Replacement Analysis

Class 11
 When would you want to
replace an Asset?
• Reduced Performance

• Altered Task Requirements

• Obsolescence of Technology
The EUAW curve over time
EUAW Rs./Year

Total EUAW curve

Minimum Cost Life

YEARS
 Why does the EUAW change?
• Ownership costs due to the initial
investments decrease

• Annual O&M costs increase

• Salvage value decreases

The replacement potential of an
Asset
• The existing asset is termed as the ‘defender’
• The potential new asset is termed as the
‘challenger’
• The defended has incurred some ‘sunk’ costs
– Present Book value – present realizable value
• Consider the realizable value of the asset and
compare it with the value of the challenger
 Example
• You own a motorbike which is deteriorating fast.
You purchased it 2 years ago for Rs. 60,000.
You want to use this bike for 10 more years. Fair
market value for a 2-year-old bike is Rs. 42,000
and for a 12 year old bike is Rs. 8,000. Annual
operating costs are Rs. 12,000 per year. The
cost of leasing the bike is Rs. 9,000 per year,
with an annual operating cost of Rs. 14,000.
Should you lease or hold at 12% interest?
 Solution
Defender Challenger
P = Rs. 42,000 Lease Cost = Rs. 9000/year
AOC = Rs. 12,000 AOC = Rs. 14,000
SV = Rs. 8,000
N = 10 years N = 10 years

• EUAWD = 42000(A/P,12%,10) + 12000 –

8000(A/F,12%,10)
– EUAWD = Rs. 18,977
• EUAWC = 9000 + 14000 = Rs. 23000
• Retain your Bike
Comparing assets with different
lives
• Select the asset – defender or challenger
– with the longer life span

• Assume that the service provided by the

shorter-lived asset can be acquired at the
same EUAW as presently computed,
throughout the life of the longer lived asset
 Example
• You have owned a machine for 3 years. Based
on the current market value, this machine has an
EUAW of Rs. 5210 per year and a remaining life
of 5 years. The possible replacement for this
asset has a first cost of Rs. 25,000, a salvage
value of Rs. 3,800, a life of 12 years and an
annual operating cost of Rs. 720 per year. If
your MARR is 10% and you plan to retain the
new asset for its full life, should the old asset be
replaced?
 Solution
• EUAWD = Rs. 5210

• EUAWC = 25000(A/P,10%,12) + 720 –

3800(A/F,10%,12)
– EUAWC = Rs. 4211

• Purchase the new machine

Sensitivity of short time periods
• Take the same example as earlier, but
look only at a 5 year time period. Assume
the salvage value is still Rs. 3,800
• EUAWD = Rs. 5210
• EUAWC = 25000(A/P,10%,5) + 720 –
3800(A/F,10%,5)
– EUAWC = Rs. 6693
• Reverse the decision and retain the old
machine
 The Cash-Flow approach
• What happens if there are different challengers
offering different trade-in values?
• Defender’s trade-in is cash flow to the
challenger
• If the defender and challenger have the same
life, set the defender first cost to zero
• Subtract the trade in value from the challenger
first cost
• Compare the alternatives
 MARR is 18%. What would you
do?
Possible Replacements
Defender Challenger 1 Challenger 2
First Cost - Rs. 10,000 Rs. 18,000
Defender Trade- - Rs. 3,500 Rs. 2,500
in
Annual Cost Rs. 3000 Rs. 1,500 Rs. 1,200
Salvage Value Rs. 500 Rs, 1,000 Rs. 500
Life estimate, 5 5 5
years
 Solution
• EUAWD = 3000 - 500(A/F,18%,5)
– EUAWD = Rs. 2930.11
• EUAWC1 = (10000-3500)(A/P,18%,5) +
1500 – 1000(A/F,18%,5)
– EUAWC1 = Rs. 3438.79
• EUAWC2 = (18000-2500)(A/P,18%,5) +
1200 – 500(A/F,18%,5)
– EUAWC1 = Rs. 6086.7
• Retain the existing asset
 Assets close to the end of their
life
• Key question: Should I retain the asset for
one more year? Or should I get a new
asset right away?
• 3 options
– Select the challenger
– Retain defender for 1 more year
– Retain defender for the rest of its life
 Replacement Analysis
Methodology
1. Calculate the EUAW of the challenger and the
cost of the defender for the next 1 year : CD(1)
2. If the defender’s one year cost is cheaper, then
retain it
3. If the challenger is cheaper, the compare
EUAWC to EUAWD to see if the challenger
continues to be cheaper over its lifetime
4. If the challenger cost is still lower, buy the
challenger.
5. Else retain the defender for another year
 Example
• A bicycle is normally owned for 5 years.
You purchased a bicycle 2 years ago.
Given the following data, should you
replace now? Retain the bikes for one
year and replace? Retain for 2 years and
replace? Or retain for 3 years and
replace? i=20%
 Data
Currently Owned Challenger
Value at AOC
Beginning of
the Year
Next year (3) Rs. 3800 Rs. 4500 First Cost Rs. 8700
Next year (4) Rs. 2800 Rs. 5000 Annual Rs. 3900
Operating
Cost
Last year (5) Rs. 500 Rs. 5500 Life, years 5
Remaining 3 Salvage Value Rs. 1800
Life, years
Salvage after Rs. 500
3 years
 Solution: Step 1
• EUAWC = 8700(A/P,20%,5) + 3900 –
1800(A/F,20%,5)
– EUAWC = Rs. 6567
• CD(1) = 3800(A/P,20%,1) + 4500 –
2800(A/F,20%,1)
– CD(1) = Rs. 6260
• Retain existing bike for at least 1 more
year
 Solution: 2nd Year
• EUAWC = Rs. 6567
• CD(2) = 2800(A/P,20%,1) + 5000 –
500(A/F,20%,1)
– CD(2) = Rs. 7860
• Challenger is cheaper
• EUAWD = 2800(A/P,20%,2) + 5000 +
500(A/G,20%,2) – 500(A/F,20%,2)
– EUAWD = Rs. 6863

• Challenger is still cheaper. Select it!

 Purchasing immediately
• Consider comparing EUAWC and EUAWD at the
beginning
• EUAWC = Rs. 6567
• EUAWD = 3800(A/P,20%,3) + 4500 +
500(A/G,20%,3) – 500(A/F,20%,3)
– EUAWD = Rs. 6606
• You would have replaced the Defender – Wrong
decision
• Incremental analysis shows that it would have
been better to retain defender for one year, and
then replace
 Minimum-Cost Life Analysis
• How long should an asset be kept in
service such that its total cost is
minimized?
• Also known as economic life or
replacement life of an asset
• Method: Start iteratively from year 1 to the
maximum life of the asset.
– Calculate EUAW
– Find the minimum EUAW
 Example
• An asset was purchased 3 years ago and
its current market value is Rs. 13,000.
Anticipated salvage values and AOCs for
the next 5 years of its life are given below.
What is its minimum-cost life? i=10%
Life SV AOC
1 Rs. 9000 Rs. 2500
2 8000 2700
3 6000 3000
4 2000 3500
5 0 4500
 Sample Solution for n=3
• EUAW3 = 13000(A/P,10%,3) – 6000(A/F,10%,3)
+ [2500(P/F,10%,1) + 2700(P/F,10%,2) +
3000(P/F,10%,3)](A/P,10%,3)
• EUAW3 = Rs. 6132

• Repeat this for all the 5 years, to find

where EUAW is the cheapest
• That is when you should plan to sell and
see if a suitable challenger is available
 Class Exercise
• An asset presently owned can last for 6 more
years with costs of Rs. 24,000 this year and
increasing by 10% per year. A desirable
challenger would cost Rs. 70,000, last for 6
years, and have an annual cost of Rs, 12,000
with a salvage value of Rs. 4,000. What is a
trade-in value of the old asset that will make
replacement economical if a 5% per year return
is desired?
Thank You