Replacement Analysis

1. A new gear grinding machine for composite materials has a first cost of P = $100,000 and can be used
for a maximum of 6 years. Its salvage value is estimated by the relation S = P (0.85)n where n is the
number of years after purchase. The operating cost will be $75,000 the first year and will increase by
$10,000 per year thereafter. Use i = 18% per year.
a. Determine the economic service life and corresponding A W of this challenger.
b. It was hoped that the machine is economically justified for retention for all 6 years, but that is
not the case since the ESL in part (a) is considerably less than 6 years. Determine the reduction
in first cost that would have to be negotiated to make the equivalent annual cost for a full 6
years of ownership numerically equal to the AW estimate determined for the calculated ESL.
Assume all other estimates remain the same, and neglect the fact that this lower P value will
still not make a newly calculated ESL equal 6 years. 11.11
2. A piece of equipment has a first cost of $150,000, a maximum useful life of 7 years, and a salvage
value described by S = 120,000 - 20,000k, where k is the number of years since it was purchased. The
salvage value does not go below zero. The AOC series is estimated using AOC = 60,000 + 10,000k.
The interest rate is 15% per year. Determine the economic service life (a) by hand solution, using
regular AW computations. 11.13
3. A lumber company that cuts fine woods for cabinetry is evaluating whether it should retain the current
bleaching system or replace it with a new one. The relevant costs for each system are known or
estimated. Use an interest rate of 10% per year to (a) perform the replacement analysis and (b)
determine the minimum resale price needed to make the challenger replacement choice now. Is this a
reasonable amount to expect for the current system? 11.21

4. An in-place machine has an equivalent annual worth of $-200,000 for each year of its maximum
remaining useful life of 2 years. A suitable replacement is determined to have equivalent annual worth
 values of $ - 300,000, $- 225,000, and $ - 275,000 per year, if kept for 1, 2, or 3 years, respectively.
When should the company replace the machine, if it uses a fixed 3-year planning horizon? Use an
interest rate of 18% per year. 11.32
5. A machine that was purchased 3 years ago for $140,000 is now too slow to satisfy increased demand.
The machine can be upgraded now for $70,000 or sold to a smaller company for $40,000. The current
machine will have an annual operating cost of $85,000 per year. If upgraded, the presently owned
machine will be kept in service for only 3 more years, then replaced with a machine that will be used
in the manufacture of several other product lines. This replacement machine, which will serve the
company now and for at least 8 years, will cost $220,000. Its salvage value will be $50,000 for years
1 through 5; $20,000 after 6 years; and $10,000 thereafter. It will have an estimated operating cost of
$65,000 per year. The company asks you to perform an economic analysis at 20% per year, using a 5-
year time horizon. Should the company replace the presently owned machine now, or do it 3 years
from now? What are the A W values?
 Solution
1. (a) Set up AW equations for years 1 to 6 and solve by hand (or PMT function for spreadsheet solution)
with P = $100,000. Use the A/G factor for the gradient in the AOC series.
For n = 1: AW1 = -100,000(A/P, 18%, 1) – 75,000 + 100,000(0.85)1(A/F, 18%, 1) = $ -108,000
For n = 2: AW2 = -100,000(A/P, 18%, 2) – 75,000 - 10,000(A/G, 18%, 2) + 100,000(0.85)2(A/F,
18%, 2) = $ - 110,316
For n = 3: AW3 = -100,000(A/P, 18%, 3) – 75,000 - 10,000(A/G, 18%, 3) + 100,000(0.85)3 (A/F,
18%, 3) = $ - 112,703
For n = 4: AW4 = $ - 115,112
For n = 5: AW5 = $ - 117,504
For n= 6 AW6 = -100,000(A/P, 18%, 6) – 75,000 - 10,000(A/G,18%,6) + 100,000(0.85)6
(A/F,18%,6)
= $ - 119,849
ESL is 1 year with AW1 = $-108,000.

(b) Set the AW relation for year 6 equal to AW1 = $-108,000 and solve for P, the required lower first
cost. AW6 = -108,000 = -P (A/P, 18%, 6) – 75,000 - 10,000(A/G, 18%, 6) + P (0.85)6(A/F, 18%, 6)
-108,000 = -P (0.28591) – 75,000 – 10,000(2.0252) + P (0.37715) (0.10591)
0.24597P = -95,252 + 108,000
P = $51,828
The first cost would have to be reduced from $100,000 to $51,828. This is a quite large reduction.
2. (a) Solution by hand using regular AW computations.

AW1 = -150,000(A/P, 15%, 1) – 70,000 + 100,000(A/F, 15%, 1) = $-142,500

 AW2 = -150,000(A/P, 15%, 2) – [70,000 + 10000(A/G, 15%, 2)] + 80,000(A/F, 15%, 2) = $-
129,709 AW3 = $-127,489
AW4 = $-127,792
AW5 = $-129,009
AW6 = $-130,608
AW7 = $-130,552

ESL = 3 years with AW3 = $-127,489.

3. (a) The n values are set; calculate the AW values directly and select D or C.
AWD = -50,000(A/P, 10%, 5) – 160,000 = -50,000(0.26380) – 160,000 = $-173,190
AWC = -700,000(A/P, 10%, 10) – 150,000 + 50,000(A/F, 10%, 10) = -700,000(0.16275) – 150,000
+ 50,000(0.06275) = $-260,788
Retain the current bleaching system for 5 more years.
(b) Find the replacement value for the current process.
-RV (A/P, 10%, 5) – 160,000 = AWC = -260,788
-0.26380 RV = -100,788
RV = $382,060
This is 85% of the first cost 7 years ago; way too high for a trade-in value now.
4. Study period is 3 years. Three options are viable: defender for 2 more years, challenger for 1;
defender 1 year, challenger for 2 years; and, challenger for 3 years. Find the AW values and select
the best option.
1. Defender 2 years, challenger 1 year:
AW = -200,000 – (300,000 – 200,000)(A/F,18%,3)
= -200,000 – 100,000 (0.27992)
= $-227,992
2. Defender 1 year, challenger 2 years
AW = [-200,000(P/F,18%,1) + 225,000(P/A,18%,2)(P/F,18%,1)](A/P,18%,3)
= [-200,000(0.8475) + 225,000(1.5656)(0.8475)](0.45992)
= $-215,261
3. Challenger for 3 years
AW = $-275,000
 Decision: Replace the defender after 1 year.
5. There are only two options: defender for 3, challenger for 2 years; defender for 0, challenger for 5.
Defender has a market value of $40,000 now.
Defender
For n = 3: AWD = - (70,000 + 40,000) (A/P, 20%, 3) – 85,000
= -110,000(0.47473) – 85,000
= $-137,220

Challenger
For n = 2: AWC = -220,000(A/P, 20%, 2) – 65,000 + 50,000(A/F, 20%, 2)
= 220,000(0.65455) – 65,000 + 50,000(0.45455)
= $-186,274
For n = 3: AWC = $-155,703
For n = 4: AWC = $-140,669
For n = 5: AWC = -220,000(A/P, 20%,5) – 65,000 + 50,000(A/F,20%,5)
= -220,000(0.33438) – 65,000+ 50,000(0.13438)
= $-131,845

The challenger AW = $-131,845 for 5 years of service is lower than that of the defender. By
inspection, the defender should be replaced now. The AW for each option can be calculated to
confirm this.

Option 1: defender 3 years, challenger 2 years

AW = [-137,220(P/A, 20%, 3) – 186,274(P/A, 20%, 2) (P/F, 20%, 3)] (A/P, 20%,
5)
= $-151,726
Option 2: defender replaced now, challenger for 5 years
AW = $-131,845
Again, replace the defender with the challenger now.