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Replacement and Retention

The document discusses replacement and retention of assets. It provides terminology used in replacement analysis such as defender, challenger, economic service life, sunk costs, and others. It gives examples of calculating present value, annual worth, and economic service life for various asset replacement scenarios. The economic service life is the number of years an asset should be retained to minimize its equivalent annual cost. In one example, the economic service life of equipment with fluctuating operating costs and salvage values is determined to be 3 years, with an annual worth of $-244,434. Extending retention 2 years beyond this increases the annual worth by 6.5%.

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188 views13 pages

Replacement and Retention

The document discusses replacement and retention of assets. It provides terminology used in replacement analysis such as defender, challenger, economic service life, sunk costs, and others. It gives examples of calculating present value, annual worth, and economic service life for various asset replacement scenarios. The economic service life is the number of years an asset should be retained to minimize its equivalent annual cost. In one example, the economic service life of equipment with fluctuating operating costs and salvage values is determined to be 3 years, with an annual worth of $-244,434. Extending retention 2 years beyond this increases the annual worth by 6.5%.

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18010 Yeash Rahman
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Engineering Economy

IPE - 3115
Course Teacher
Ridwan Mustofa
Lecturer
Dept of Industrial Engineering and Management
Khulna University of Engineering & Technology
REPLACEMENT & RETENTION

Replacement Reasons are:

1. Reduced performance
2. Altered requirements
3. Obsolescence
TERMINOLOGY

Defender – Currently installed asset


Challenger – Potential replacement for defender
Market value (MV) – Value of defender if sold in open market
Economic service life – Number of years at which lowest AW of cost occurs
Defender first cost – MV of defender; used as its first cost (P) in analysis
Challenger first cost – Capital to recover for challenger (usually its P value)
Sunk cost – Prior expenditure not recoverable from challenger cost
Nonowner’s viewpoint – Outsider’s (consultant’s) viewpoint for objectivity
EXAMPLE: REPLACEMENT BASICS

An asset purchased 2 years ago for $40,000 is harder to maintain than


expected. It can be sold now for $12,000 or kept for a maximum of 2
more years, in which case its operating cost will be $20,000 each year,
with a salvage value of $9,000 two years from now. A suitable
challenger will have a first cost of $60,000 with an annual operating
cost of $4,100 per year and a salvage value of $15,000 after 5 years.
Determine the values of
P, A, n, and S for the defender and challenger for an AW analysis.
Solution:

Defender: P = $-12,000; A = $-20,000; n = 2; S = $9,000

Challenger: P = $-60,000; A = $-4,100; n = 5; S = $15,000


ECONOMIC SERVICE LIFE

Economic service life (ESL) refers to the asset


retention time (n) that yields its lowest equivalent AW

Determined by calculating AW for 1, 2, 3,…n years


EXAMPLE-1: ECONOMIC SERVICE LIFE
Determine the ESL of an asset which has the costs shown below. Let i = 10%
Year Cost,$/year Salvage value,$
0 - 20,000 -
1 -5,000 10,000
2 -6,500 8,000
3 - 9,000 5,000
4 -11,000 5,000
5 -15,000 3,000

Solution:
AW1 = - 20,000(A/P,10%,1) – 5000(P/F,10%,1)(A/P,10%,1) + 10,000(A/F,10%,1)
= $ -17,000
AW2 = - 20,000(A/P,10%,2) – [5000(P/F,10%,1) + 6500(P/F,10%,2)](A/P,10%,2)
+ 8000(A/F,10%,2)
= $ -13,429
Similarly,
AW3 = - 20,000(A/P,10%,3) – [5000(P/F,10%,1) + 6500(P/F,10%,2)+9000
(P/F,10%,3)](A/P,10%,3)+ 5000(A/F,10%,3)

= $ -13,239
AW4 = - 20,000(A/P,10%,4) – [5000(P/F,10%,1) + 6500(P/F,10%,2)+9000
(P/F,10%,3)+11,000(P/F,10%,4)](A/P,10%,4)+ 5000(A/F,10%,4)

= $ -12,864
AW5 = - 20,000(A/P,10%,5) – [5000(P/F,10%,1) + 6500(P/F,10%,2)+9000
(P/F,10%,3)+11,000(P/F,10%,4)+ 15,000(P/F,10%,5](A/P,10%,5)
+ 3000(A/F,10%,5)
= $ -13,623

So, Economic Service Life is 4 Years


Practice 2

To improve package tracking at a UPS transfer facility, conveyor equipment was


upgraded with RFID sensors at a cost of $345,000. The operating cost is expected to
be $148,000 per year for the first 3 years and $210,000 for the next 3 years. The
salvage value of the equipment is expected to be $140,000 for the first 3 years, but
due to obsolescence, it won’t have a significant value after that. At an interest rate of
10% per year, determine
(a) The economic service life of the equipment and associated annual worth
(b) The percentage increase in the AW of cost if the equipment is retained 2 years
longer than the ESL
(a) Find total AW for each year of ownership
AW1 = -345,000(A/P,10%,1) – 148,000 + 140,000(A/F,10%,1)
= $-387,500
AW2 = -345,000(A/P,10%,2) – 148,000 + 140,000(A/F,10%,2)
= $-280,119
AW3 = -345,000(A/P,10%,3) – 148,000 + 140,000(A/F,10%,3)
= $-244,434
AW4 = -345,000(A/P,10%,4) – 148,000(P/A,10%,3)(A/P,10%,4)
-210,000(P/F,10%,4)(A/P,10%4)
= $-270,197
AW5 = -345,000(A/P,10%,5) – 148,000(P/A,10%,3)(A/P,10%,5)
-210,000(P/A,10%,2)(P/F,10%,3)(A/P,10%,5)
= $-260,337
AW6 = -345,000(A/P,10%,5) – 148,000(P/A,10%,3)(A/P,10%,6)
-210,000(P/A,10%,3)(P/F,10%,3)(A/P,10%,6)
= $-253,813
ESL is 3 years with AW = $-244,434

(b) If retained 5 years, AW = $260,337 per year,


Percent increase = (260,337 - 244,434)/244,434 = 0.065 (6.5%)
Practice 3:

A construction company bought a 180,000 metric ton earth sifter at a cost of


$65,000. The company expects to keep the equipment a maximum of 7 years. The
operating cost is expected to follow the series described by 40,000 + 10,000 k ,
where k is the number of years since it was purchased ( k = 1, 2, . . . , 7). The
salvage value is estimated to be $30,000 for years 1 and 2 and $20,000 for years 3
through 7. At an interest rate of 10% per year, determine
the economic service life and the associated equivalent annual cost of the sifter.
Solution:

AW1 = -65,000(A/P,10%,1) – 50,000 + 30,000(A/F,10%,1)


= $-91,500
AW2 = -65,000(A/P,10%,2) – [50,000 + 10,000(A/G,10%,2)] + 30,000(A/F,10%,2)
= $-77,929
AW3 = -65,000(A/P,10%,3) – [50,000 + 10,000(A/G,10%,3)] + 20,000(A/F,10%,3)
= $-79,461
AW4 = -65,000(A/P,10%,4) – [50,000 + 10,000(A/G,10%,4)] + 20,000(A/F,10%,4)
= $-80,008
AW5 = -65,000(A/P,10%,5) – [50,000 + 10,000(A/G,10%,5)] + 20,000(A/F,10%,5)
= $-81,972
AW6 = -65,000(A/P,10%,6) – [50,000 + 10,000(A/G,10%,6)] + 20,000(A/F,10%,6)
= $-84,568
AW7 = -65,000(A/P,10%,7) – [50,000 + 10,000(A/G,10%,7)] + 20,000(A/F,10%,7)
= $-87,459
ESL is 2 years with AW = $-77,929

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