CHAPTER 9
REPLACEMENT
ANALYSIS
1
Replacement Concept
Replacement refers to
Selection of new assets to replace existing assets.
The evaluation of entirely different ways to perform an
asset’s function.
Example:
Old trucks can be replaced with new models that operate
similarly but have additional features that improve
performance or efficiency.
Trucks could be replaced with conveyor system,
overhead crane, subcontract for hauling, or manual
labour; that serves the needed function.
2
Introduction
The pressure of competition in business such as
requiring higher quality goods and services, shorter
response times, competitive price often lead to a
situation whereby organisations have to decide
whether the existing asset should be
Retired from use,
Retain the asset for backup,
Continued in service, or
Replaced with a new assets.
3
INTRODUCTION
In REPLACEMENT ANALYSIS, the reference for
comparison is the existing resource --- anything that is used
in business such as machine, tools, or equipment.
The question is:
When should we replace the resource?
Or more focused question:
Should we replace the equipment now or sometime
later?
Precise question:
Should we budget now to replace the resource during
the next financial year?
4
REPLACEMENT ANALYSIS
The evaluation of changes in economics of assets
associated with their use in an operating environment.
Considers asset:
replacement
retirement
Augmentation (increase the capability)
5
The Importance of Replacement Decision
Timely replacement decisions are critically important to a
company:
A decision to replace a machine because it is temporarily
out of order, or untimely replacement for latest
technology, can be a serious drain on operating capital
of a company.
A decision to postpone replacement until there is no
other way to continue production, can place a company
in a dangerous position of becoming uncompetitive.
Therefore, we need to recognise when an asset is no longer
employed efficiently, what replacement should be considered, and
when replacement is economically feasible.
The GOAL is to be COST EFFICIENT.
6
DEFENDER – CHALLENGER CONCEPT
Replacement analysis can be conceptualised better by
considering the existing resource as a defender as it were
trying to defend its continued use.
The one being considered to replace the defender is called
challenger.
A complete replacement analysis involves three tasks:
1. Selection of the defender and its analysis
2. Selection of the challenger and its analysis
3. Defender – challenger comparison
7
REASONS FOR REPLACEMENT
ANALYSIS
Physical Impairment (Deterioration)
Altered Requirements
Technology
Financing [rental (lease) is more attractive than ownership]
8
PHYSICAL IMPAIRMENT
(DETERIORATION)
Efficiency loss resulting from continued use - - - aging
Increased routine and corrective maintenance costs
Greater energy requirements
Increased need for operator intervention
Unanticipated problems leading to equipment
deterioration
9
ALTERED REQUIREMENTS
Significant change in demand for related
products or services
Significant change in the composition or design
of associated products or services
May be considered a form of obsolescence
10
TECHNOLOGY
Impact of technological change varies with
associated industry
Technological changes typically reduce cost
per unit and improve quality of output
Results in earlier replacement of existing
assets with improved assets
May be considered a form of obsolescence
11
FINANCING
Considers economic opportunity changes
external to the physical operation or use of the
asset(s)
May involve income tax considerations
(depreciation and after-tax analysis)
EG: rental of assets may become more
attractive than ownership
May be considered a form of obsolescence
12
REPLACEMENT ANALYSIS
Two types of approach available [when to apply]:
1. EUAC-BASED analysis [zone A and early part of zone B]
2. MARGINAL-COST-BASED analysis [later part of zone B]
A B
Cost
Total cost
Operating cost
EUAC min
Capital Recovery cost
Economic life Age
13
MARGINAL-COST
Marginal cost is the cost to keep an asset in service one
more year. This concept is applicable to mature, older
existing equipment (defender) with increasing operating
costs.
Require knowledge of the future MV of the asset.
The marginal cost is calculated for each year of the asset’s
life.
The marginal cost is used to compare against EUAC of the
proposed replacement.
14
ECONOMIC LIFE
ECONOMIC LIFE is the period of time (years) that
results in the minimum Equivalent Uniform Annual Cost
(EUAC) of owning and operating an asset
Assuming good asset management, economic life
should coincide with time from date of acquisition to
date of abandonment, demotion in use, or replacement
from primary intended service
Replacement studies are usually made as EUAC (annual
equivalent) calculations to take advantage of data
commonly collected as annual charges {maintenance
costs, operating expenses, salaries, inflation,
depreciation, taxes, etc}.
15
ECONOMIC LIFE
Economic life is sometimes called minimum-cost
life or optimum replacement interval (for cyclic
replacement of assets)
For a new asset, economic life can be computed if
capital investment, annual expenses, and year-
by-year market values are known or can be
estimated
16
OWNERSHIP LIFE
Period between date of acquisition and date of disposal
by a specific owner
A given asset may have different categories of use
during this period
17
PHYSICAL LIFE
Period of time between original acquisition and
final disposal of an asset over its succession of
owners
18
USEFUL LIFE
The time period in years that an asset is kept in
productive service either in primary or backup
mode
An estimate of how long an asset is expected to
be used in a trade or business to produce
income
19
ECONOMIC LIFE FOR CYCLIC REPLACEMENT
Many mechanical items used are replaced by essentially
the same machine when the original one wears out.
Informal rules may be used to establish cyclic replacement
times. A company replaces a car whenever it exceeds 5
years of service. A rental car company replaces their cars
whenever they exceed 100,000km.
Such replacement rules recognise that the automobiles or
similar machines become less efficient and accumulate
higher and higher repair bills as they age.
The total lifetime cost continues to increase with age, but
average annual cost passes through a minimum.
Refer to Figure 9.1
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Figure 9.1
$ Cumulative total cost, CTC
60,000
Cumulative operating cost, COC
40,000
Cumulative capital cost =
(initial cost – resale cost)
20,000 Average annual cost=
CTC / age of replacement
Min average annual cost
1 2 3 4 5 6 7 8
Age at replacement, years
21
Example 1: Cyclic Replacement Analysis:
A delivery service company owns a fleet of small delivery trucks
for store-to-home deliveries. The purchase price per truck is
$20,000, and the anticipated schedule of future operating costs
and salvage value is shown below.
Table 1
1 2 3 4 5
Operating cost 2,000 3,000 4,620 8,000 12,000
Market value (MV) 15,000 11,250 8,500 6,500 4,700
We are required to calculate the least-cost replacement interval.
22
Table 2 From Table 1 Given
Cycle time iterative results
Loss in Cost of capital operating Total marginal EUAC
EOY MV @ MV during 10% of begin'g cost cost for year through
k EOY k year k of year MV (Ek) (TCk) year k
(A) (B) (C)=(A)*0.1 (D) (B)+(C)+(D)
0 20,000
1 15,000 5,000 2,000 2,000 9,000 9,000
2 11,250 3,750 1,500 3,000 8,250 8,643
3 8,500 2,750 1,125 4,620 8,495 8,598 Least cost
4 6,500 2,000 850 8,000 10,850 9,084
5 4,750 1,750 650 12,000 14,400 9,954
The above tabular solution method reveals that trading-in the trucks
after 3 years for new unit is the minimum-cost replacement cycle.
This is the economic life of the challenger, where EUAC is at the
lowest.
23
Sample calculation of EUAC for N at year 2.
Table 3
k for year (TCk)
0
1 9,000 9,000
2* 8,250 8,643
3 8,495 8,598
4 10,850 9,084
5 14,400 Least cost 9,954
* sample calculation for 2 years ownership:
EAC (N=2) = ($9,000)(P/F, 10%, 1)(A/P, 10%, 2)
+ $8,250(A/F, 10%, 2)
= $4,714.40 + $3,928.65
= $8,643
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REPLACEMENT STUDY CONSIDERATIONS
1. Recognition and acceptance of past errors
2. Sunk costs
3. Existing asset value and the outsider viewpoint
4. Income tax considerations
5. Economic life of the proposed replacement
(Challenger)
6. Remaining (economic) life of the old asset (defender)
25
PAST ESTIMATION ERRORS
Past estimation errors are irrelevant unless there are
income tax implications
Example:
1. when BV > current MV, frequently attributed to
estimation error,
2. inadequate capacity,
3. maintenance costs higher than anticipated.
The above are mainly due to the inability to foresee
future conditions better at the time of original estimates.
Must focus on valid estimation of future replacement,
without consideration of loss which may have occurred
in the past.
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THE SUNK COST TRAP
Only present and future cash flows should be
considered in replacement studies
Unamortized values of existing asset considered
for replacement are the result of past decisions --
(Sunk costs = BV - MV)
Sunk costs are irrelevant to replacement decisions,
except to extent they affect income taxes
When tax considerations are involved, sunk costs
must be included in study
27
EXISTING ASSET INVESTMENT VALUE --- AN
OUSIDER VIEWPOINT
Perspective of impartial third party in establishing
fair market value (MV) of your used asset
Present realizable MV defines correct investment
amount for asset in replacement studies
Consider the opportunity cost of retaining the asset
-- the defender
28
THE OUTSIDER VIEWPOINT
The total investment in the defender is the
opportunity cost of not selling the existing
asset for its current MV, plus the cost of
upgrading to be competitive with best
available challenger
29
Example 9.1
The purchase price of a new automobile (challenger) is
RM 21,000. The present automobile (defender) can be
sold for RM 10,000. The defender was purchased three
years ago and its current BV is RM 12,000. To make
defender comparable in continued service to the
challenger, your firm would need to make some repairs at
an estimated cost of RM 1,500.
1. Total capital investment in the defender (if kept):
RM 10,000 + RM 1,500 = RM 11,500
2. Unamortised value of the defender is:
RM 12,000 – RM 10,000 = RM 2,000 (loss)
This is the difference between the current market value
and the current book value of the defender.
This represents sunk cost and has no relevance to the
replacement decision.
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Example 9.2
A old pressure vessel has annual O&M expenses of
$60,000 per year and it can be kept for 5 years more at
which time it will have $0 MV. The present MV is $30,000 if
it were sold now.
A new pressure vessel cost $120,000. It will have a MV of
$50,000 in 5 years and will have O&M expenses of $30,000
per year.
Using before tax MARR of 20% per year, determine
whether or not the old pressure vessel should be replaced.
Solution:
The 1 st step is to determine the investment value of
the defender (old vessel). Using outsider viewpoint, the
investment value of the defender is $30,000, its present
MV.
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Example 9.2 cont’d
The problem can be solved using PW, FW or AW method.
Defender:
AW(20%) = -$30,000(A/P,20%,5) - $60,000
= -$70,032
Challenger:
AW(20%) = -120,000(A/P,20%,5) - $30,000
+ $50,000(A/F,20%,5)
= -$63,408
EUAC challenger < EUAC defender.
Thus, the old pressure vessel should be replaced.
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THREE CASES OF USEFUL LIFE USED IN
REPLACEMENT ANALYSIS
Useful lives of the defender and challenger are
known and the same and also equal study period.
Useful lives of the defender and challenger may or
may not be known but economic life can be
determined.
Useful lives of the defender and challenger are
known but not the same.
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ECONOMIC LIFE OF THE CHALLENGER
Economic life of an asset minimizes equivalent uniform
annual cost of owning and operating an asset
Economic life is often shorter than useful or physical life
Economic data regarding challengers are periodically
(often annually) updated
Replacement studies then repeated to ensure an on-
going evaluation of improvement opportunities.
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ECONOMIC LIFE OF DEFENDER
Often one year
Because different lives of the challenger and defender are
involved, care should be taken when comparing defender
with challenger
Defender should be kept longer than apparent economic
life as long as its marginal cost < minimum equivalent
uniform annual cost of challenger over its economic life
35
Example 2:
It is desired to determine how much longer a fork lift should remain
in service before it is replaced by new unit (challenger) discussed
in Example 1.
The defender in this case is 2 years old, originally cost $13,000,
and has a present MV of $5,000. If kept, its market values and
annual expenses are as tabulated below:
Loss in Cost of capital operating Total marginal
EOY MV @ MV during 10% of begin'g expenses cost for year
k EOY k year k of year MV (Ek) (TCk)
0 5,000
1 4,000 1,000 500 5,500 7,000
2 3,000 1,000 400 6,600 8,000
3 2,000 1,000 300 7,800 9,100
4 1,000 1,000 200 8,800 10,000
Since the defender’s marginal cost increases during the four-year
analysis period, we compare its marginal cost, year by year, with the
corresponding EUAC of the challenger to decide when to replace it.
36
From previous calculation
Cycle time iterative results
Loss in Cost of capital operating Total marginal EUAC
EOY MV @ MV during 10% of begin'g cost cost for year through
k EOY k year k of year MV (Ek) (TCk) year k
(A) (B) (C)=(A)*0.1 (D) (B)+(C)+(D)
0 20,000
1 15,000 5,000 2,000 2,000 9,000 9,000
2 11,250 3,750 1,500 3,000 8,250 8,643
3 8,500 2,750 1,125 4,620 8,495 8,598
4 6,500 2,000 850 8,000 10,850 9,084
5 4,750 1,750 650 12,000 14,400 9,954
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EOY Defender's Challenger's Decision
k marginal cost EUAC to replace
0 (from Table 2)
1 7,000 9,000 NO
2 8,000 8,643 NO
3 9,100 8,598 YES
4 10,000 9,084
Since the defender’s marginal cost at year 3 ($9,100)
exceeds the EUAC of the challenger ($8,598), the defender
is replaced at year 3.
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RETENTION OF THE
DEFENDER
The defender should be kept longer than the
apparent economic life of the defender as
long as its marginal cost (total cost for an
additional year of service) is less than the
minimum EUAC for the best alternative
challenger
39
PROJECT RETIREMENT WITHOUT
REPLACEMENT -- ABANDONMENT
Two assumptions apply:
Once capital investment made, firm desires to postpone project
abandonment as long as its present equivalent value (PW) is not
decreasing
The project will be terminated at the best abandonment time and
will not be replaced by the firm
Note:
In abandonment problems, annual benefits are present.
In economic life analysis, costs are dominant.
For both cases the objective is to increase the wealth of the firm
by: a) finding the life that maximises profits,
b) finding the life that minimises the costs.
See Example 9-7
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Example 9.7
A $50,000 baling machine for recycled paper is being considered
by the XYZ company. Annual revenues less expenses and end-
of-year abandonment values (MV) for the machine have been
estimated for the project. The MARR is 12% per year. What is
the best time to abandon the project if the firm decided to acquire
the baling machine and use it for no longer than 7 years?
[finding the life that maximises profits]
End of Year, $
1 2 3 4 5 6 7
Annual Rev - Exp 10,000 15,000 18,000 12,000 7,000 4,000 3,500
MV of machine 40,000 32,000 25,000 19,000 15,000 12,000 10,000
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Sample calculation:
Keep for one year
$40,000
$10,000
0 1
$50,000
PW (12%) = -$50,000 + ($10,000 + $40,000) ( P/F, 12%, 1)
= ($5,355)
Keep for two years $32,000
$10,000 $15,000
0 1 2
$50,000
PW (12%) = -$50,000 + $10,000 (P/F, 12%, 1) + ($15,000 + $32,000) (P/F, 12%, 2)
= ($3,603)
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In the same manner, the PW (12%) for years three through seven
can be computed. The results are as follows:
Keep for three years PW (12%) = $1,494
Keep for four years PW (12%) = $3,400
Keep for five years PW (12%) = $3,802
Keep for six years PW (12%) = $3,403
Keep for seven years PW (12%) = $3,430
Conclusion:
It is obvious that PW is maximised ($3,802) by retaining the
machine for a total of 5 years.
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