Copyright Oxford University Press 2009

Chapter 13
Replacement Analysis
Copyright Oxford University Press 2009
Replacement Problem
Replacement Analysis Decision Maps
Minimum-Cost Life
Marginal Cost of Keeping an Asset one more year
Replacement Analysis Techniques
Replacement Repeatability Assumptions
After-tax Replacement Analysis
Spreadsheet and Replacement Analysis
Chapter Outline
Copyright Oxford University Press 2009
Recognize and develop replacement problems
Use the decision map to select the appropriate
replacement analysis technique to apply
Calculate the minimum cost life of an asset
Apply replacement analysis techniques correctly
Perform replacement problems on an after-tax
basis
Use spreadsheet in solving replacement
analysis problems
Learning Objectives
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Should the existing equipment be retained or
replaced?
The Defender is the existing equipment.
The Challenger is the best available
replacement equipment.
If the defender proves more economical, it will
be retained. If the challenger proves more
economical, it will be installed.
Replacement Analysis
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Obsolescence occurs when an assets technology
is surpassed by newer and/or different
technologies (PC)
Depletion is the gradual loss of market value of an
asset as it is being consumed or exhausted (Oil
well, Timber)
Deterioration is the general loss in value of an
asset due to aging process (Production machinery)
The Replacement Problem
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Planned replacements can be scheduled to minimize
the time and cost of disruptions.
Variations of replacement problems, such as
abandonment, retirement, improvements of defender
or keeping defender as spare, can be considered as
potential new challenger.
Since replacement problems usually are considered
with fixed output, only costs of defender and
challengers are analyzed.
Due to the lives of the defender and challengers are
usually different, most calculations focus on annual
marginal costs or on EUAC.
The Replacement Problem
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Replacement Analysis
Decision Map
Identify Alternatives Best Challenger Defender
Defender
Marginal Cost Data?
Analysis Technique 3:
Defenders EUAC
over its remaining life
Challengers EUAC
at its min. cost life
Analysis Technique 2:
Defenders lowest
EUAC Challengers
EUAC at its minimum
cost life
Defender
Marginal Cost
Increasing?
Available
Find EUAC
over given life
Not Available
Find lowest EUAC
for Defender
No
Analysis Technique 1:
Defenders next year
marginal cost
Challengers EUAC
Yes
Copyright Oxford University Press 2009
The minimum cost life of any new asset is the number of
years at which the EUAC of ownership is minimized.
Because of increasing operating and maintenance
costs, the minimum cost life is often shorter than the
assets useful life.
EUAC for each possible life, less than or equal to the
useful life, is determined. The number of years at
which the EUAC is minimum can then be identified.
Minimum Cost Life of a New Asset
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Example 13-1
Minimum Cost Life of a New Asset
EUAC(O&M) CR EUAC(Total)
$500 $8,100 $8,600
1,125 4,206 5,331
1,733 2,910 4,644
2,325 2,264 4,590*
2,900 1,878 4,779
3,459 1,622 5,082
4,002 1,441 5,442
4,528 1,305 5,833
5,038 1,201 6,239
5,533 1,118 6,650
6,011 1,051 7,062
6,474 995 7,470
6,922 949 7,871
7,355 910 8,265
7,773 876 8,649
Year Maint. Operating O&M
1
$0
$500 $500
2
900
900 1,800
3
1,800
1,300 3,100
4
2,700
1,700 4,400
5
3,600
2,100 5,700
6
4,500
2,500 7,000
7
5,400
2,900 8,300
8
6,300
3,300 9,600
9
7,200
3,700 10,900
10
8,100
4,100 12,200
11
9,000
4,500 13,500
12
9,900
4,900 14,800
13
10,800
5,300 16,100
14
11,700
5,700 17,400
15
12,600
6,100 18,700
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Example 13-1
Minimum Cost Life of a New Asset
0
2000
4000
6000
8000
10000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Year
C
o
s
t
Capital Recovery
O&M
Total EUAC
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Replacement Analysis
Decision Map
Identify Alternatives Best Challenger Defender
Defender
Marginal Cost Data?
Analysis Technique 3:
Defenders EUAC
over its remaining life
Challengers EUAC
at its min. cost life
Analysis Technique 2:
Defenders lowest
EUAC Challengers
EUAC at its minimum
cost life
Defender
Marginal Cost
Increasing?
Available
Find EUAC
over given life
Not Available
Find lowest EUAC
for Defender
No
Analysis Technique 1:
Defenders next year
marginal cost
Challengers EUAC
Yes
Copyright Oxford University Press 2009
Are the defender marginal cost data available?
Are the defender marginal costs increasing?
The total marginal cost for any year can include:
Capital recovery cost (loss in market value and
loss interest for the year)
Yearly operating and maintenance costs
Yearly taxes and insurance
Any other expenses that occurs during that year
The marginal cost is calculated as an equivalent
end-of-year cash flow
Defenders Marginal Cost Data
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Example 13-2
Marginal Cost Calculation
Year
Market
Value
Capital
Recovery O&M
Cost of
Breakdown
Risk
Total
Marginal
Cost
1
$18,000
$10,750 $2,000 $5,000 $17,750
2
13,000
7,700 2,500 5,000 15,200
3
9,000
5,950 3,000 5,000 13,950
4
6,000
4,350 3,500 6,500 14,350
5
4,000
2,900 4,000 8,000 14,900
6
3,000
1,600 4,500 9,500 15,600
7
2,500
950 5,000 11,000 16,950
Capital Recovery Cost = MV
N-1
(A/P, 15%, 1) MV
N
(A/F, 15, 1)
= MV
N-1
(1+15%) MV
N
(1)
= (MV
N-1
MV
N
) + MV
N-1
(15%)
Copyright Oxford University Press 2009
Example 13-3
Marginal Cost Calculation
Year
Market
Value
Capital
Recovery
Operating
Cost
Total
Marginal
Cost
0
$15,000
1
14,000
$3,250 $10,000 $13,250
2
13,000
3,100 11,500 14,600
3
12,000
2,950 13,000 15,950
4
11,000
2,800 14,500 17,300
5
10,000
2,650 16,000 18,650
Capital Recovery Cost = MV
N-1
(A/P, 15%, 1) MV
N
(A/F, 15, 1)
= MV
N-1
(1+15%) MV
N
(1)
= (MV
N-1
MV
N
) + MV
N-1
(15%)
Copyright Oxford University Press 2009
Maintain the Defender as long as the
marginal cost of ownership for one more
year is less than the Challengers minimum
EUAC.
When the Defenders marginal cost
becomes greater than the Challengers
minimum EUAC, then replace the Defender
with the Challenger.
Replacement Analysis Technique 1:
Defender Marginal Cost Increasing
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Example 13-4
Replacement Analysis Technique 1
Year
Challenger
Marginal Cost
Challenger
EUAC
1 $17,750 $17,750.00
2 15,200 16,563.95
3 13,950 15,811.20
4 14,350 15,518.57
5 14,900 15,426.83*
6 15,600 15,446.61
7 16,950 15,582.46
Year
Defender
Marginal Cost
1 $13,250
2 14,600
3 15,950
4 17,300
5 18,650
) N %, 15 , P A ]( ) j %, 15 , F P )( Cost (Marginal [ UAC E
N
1 j
j

Copyright Oxford University Press 2009

Currently available best Challenger will
continue to be available in subsequent years
and will be unchanged in its economic costs.
When the Defender is ultimately replaced, it
will be replaced with this Challenger.
The period of needed services of the asset
is indefinitely long.
Replacement Repeatability
Assumption
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Calculate the Defenders minimum EUAC.
If the Defenders minimum EUAC exceeds the
Challengers minimum EUAC, then replace
immediately.
If the Defenders minimum EUAC is lower than the
Challengers minimum EUAC, then the Defender
will be kept at least the minimum cost life.
After the minimum cost life, then replace when the
Defenders increasing marginal cost exceeds the
Challengers minimum EUAC.
Replacement Analysis Technique 2:
Defender Marginal Cost Not Increasing
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Example 13-5
Replacement Analysis Technique 2
Year
Challenger
Marginal
Cost
Challenger
EUAC
1 $17,750 $17,750.00
2 15,200 16,563.95
3 13,950 15,811.20
4 14,350 15,518.57
5 14,900 15,426.83*
6 15,600 15,446.61
7 16,950 15,582.46
Year
Defender
Marginal
Cost
Defender
EUAC
1 $16,000 $16,000.00
2 14,000 $15,069.77
3 13,500 $14,617.71*
4 15,300 $14,754.35
5 17,500 $15,161.57
) N %, 15 , P A ]( ) j %, 15 , F P )( Cost (Marginal [ UAC E
N
1 j
j

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Example 13-6
Finding Minimum Cost Life
Year
Market
Value
Capital
Recovery O&M
Marginal
Cost EUAC
0
$5,000
1
4,000
$1,500 $0 $1500 $1,500.00
2
3,500
900 100 1000 1,261.90
3
3,000
850 200 1050 1,197.89
4
2,500
800 300 1100 1,176.79
5
2,000
750 400 1150 1,172.41
6
2,000
200 500 700 1,111.18
7
2,000
200 600 800 1,078.38
8
2,000
200 700 900 1,062.78
9
2,000
200 800 1000 1,058.16*
10
2,000
200 900 1100 1,060.78
11
2,000
200 1,000 1200 1,068.29
Copyright Oxford University Press 2009
Example 13-7
Replacement Analysis Technique 2
Year
Challenger
EUAC
1 $8,600
2 5,331
3 4,644
4 4,590*
5 4,779
Year
Defender
Overhaul
Cost
Defender
O&M
Defender
Marginal
Cost
Defender
EUAC
0 $4,000
1 $1,800 $6,120 $6,120.00
2 1,800 1,800 4,043.08
3 2,800 2,800 3,660.17*
4 3,800 3,800 3,691.20
5 4,800 4,800 3,880.20
) N %, 8 , P A ]( ) j %, 8 , F P )( Cost (Marginal [ UAC E
N
1 j
j

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Calculate the Defenders EUAC over its stated
useful life.
If the Defenders EUAC exceeds the Challengers
minimum EUAC, then replace immediately.
If the Defenders EUAC is lower than the
Challengers minimum EUAC, then the Defender
will be kept.
Replacement Analysis Technique 3:
Defender Marginal Cost Not Available
Copyright Oxford University Press 2009
Present market value, not the trade-in value,
should be assigned as the first cost of the
Defender.
The first cost of the Challenger should include the
purchase price, sales tax, installation cost, and
other items that occur initially on a one-time basis
if the Challenger is selected.
The Defenders potential market (or salvage) value
should not be subtracted from the Challengers
first cost.
Defining First Costs of
Defender and Challenger
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Defender: SK-30, purchased 2 years ago for $1600, was
depreciated with SL using 4-year life and 0 salvage.
Challenger: EL-40, $1200 with a trade-in allowance of $350
for the SK-30; $1050 without a trade-in.
Current price for new SK-30 is $995.
Example 13-8
Defining Defender First Cost
Defender: SK-30,
Original cost: $1600 (Basis for SL depreciation)
Present cost: $995 (Irrelevant)
Book value: $800 (Useful in determining depreciation
recapture or loss)
Trade-in value: $350 (Irrelevant)
Market value: $200 (First cost assigned to Defender)
Copyright Oxford University Press 2009
Circumstances where Repeatability Assumption may
not apply:
When there is a specific study period instead of an
indefinite need for the asset
When future Challengers are not assumed to be
identical to the current best Challenger
Repeatability Assumption
Not Acceptable
Copyright Oxford University Press 2009
A Closer Look at Future Challengers
It seems likely that future
challengers will be better
than the present Challenger
The prospect of better
future challengers may
make it more desirable to
retain the Defender and to
reject the present
Challenger
Selecting the current best
Challenger could be risky if
1) high cost and/or 2) long
economic life
0 1 2 3 4
Year
E
U
A
C

a
t

E
c
o
n
o
m
i
c

L
i
f
e
Present
Challenger
Uniform Decline
Rapid Improvements
In Technology
Copyright Oxford University Press 2009
Ordinary taxes
Gains and losses due to asset disposal
After-Tax Replacement Analysis
Copyright Oxford University Press 2009
Example 13-9
Marginal Costs on After-Tax Basis
Year
Market
Value
Book
Value
Recaptured
Depr. or
Loss Tax
After-Tax
Market
Value
0
$25,000
$25,000 $25,000
1
18,000
20,000 -$2,000 -$800 18,800
2
13,000
15,000 -2,000 -800 13,800
3
9,000
10,000 -1,000 -400 9,400
4
6,000
5,000 1,000 400 5,600
5
4,000
4,000 1,600 2,400
6
3,000
3,000 1,200 1,800
7
2,500
2,500 1,000 1,500
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Example 13-9
Marginal Costs on After-Tax Basis
Year
After-
Tax
Market
Value
Capital
Recovery
O&M+
Ins.
Taxable
Income Tax
After-Tax
Marginal
Cost
0 $25,000
1 18,800 $8,700 $7,000 -$12,000 -$4,800 $10,900
2 13,800 6,880 7,500 -12,500 -5,000 9,380
3 9,400 5,780 8,000 -13,000 -5,200 8,580
4 5,600 4,740 10,000 -15,000 -6,000 8,740
5 2,400 3,760 12,000 -17,000 -6,800 8,960
6 1,800 840 14,000 -14,000 -5,600 9,240
7 1,500 480 16,000 -16,000 -6,400 10,080
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Example 13-10
After-Tax Minimum Cost Life
Year
Market
Value
MACRS
Depr.
Book
Value
Recaptured
Depr. or
Loss Tax
After-Tax
Market
Value
0 $100,000 $100,000 $100,000
1 50,000 $14,290 85,710 -$35,710 -$14,284 64,284
2 45,000 24,490 61,220 -16,220 -6,488 51,488
3 40,000 17,490 43,730 -3,730 -1,492 41,492
4 35,000 12,490 31,240 3,760 1,504 33,496
5 30,000 8,930 22,310 7,690 3,076 26,924
6 25,000 8,920 13,390 11,610 4,644 20,356
7 20,000 8,930 4,460 15,540 6,216 13,784
8 15,000 4,460 0 15,000 6,000 9,000
9 10,000 0 10,000 4,000 6,000
10 5,000 0 5,000 2,000 3,000
Copyright Oxford University Press 2009
Example 13-10
After-Tax Minimum Cost Life
Yr.
After-tax
Market
Value
Capital
Recovery O&M
Taxable
Income Tax
After-Tax
Marginal
Cost EUAC
0 $100,000
1 64,284 $41,716 $10,000 -$24,290 -$9,716 $42,000 $42000
2
51,488 16,653 14,000 -38,490 -15,396 15,257 29018
3 41,492 13,085 18,000 -35,490 -14,196 16,889 25208
4 33,496 10,486 22,000 -34,490 -13,796 18,690 23718
5 26,924 8,582 26,000 -34,930 -13,972 20,610 23167
6 20,356 8,183 30,000 -38,920 -15,568 22,615 23088*
7 13,784 7,793 34,000 -42,930 -17,172 24,621 23270
8 9,000 5,611 38,000 -42,460 -16,984 26,627 23610
9 6,000 3,540 42,000 -42,000 -16,800 28,740 24056
10 3,000 3,360 46,000 -46,000 -18,400 30,960 24580
Copyright Oxford University Press 2009
Example 13-11
Before-Tax Minimum Cost Life
Yr.
Market
Value
Capital
Recovery O&M EUAC(O&M)
Total
EUAC
0 $19,999
1 13,999 $8,281.62 $50 $50.00 $8,331.62
2 11,199 6,174.98 50 50.00 6,224.98
3 8,960 5,232.66 50 50.00 5,282.66
4 7,168 4,623.71 450 138.77 4,762.48
5 6,092 4,113.17 850 260.00 4,373.17
6 5,179 3,740.77 1,250 394.95 4,135.72
7 4,402 3,452.78 1,650 535.61 3,988.39
8 3,742 3,221.47 2,050 677.99 3,899.45
9 3,180 3,030.81 2,450 819.89 3,850.69
10 2,703 2,870.70 2,850 960.03 3,830.73
11 2,298 2,734.39 3,250 1,097.60 3,831.99
12 1,953 2,617.10 3,650 1,232.10 3,849.20
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Example 13-11
Before-Tax Minimum Cost Life
) N %, 8 , F A )( 250 MV ( ) N %, 8 , P A )( 400 999 , 19 ( CR
N N

) N %, 8 , P A ]( ) j %, 8 , F P ( ) M & O ( [ ) M & O ( EUAC
N
1 j
j N