Chapter 13

Replacement Analysis

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 Chapter Outline

• 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

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 Learning Objectives

• 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

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 Issues
• Should we replace the current equipment
with the new one?
• Should we retain the current equipment for
another year and then replace it?

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 The Replacement Problem

• Obsolescence occurs when an asset’s 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)

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 The Replacement Problem

• 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.
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 Minimum Cost Life of a New Asset

• 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
asset’s 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.
• N (period) where the EUAC is minimum is called the
economic life
• Why?

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 Minimum Cost Life of a New Asset

• If assets are kept for only a few years, then the

EUAC is high because capital costs are spread
over only a few years.
• If assets are kept for too long, then the EUAC is
high because maintenance and operating costs
become large.
• The economic life strikes a balance that minimizes
the total EUAC.

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 Example 13-1*
Minimum Cost Life of a New Asset
A machine costs $6800 to buy, $700 to install, and has no
salvage value. Maintenance costs are expected to be $0
the first year, but will increase by $900 every year after
that. Operating costs are expected to be $500 the first year,
but will increase by $400 every year after that. If the
machine will last 15 years and the interest rate is 8%,
compute the machine’s economic life that minimizes the
EUAC.

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 Example 13-1*
Minimum Cost Life of a New Asset
Year Maint. Operating O&M EUAC(O&M) CR EUAC(Total)
1 $0 $500 $500 $500 $8,100 $8,600
2 900 900 1,800 1,125 4,206 5,331
3 1,800 1,300 3,100 1,733 2,910 4,644
4 2,700 1,700 4,400 2,325 2,264 4,590*
5 3,600 2,100 5,700 2,900 1,878 4,779
6 4,500 2,500 7,000 3,459 1,622 5,082
7 5,400 2,900 8,300 4,002 1,441 5,442
8 6,300 3,300 9,600 4,528 1,305 5,833
9 7,200 3,700 10,900 5,038 1,201 6,239
10 8,100 4,100 12,200 5,533 1,118 6,650
11 9,000 4,500 13,500 6,011 1,051 7,062
12 9,900 4,900 14,800 6,474 995 7,470
13 10,800 5,300 16,100 6,922 949 7,871
14 11,700 5,700 17,400 7,355 910 8,265
15 12,600 6,100 18,700 7,773 876 8,649
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 Example 13-1
Minimum Cost Life of a New Asset
10000

8000
Total EUAC
6000
Cost

O&M
4000

2000 Capital Recovery

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Year

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 Replacement Analysis
Decision Map
Defender Identify Alternatives Best Challenger

Available Defender Not Available

Marginal Cost Data?

Defender No Find EUAC

Marginal Cost Find lowest EUAC
over given life
Increasing? for Defender
Yes
Analysis Technique 2: Analysis Technique 3:
Analysis Technique 1: Defender’s lowest Defender’s EUAC
Defender’s next year EUAC  Challenger’s over its remaining life
marginal cost  EUAC at its minimum  Challenger’s EUAC
Challenger’s EUAC cost life at its min. cost life

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 Replacement Analysis
Fundamental
• By looking at the replacement analysis map, we see
that the first step is to identify the alternatives.
• Again, in replacement analysis we are interested in
comparing the previously implemented asset (the
defender) against the best current available
challenger.

If the defender proves more economical, it will

be retained. If the challenger proves more
economical, it will be installed.
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 Defender’s Marginal Cost Data

• Are the Defender marginal cost data available?

• Are the Defender marginal cost 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
• Marginal costs, as opposed to an EUAC, are the
year-by-year costs of keeping an asset. Therefore, the
“period” of any yearly marginal cost of ownership is
always 1 year.
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 Example 13-5
Marginal Cost Calculation

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 Example 13-6
Marginal Cost Calculation
An asset purchased 5 years ago for $75,000 can be sold
today for $15,000. Operating expenses will be $10,000 this
year, but these will increase by $1500 per year. It is
estimated that the asset’s salvage value will decrease by
$1000 per year over the next 5 years. If the MARR used by
the company is 15%, calculate the total marginal cost of
ownership of this old asset (that is, the currently
implemented asset) for each of the next 5 years.

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 Example 13-6
Marginal Cost Calculation
Total
Market Capital Operating Marginal
Year Value Recovery Cost 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 = (𝑀𝑉𝑁−1 – 𝑀𝑉𝑁 ) + 𝑀𝑉𝑁−1 (15%)

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 Replacement Analysis Technique 1:
Defender Marginal Cost Increasing
• Maintain the Defender as long as the
marginal cost of ownership for one more
year is less than the Challenger’s minimum
EUAC.
• When the Defender’s marginal cost
becomes greater than the Challenger’s
minimum EUAC, then replace the Defender
with the Challenger.

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 Example 13-4
Replacement Analysis Technique 1
Challenger Challenger Defender
Year Marginal Cost EUAC Year Marginal Cost
1 $17,750 $17,750.00 1 $13,250
2 15,200 16,563.95 2 14,600
3 13,950 15,811.20 3 15,950
4 14,350 15,518.57 4 17,300
5 14,900 15,426.83* 5 18,650
6 15,600 15,446.61
7 16,950 15,582.46
𝑁
𝐸𝑈𝐴𝐶 = ෍ 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡𝑗 𝑃Τ𝐹 , 15%, 𝑗 (𝐴Τ𝑃 , 15%, 𝑁)
𝑗=1
KEEP THE DEFENDER FOR 2 YEARS AND THEN REPLACE IT

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Calculating EUAC from MC

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 Exercise
A machine has a first cost of $50,000. Its market
value declines by 25% annually. The operating
and maintenance costs start at $2000 per year and
climb by $3000 per year. The firm’s MARR is 9%.
Find the minimum EUAC for this machine and its
economic life.

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 Exercise
Five years ago, Thomas Martin installed production
machinery that had a first cost of $25,000. At that time
initial yearly costs were estimated at $1250, increasing
by $500 each year. The market value of this machinery
each year would be 90% of the previous year’s value.
There is a new machine available now that has a first
cost of $27,900 and no yearly costs over its 5-year
minimum cost life. If Thomas Martin uses an 8%
before-tax MARR, when, if at all, should he replace the
existing machinery with the new unit?
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 Replacement Repeatability
Assumption
• 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.

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 Replacement Analysis Technique 2:
Defender Marginal Cost Not Increasing
• Calculate the Defender’s minimum EUAC.
• If the Defender’s minimum EUAC exceeds the
Challenger’s minimum EUAC, then replace
immediately.
• If the Defender’s minimum EUAC is lower than the
Challenger’s minimum EUAC, then the Defender
will be kept at least the minimum cost life.
• After the minimum cost life, then replace when the
Defender’s increasing marginal cost exceeds the
Challenger’s minimum EUAC.

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 Example 13-5
Replacement Analysis Technique 2
Challenger Defender
Marginal Challenger Marginal Defender
Year Cost EUAC Year Cost EUAC
1 $17,750 $17,750.00 1 $16,000 $16,000.00
2 15,200 16,563.95 2 14,000 $15,069.77
3 13,950 15,811.20 3 13,500 $14,617.71*
4 14,350 15,518.57 4 15,300 $14,754.35
5 14,900 15,426.83* 5 17,500 $15,161.57
6 15,600 15,446.61
7 16,950 15,582.46
𝑁
𝐸𝑈𝐴𝐶 = ෍ 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡𝑗 𝑃Τ𝐹 , 15%, 𝑗 (𝐴Τ𝑃 , 15%, 𝑁)
𝑗=1
KEEP THE DEFENDER AT LEAST 3 YEARS, YEAR 4 & 5 USE TECHNIQUE 1
Year 4 keep the defender because its marginal cost is less than Challenger EUAC
Replace the defender at the end of year 4
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 Example 13-6
Finding Minimum Cost Life
Market Capital Marginal
Year Value Recovery O&M 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
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13.6 Calculating minimum
EUAC

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 Example 13-7
Replacement Analysis Technique 2
Challenger Defender Defender
Year EUAC Overhaul Defender Marginal Defender
1 $8,600 Year Cost O&M Cost EUAC
2 5,331 0 $4,000
3 4,644 1 $1,800 $6,120 $6,120.00
4 4,590* 2 1,800 1,800 4,043.08
5 4,779 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
𝐸𝑈𝐴𝐶 = ෍ 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡𝑗 𝑃Τ𝐹 , 8%, 𝑗 (𝐴Τ𝑃 , 8%, 𝑁)
𝑗=1
Overhaul the defender, keep for 3 years and then use Technique 1

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 Replacement Analysis Technique 3:
Defender Marginal Cost Not Available
• Calculate the Defender’s EUAC over its stated
useful life.
• If the Defender’s EUAC exceeds the Challenger’s
minimum EUAC, then replace immediately.
• If the Defender’s EUAC is lower than the
Challenger’s minimum EUAC, then the Defender
will be kept.

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 Defining First Costs of
Defender and Challenger
• 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 Defender’s potential market (or salvage) value
should not be subtracted from the Challenger’s
first cost.

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 Example 13-9
Defining Defender First Cost
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.

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)
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 Repeatability Assumption
Not Acceptable
Circumstances that 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

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 A Closer Look at Future Challengers

• It seems likely that future Present

Challenger
challengers will be better
than the present Challenger Uniform Decline

EUAC at Economic Life

• The prospect of better
future challengers may
make it more desirable to
retain the Defender and to Rapid Improvements
reject the present In Technology
Challenger
• Selecting the current best
Challenger could be risky if
1) high cost and/or 2) long
0 1 2 3 4
economic life Year

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