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KIX2006: ENGINEERING ECONOMICS AND

PROJECT MANAGEMENT
Week 8: Replacement Analysis

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The objective of Chapter 9 is to address the question of
whether a currently owned asset should be kept in
service or immediately replaced.

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Chapter 9: Replacement Analysis

 9.1 Introduction
 9.2 Reasons for Replacement Analysis
 9.3 Factors that Must be Considered in Replacement Studies
 9.4 Typical Replacement Problems
 9.5 Determining the Economic Life of a New Asset
 9.6 Determining the Economic Life of a Defender
 9.7 Comparisons in which the Defender’s Useful Life Differs from
that of the Challenger
 9.8 Retirement Without Replacement (Abandonment)

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What to do with an existing asset?

 Keep it
 Abandon it (do not replace)
 Replace it, but keep it for backup purposes
 Augment the capacity of the asset
 Dispose of it, and replace it with another

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9.2 Reasons for Replacement Analysis

Three reasons to consider a change:

 Physical impairment (deterioration)
 Altered requirements
 New and improved technology is now available.

The second and third reasons are sometimes referred to as

different categories of obsolescence.

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Some important terms for replacement analysis
the period of time (years) that yields the minimum
Economic life equivalent uniform annual cost (EUAC) of owning and
operating an asset.

the period between acquisition and disposal by a specific

Ownership life
owner.

period between original acquisition and final disposal

Physical life
over the entire life of an asset.

the time period an asset is kept in productive service

Useful life
(primary or backup).
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9.3 Factors that Must be Considered in Replacement Analysis

 Past Estimation Errors

 The Sunk-Cost Trap
 Investment Value of Existing Assets and the Outsider
Viewpoint
 Economic Life of the Challenger
 Economic Life of the Defender
 The Importance of Income Tax Consequences

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9.3.1 Replacement: past estimation errors

 Any study today is about the future—past estimation

“errors” related to the defender are irrelevant.
 The only exception to the above is if there are income tax
implications forthcoming that were not foreseen.

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9.3.2 Replacement: watch out for the sunk-cost trap

 Only present and future cash flows are considered in

replacement studies.
 Past decisions are relevant only to the extent that they
resulted in the current situation.
 Sunk costs—used here as the difference between an
asset’s BV and MV at a particular point in time—have no
relevance except to the extent they affect income taxes.
i.e. paid rental, cash spent on machinery fuel

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9.3.3 Replacement: the outsider viewpoint

 The outsider viewpoint is the perspective taken by an

impartial third party to establish the fair MV of the
defender. Also called the opportunity cost approach.
 The opportunity cost is the opportunity foregone by
deciding to keep an asset.
 If an upgrade of the defender is required to have a
competitive service level with the challenger, this should
be added to the present realizable MV.

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EXAMPLE 9-1: Investment Cost of the Defender (Existing Asset)

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EXAMPLE 9-1: Investment Cost of the Defender (Existing Asset)
(cont.)

Unarmotized value (lost) of defender:

𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉(𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙)𝑑𝑑 = 𝑀𝑀𝑀𝑀𝑑𝑑 − 𝐵𝐵𝐵𝐵𝑑𝑑
= $10,000 − $12,000
= ($2,000)

Total Investment for Defender: Total Investment for Challenger:

𝐼𝐼𝑑𝑑 = 𝑀𝑀𝑀𝑀𝑑𝑑 + 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝐼𝐼𝑐𝑐 = $21,000
= $10,000 + $1,500
= $11,500

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9.3.4 and 9.3.5 Replacement: economic lives of the
challenger and defender

 The economic life of the challenger minimizes the EUAC.

 The economic life of the defender is often one year, so a
proper analysis may be between different-lived
alternatives.
 The defender may be kept longer than its apparent
economic life as long as its marginal cost is less than the
minimum EUAC of the challenger over its economic life.

*EUAC: Equivalent Uniform Annual Cost

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9.3.6 Replacement: income taxes

 Replacement often results in gains or losses from the sale

of depreciable property.
 Studies must be made on an after-tax basis for an
accurate economic analysis since this can have a
considerable effect on the resulting decision.

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9.4 Typical Replacement Problems
Before-tax PW example
Acme owns a CNC machine that it is considering replacing. Its current market
value is $25,000, but it can be productively used for four more years at which
time its market value will be zero. Operating and maintenance expenses are
$50,000 per year.
Acme can purchase a new CNC machine, with the same functionality as the
current machine, for $90,000. In four years, the market value of the new
machine is estimated to be $45,000. Annual operating and maintenance costs
will be $35,000 per year.
Should the old CNC machine be replaced using a before-tax MARR of 15% and
a study period of four years?

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Example solution

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EXAMPLE 9-2: Replacement Analysis Using Present Worth (Before Taxes)

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EXAMPLE 9-3: Before-Tax Replacement Analysis Using EUAC

18 continued on next slide

EXAMPLE 9-3: Before-Tax Replacement Analysis Using EUAC (cont.)

19 continued on next slide

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EXAMPLE 9-3: Before-Tax Replacement Analysis Using EUAC (continued)

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9.5 Determining the Economic Life of a New Asset
(Challenger)

 Proper analysis requires knowing the economic life

(minimum EUAC) of the alternatives.
 The EUAC of a new asset can be computed if the capital
investment, annual expenses, and year-by-year market
values are known or can be estimated.
 The difficulties in estimating these values are encountered
in most engineering economy studies, and can be
overcome in most cases.

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Finding the EUAC of the challenger requires finding the total
marginal cost of the challenger, for each year. The minimum
such value identifies the economic life.
This equation represents the present worth, through year k,
of total costs. (Although the sign is positive, it is a cost)

𝑘𝑘

𝑃𝑃𝑃𝑃𝑘𝑘 𝑖𝑖% = 𝐼𝐼 − 𝑀𝑀𝑀𝑀𝑘𝑘 𝑃𝑃⁄𝐹𝐹 , 𝑖𝑖%, 𝑘𝑘 + � 𝐸𝐸𝑗𝑗 (𝑃𝑃⁄𝐹𝐹 , 𝑖𝑖%, 𝑗𝑗)

𝑗𝑗=1
Equation (9-1)
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Total marginal cost formula

The total marginal cost, 𝑇𝑇𝑇𝑇𝑘𝑘 , is the equivalent worth, at the

end of year 𝑘𝑘, of the increase in 𝑃𝑃𝑃𝑃 of total cost from year
𝑘𝑘 − 1 to year 𝑘𝑘.
𝑇𝑇𝑇𝑇𝑘𝑘 = (𝑃𝑃𝑃𝑃𝑘𝑘 − 𝑃𝑃𝑃𝑃𝑘𝑘−1 )(𝐹𝐹 ⁄𝑃𝑃 , 𝑖𝑖𝑖, 𝑘𝑘)

This can be simplified to:

𝑇𝑇𝑇𝑇𝑘𝑘 𝑖𝑖𝑖 = 𝑀𝑀𝑀𝑀𝑘𝑘−1 − 𝑀𝑀𝑀𝑀𝑘𝑘 + 𝑖𝑖𝑀𝑀𝑀𝑀𝑘𝑘−1 + 𝐸𝐸𝑘𝑘

Equation (9-2)
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Finding the economic life of the new CNC machine
Year 1 Year 2 Year 3 Year 4
O&M costs $35,000 $35,000 $35,000 $35,000
Market value $75,000 $60,000 $50,000 $45,000

Marginal costs:
Year 1 Year 2 Year 3 Year 4
O&M $35,000 $35,000 $35,000 $35,000
Depreciation $15,000 $15,000 $10,000 $5,000
Int. on capital $13,500 $11,250 $9,000 $7,500
TC $63,500 $61,250 $54,000 $47,500

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What is the initial cost (I) of the machine?
EXAMPLE 9-4: Economic Life of a Challenger (New Asset)

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𝑬𝑬𝑼𝑼𝑨𝑨𝑨𝑨𝟐𝟐 = 𝟏𝟏𝟏𝟏, 𝟓𝟓𝟓𝟓𝟓𝟓 𝑷𝑷/𝑭𝑭, 𝟏𝟏𝟏𝟏𝟏, 𝟏𝟏 + 𝟏𝟏𝟏𝟏, 𝟑𝟑𝟑𝟑𝟑𝟑 𝑷𝑷/𝑭𝑭 𝟏𝟏𝟏𝟏𝟏, 𝟐𝟐 𝑨𝑨/𝑷𝑷 , 𝟏𝟏𝟏𝟏𝟏, 𝟐𝟐 = 𝟏𝟏𝟏𝟏, 𝟗𝟗𝟗𝟗𝟗𝟗
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EXAMPLE 9-4: Economic Life of a Challenger (New Asset) (continued)

28 continued on next slide

EXAMPLE 9-5: Economic Life of a Laptop Computer

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continued on next slide
EXAMPLE 9-5 (continued)

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9.6 Determining the Economic Life of a Defender

 If a major overhaul is needed, the life yielding the

minimum EUAC is likely the time to the next major
overhaul.
 If the MV is zero (and will be so later), and operating
expenses are expected to increase, the economic life will
the one year.
 The defender should be kept as long as its marginal cost
is less than the minimum EUAC of the best challenger.

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Finding the economic life of the defender CNC machine.
Year 1 Year 2 Year 3 Year 4
O&M costs $50,000 $50,000 $50,000 $50,000
Market value $15,000 $10,000 $5,000 $0

Year 1 Year 2 Year 3 Year 4

O&M $50,000 $50,000 $50,000 $50,000
Depreciation $10,000 $5,000 $5,000 $5,000
Int. on capital $3,750 $2,250 $1,500 $750
TC $63,750 $57,250 $56,500 $55,750
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EXAMPLE 9-6: Economic Life of a Defender (Existing Asset)

33 continued on next slide

Figure 9-2 Defender versus Challenger Forklift Trucks (Based on Examples 9-4 and 9-6)

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9.7 Comparisons in Which the Defender’s Useful Life Differs
from that of the Challenger
Replacement cautions:
 In general, if a defender is kept beyond where the TC exceeds the
minimum EUAC for the challenger, the replacement becomes more
urgent.
 Rapidly changing technology, bringing about significant
improvement in performance, can lead to postponing replacement
decisions.
 When the defender and challenger have different useful lives, often
the analysis is really to determine if now is the time to replace the
defender.
 Repeatability or cotermination can be used where appropriate.
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Figure 9-4 Effect of the Repeatability Assumption Applied to
Alternatives in Example 9-6

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EXAMPLE 9-7 Replacement Analysis Using the Coterminated Assumption

38 continued on next slide

39 𝐸𝐸𝑈𝑈𝐴𝐴𝐴𝐴4 = [13,500 𝑃𝑃/𝐹𝐹, 10%, 1 + … . . 14,275 𝑃𝑃/𝐹𝐹 , 10%, 4 ] 𝐴𝐴/𝑃𝑃 , 10%, 4 = 13,211
EXAMPLE 9-7 (continued)

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9.8 Abandonment is retirement without replacement
 For projects having positive net cash flows (following an
initial investment) and a finite period of required service.
 Should the project be undertaken? If so, and given market
(abandonment) values for each year, what is the best year
to abandon the project? What is its economic life?
 These are similar to determining the economic life of an
asset, but where benefits instead of costs dominate.
 Abandon the year PW is a maximum.

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Abandonment example
A machine lathe has a current market value of $60,000 and
can be kept in service for 4 more years. With an MARR of
12%/year, when should it be abandoned? The following
data are projected for future years.

Year 1 Year 2 Year 3 Year 4

Net receipts $50,000 $40,000 $15,000 $10,000
Market value $35,000 $20,000 $15,000 $5,000
R-E
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Abandonment solution
Keep for one year Keep for two years

𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃
= −$60,000 = −$60,000
+ ($35,000 + $50,000 𝑃𝑃⁄𝐹𝐹 , 12%, 1 + ($40,000
+ $50,000) 𝑃𝑃⁄𝐹𝐹 , 12%, 1 + $20,000)(𝑃𝑃⁄𝐹𝐹 , 12%, 2)
= $𝟏𝟏𝟏𝟏, 𝟖𝟖𝟖𝟖𝟖𝟖. 𝟓𝟓𝟓𝟓 = $𝟑𝟑𝟑𝟑, 𝟒𝟒𝟒𝟒𝟒𝟒
Keep for three years Keep for four years

𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃
= −$60,000 = −$60,000
+ $50,000 𝑃𝑃⁄𝐹𝐹 , 12%, 1 + $50,000 𝑃𝑃⁄𝐹𝐹 , 12%, 1
+ $40,000 𝑃𝑃⁄𝐹𝐹 , 12%, 2 + ($15,000 + $40,000 𝑃𝑃⁄𝐹𝐹 , 12%, 2
+ $15,000)(𝑃𝑃⁄𝐹𝐹 , 12%, 3) + $15,000 𝑃𝑃⁄𝐹𝐹 , 12%, 3 + ($10,000
= $𝟑𝟑𝟑𝟑, 𝟖𝟖𝟖𝟖𝟖𝟖 + $5,000)(𝑃𝑃⁄𝐹𝐹 , 12%, 4)
= $𝟑𝟑𝟑𝟑, 𝟕𝟕𝟕𝟕𝟕𝟕. 𝟓𝟓𝟓𝟓
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EXAMPLE 9-8

44 continued on next slide

EXAMPLE 9-8 (continued)

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P9.8 A city water and waste-water department has a four-year old
sludge pump that was initially purchased for $65,000. This pump
can be kept in service for an additional four years, or it can be sold
for $35,000 and replaced by a new pump. The purchase price of
the replacement pump is $50,000. The projected MVs and
operating and maintenance costs over the four-year planning
horizon as shown in table. Assuming MARR is 10%,
a) determine the economic life of the challenger, and
b) determine when the defender should be replaced.
Defender Challenger
Year MV at EOY O&M Cost MV at EOY O&M Cost
1 $25,000 $18,500 $40,000 $13,000
2 21,000 21,000 32,000 15,500
3 17,000 23,500 24,000 18,000
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4 13,000 26,000 16,000 20,500
 a. Economic of life of the challenger

EOY MV Loss in MV Cost of Cap Annual Exp TC EUAC

0
1
2
3
4
Economic of life of the defender

EOY MV Loss in MV Cost of Cap Annual Exp TC EUAC

0
1
2
3
b. Replacement analysis 4
Keep Keep EUAC (10%)
1 2 3 4
Defender for Challenger for for 4 years
0 4
1 3
2 2
3 1
474 0
P9.9 The replacement of a planning machine is being considered by the
Reardorn Furniture Company. The best challenger will cost $30,000
for installation and will have an estimated economic life of 12 years
and a $2,000 MV at that time. It is estimated that the annual
expenses will average $16,000/year. The defender has a present BV
of $6,000 and a present MV of $4,000. Data for the defender for the
next 3 years given below. Use a before-tax interest rate of 15% per
year, make a comparison to determine whether it is economical to
make the replacement now.

Year MV at EOY BV at EOY Expenses during the year

1 $3,000 $4,500 $20,000
2 2,500 3,000 25,000
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3 2,000 1,500 30,000
The replacement of a planning machine is
being considered by the Reardorn Furniture
Company. The best challenger will cost
$30,000 for installation and will have an
estimated economic life of 12 years and a
$2,000 MV at that time. It is estimated that
the annual expenses will average Economic of life of the defender
$16,000/year. The defender has a present
BV of $6,000 and a present MV of $4,000. Loss in Cost of Annual
Data for the defender for the next 3 years EOY MV TC EUAC
given below. Use a before-tax interest rate of
MV Cap Exp
15% per year, make a comparison to 0
determine whether it is economical to make
the replacement now. 1
2
3
15 15

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 End of Slides

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