Capital j = iMV j 1

TC j = E j + MV Loss j + Cost of Capital j

Year j 0 1 2 3 4 5

MVj 13000 9000 8000 6000 2000 0

Ej

Cost of Total Capital Marginal MV Loss(j) i=10% Cost(TCj) TCj(P/F,i,j) TCj(P/F,i,j)

EUACj

2500 2700 3000 3500 4500

4000 1000 2000 4000 2000

1300 900 800 600 200

7800 4600 5800 8100 6700

7091 3802 4358 5532 4160

7091 10893 15250 20783 24943

7800 6276 6132 6556 6580

36

IE 343 Fall 2011

Example 9.3 Solution

Plot of EUACj
9000

8000

7000

6000

5000 EUACj 4000

3000

minimum EUACj (NC*) = 3 Years

2000

1000

0 1 2 3 4 5

IE 343 Fall 2011

37

Example 9.3 Solution

So the Economic Life of the new manufacturing process asset which reaches the minimum EUAC is 3 years After 3 years, the old manufacturing process asset is no longer economically justifiable

IE 343 Fall 2011

38

Determining the Economic Life of an Existing Asset (Defender)

IE 343 Fall 2011

39

Example 9.4
Two years ago, an electronics firm made a $70,000 investment in a new assembly line machine. This year, new international industry standards will require a $16,000 upgrade. Also there is a new machine which is challenging the retention of the two-year-old machine. At MARR = 10%, and the estimates below, perform a replacement study this year and each year in the future, if needed.

IE 343 Fall 2011

40

Example 9.4
Defender: First Cost: $15,000 Future MVs: decreasing by 20% per year Estimated Retention Period: no more than 3 years Annual Operating Cost Estimates: $4,000 per year, increasing by $4,000 per year thereafter

IE 343 Fall 2011

41

Example 9.4
Challenger: First Cost: $50,000 Future MVs: decreasing by 20% per year Estimated Retention Period: no more than 5 years Annual Operating Cost Estimates: $5,000 in year 1, increasing by $2,000 per year thereafter

IE 343 Fall 2011

42

Example 9.4
Year j 0 1 2 3 Year j 0 1 2 3 4 5
IE 343 Fall 2011

DEFENDER MVj Annual Expenses 15000 12000 20000 9600 8000 7680 12000 CHALLENGER MVj Annual Expenses 50000 40000 5000 32000 7000 25600 9000 20480 11000 16384 13000
43

Example 9.4 Defender

Year j MVj 0 1 2 3 15000

Ej

Cost of Total MV Capital Marginal Loss(j) i=10% Cost(TCj) TCj(P/F,i,j) TCj(P/F,i,j) EUACj

12000 20000 9600 8000

3000 2400 1920

1500 1200 960

24500 11600 14880

22273 9587 11180

22273 31860 43039

24500 18357 17307

7680 12000

Economic Life of the Defender is 3 years EUACj = 17307

IE 343 Fall 2011 44

Example 9.4 Challenger

Cost of Total MV Capital Marginal Loss(j) i=10% Cost(TCj) TCj(P/F,i,j) TCj(P/F,i,j) EUACj

Year j 0 1 2 3 4 5

MVj 50000 40000 32000 25600

Ej

5000 10000 7000 9000 8000 6400

5000 4000 3200 2560 2048

20000 19000 18600 18680 19144

18182 15702 13974 12759 11887

18182 33884 47859 60617 72504

20000 19524 19245 19123 19126

20480 11000 5120 16384 13000 4096

Economic Life of the Challenger is 4 years EUACj = 19123

IE 343 Fall 2011 45

Example 9.4 Solution

Plot of EUACj for Defender and Challenger
30000

EUACj (Defender)
25000

24500 20000 19524 18357 19245 17307

EUACj (Challenger)

20000

19123

19126

15000

10000

Select the Defender because it has better EUACj and expect to retain it for 3 more years

5000

0 1 2 3 4 5

IE 343 Fall 2011

46

Next Time
Determining the Economic Life

IE 343 Fall 2011

47