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Replacement Analysis

If a company would like to replace a certain


machine. They have to analyze the following
options:
ENGR 301 Lecture 17 1. Repair the existing machine and extend its
service life. “Defender”
2. Replace the existing machine with a new one.
Application of Economic Evaluation “Challenger”
Techniques
Replacement analysis

S. El-Omari ENGR 301 Lecture 17 S. El-Omari ENGR 301 Lecture 17

Replacement Analysis Replacement Analysis


Three aspects of replacement analysis: In any economic analysis only future costs should
1. Approaches for comparing defender and be considered. Past costs or Sunk Costs should be
challenger. ignored.
2. Determination of economic service life.
3. Replacement analysis when the required service
period is long.

S. El-Omari ENGR 301 Lecture 17 S. El-Omari ENGR 301 Lecture 17

Replacement Analysis Replacement Analysis


printing machine was purchased two years ago for The main reason to perform replacement analysis
$20,000. that it becomes more expensive to operate the
Estimated salvage value after 5-year life = $5000 equipment with time.
But reduced now to $2500 at the end of its service Total cost of operating an equipment include.
life.
Repair, maintenance, wages for operators, energy
$5000 was spent in repair last year. For future analysis consumption costs, and cost of materials.
Operating cost = $8000 per year.
The machine has a market value today = $10,000. Operating costs
Sunk cost = (20,000 – 10,000) + 5000 = $15,000
Increase in any or in combination = replacement analysis
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Approaches for comparing defender
Replacement Analysis
and challenger.
Defender Challenger
1. Cash flow approach
– Applied for replacement alternatives with equal
Usually newer and incorporate new technology analysis periods.
– Comparison based on PE or AE.
2. Opportunity cost approach.
– Considering the current market value of the
defender as a cash out flow. (or investment
required to keep the defender)

S. El-Omari ENGR 301 Lecture 17 S. El-Omari ENGR 301 Lecture 17

Cash flow approach Cash flow approach


5500
(a) Defender (b) Challenger
2500
Example:
0 1 2 3 0 1 2 3
As challenger for the $10,000 machine consider
the option: 5000
8000 6000
New printing machine = $15,000 with 3-year life.
PE(12%) = 2500(P/F,12%,3) - PE(12%) = 5500(P/F,12%,3)
Operating cost cut from $8,000 to $6,000. 8000 (P/A,12%,3) = -$17,434 –5000- 6000 (P/A,12%,3)
Salvage value after 3 years = $5,500 PE(12%) = = -$15,496
AE(12%)(P/A,12%,3)
Include the market value of the old machine in the PE(12%) = AE (P/A,12%,3)
AE= PE(12%) / (P/A,12%,3)
new machine cash flow. AE = PE(12%) / (P/A,12%,3)
AE(12%) = -$7259.1 AE(12%) = -$6451
The company’s interest rate is 12%.
Replacement should be made
S. El-Omari ENGR 301 Lecture 17 S. El-Omari ENGR 301 Lecture 17

Opportunity Cost Approach Economic Service Life


5500
(a) Defender (b) Challenger
2500
• To decide when to perform replacement.
0 1 2 3 0 1 2 3
• To prepare for the replacement early enough.
10000 15000
8000 6000

PE(12%) = 2500(P/F,12%,3) – PE(12%) = 5500(P/F,12%,3)


10000 -8000 (P/A,12%,3) = –15000- 6000 (P/A,12%,3)
-$27,434
= -$25,496
PE(12%) =
AE(12%)(P/A,12%,3) PE(12%) = AE (P/A,12%,3)
AE= PE(12%) / (P/A,12%,3) AE = PE(12%) / (P/A,12%,3)
AE(12%) = -$11,422 AE(12%) = -$10,615
Replacement should be made
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Economic Service Life Economic Service Life
Cost of an asset
Annual Equivalent Cost (AEC) = CR + AEOC
Capital cost Operating Cost  N 
AEC = P( A / P, i , N ) − S ( A / F , iN ) +  ∑ OC ( P / F , i , n) ( A / P, i , n)
n = 1 n 
Operators Repair
Initial cost Salvage value
Energy Maintenance The economic service life of an asset is defined to
CR = P(A/P,i,N) – S(A/F,i,N) be the period of useful life that minimizes the
Material
Annual Capital Recovery cost annual equivalent costs of owing and operating
 N 
AEOC =  ∑ OC ( P / F , i , n) ( A / P , i , n) the asset.
n = 1 n 
AEOC = Annual Equivalent of the Operating Cost
S. El-Omari ENGR 301 Lecture 17 S. El-Omari ENGR 301 Lecture 17

Economic Service Life Economic Service Life


Example:
Initial cost = $18,000 total life = 7 years
AEOC Salvage value at end of 1st year = 10,000 and decline by 2000 every
year
Operating cost = $4,000 and increases by 1,500 every following
year and require 3000 overhaul cost at the end of the 5th year
Find the economic service life at 15% company interest rate

CR

S. El-Omari ENGR 301 Lecture 17 S. El-Omari ENGR 301 Lecture 17

Economic Service Life Economic Service Life


For N=2
If the asset revenue is unknown or irrelevant, the AEC(15%) = (18000+ 4000(P/F,15%,1) + 5500
economic life is computed based of the costs of (P/F,15%,2))(A/P,15%,2) – 8000(A/F,15%,2)
the asset and its year by year salvage value. = $12,048
Option comparison for replacing the asset after 1 For N=3 AEC(15%) = $11,516
year, 2 years, 3 years till the end of its service For N=4 AEC(15%) = $11,694
life. For N=5 AEC(15%) = $12,420
For N=1 For N=6 AEC(15%) = $12,639
AEC(15%) = 18000(A/P,15%,1) + 4000 – 10000 For N=7 AEC(15%) = $12,725
= $14,700 AEC (15%) is smallest when N=3 and it’s the economic
service life of the forklift
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Economic Service Life Defender
1000
Defender 1 2 3
4
life = 5 years more If kept will require $1200 overhaul
Salvage value now = 5,000 and decline by 1000 every year 2000
Operating cost = $2000 and increases by 1,500 every following year G=1500 6500
Challenger: 5000+1200=6200
Initial cost = $10,000 total life = 7 years N Overhaul Forecasted operating cost Market value
Salvage value at end of 1st year = 6,000 and decline by 15% every
0 1200 5000
year
Operating cost = $2000 and increases by 800 every following year 1 0 2000 4000
and require 3000 overhaul cost at the end of the 5th year 2 0 3500 3000
Find the economic service life of the defender and the challenger at 3 0 5000 2000
15% company interest rate and determine when the defender
4 0 6500 1000
should be replaced
5 0 8000 0
S. El-Omari ENGR 301 Lecture 17 S. El-Omari ENGR 301 Lecture 17

Defender
1000
1 2 3
4
Economic Service Life
2000 Challenger:
G=1500 6500 N=1 AEC(15%) = 7500
N=4
5000+1200=6200 N=2 AEC(15%) = 6151
ACE = 5826
N=4 years :AEC(15%) = N=3 AEC(15%) = 5857 = the Challenger economic life
6200(A/P,15%,4)+2000+1500(A/G,15%,4)-1000(A/F,15%,4)
N=4 AEC(15%) = 5826
= $5961
N=5 AEC(15%) = 5897
N=1 AEC(15%) = 5130
N=2 • Should the defender be replaced now? The answer is NO as
N=2 AEC(15%) = 5116
ACE = 5116 AEC of the defender is = $5116 < AEC of the challenger = $5826
N=3 AEC(15%) = 5500
= the defender economic life the defender should be used for at least till the end of its economical
N=4 AEC(15%) = 5961
N=5 AEC(15%) = 6434 life, which is 2 years from now.

S. El-Omari ENGR 301 Lecture 17 S. El-Omari ENGR 301 Lecture 17

Economic Service Life


• When to replace the defender?
If the defender will be used for one more year after its economical
life, the cost at the end of year 3 should be calculated
Market value at end of year 2 = 3000
Operating cost at end of year 3 = 5000
Salvage value = 2000
FE = 3000 x 1.15 + 5000 – 2000 = $6450 < AEC of the challenger
= $5826
The decision is to replace the defender at the end of its economical
life, which is = 2 years.

S. El-Omari ENGR 301 Lecture 17