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Lec 7

The document discusses engineering economy and accounting principles related to replacement and retention decisions for assets. It defines key concepts such as Economic Service Life (ESL) and outlines the process for conducting replacement studies, including when to replace or retain an asset based on annual worth (AW) calculations. Examples illustrate how to analyze costs and make decisions regarding the timing of asset replacement.

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Mohamed Alaa
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44 views33 pages

Lec 7

The document discusses engineering economy and accounting principles related to replacement and retention decisions for assets. It defines key concepts such as Economic Service Life (ESL) and outlines the process for conducting replacement studies, including when to replace or retain an asset based on annual worth (AW) calculations. Examples illustrate how to analyze costs and make decisions regarding the timing of asset replacement.

Uploaded by

Mohamed Alaa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Engineering Economy and

Accounting
Dr. Maha Raouf
Lecture 7

Selecting The Basic Analysis


Tool
Replacement & Retention
Decisions
Retention Decisions

Economic Service Life: is the remaining


useful life of an asset that results in the
minimum annual equivalent cost.
Example:
Determine the ESL of an asset which has the costs shown below. Let i = 10%

End of Year Cost, $ 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
When you should stop the study?

When the Aw starts to increase;


❖ Aw1 = ‐ 10 Continue
❖ Aw2 = ‐ 8 Continue
❖ Aw3 = ‐ 7 Continue
❖ Aw4 = ‐ 7.2 Stop

• The ESL is 3 Years and Aw = ‐ 7


Replacement Decisions
Replacement Decisions
Replacement or Retention?
• The fundamental question answered by a replacement study about a currently
installed asset or system is: “Should it be replaced now or later?”

• If the decision is to replace, the study is complete.

• If the decision is to retain, the cost estimates and decision will be revisited each
year.
Replacement Decisions
The need for a replacement study can develop from several sources:
• Reduced performance: Physical deterioration, reduced reliability or productivity.

• Altered requirements: New requirements of accuracy, speed, or other specifications


cannot be met by the existing equipment or system

• Obsolescence: International competition and rapidly changing technology make


currently used systems and assets perform acceptably but less productively than
equipment coming available
Important Definitions

Defender Currently installed asset

Challenger The “best” alternative to replace the defender

Primary economic measure of comparison between defender and


AW challenger
Important Definitions

Economic Service Number of years at which the lowest AW of cost for


Life (ESL) an alternative occurs

Defender First The current market value of the


Cost defender

Challenger First The actual investment needed for acquisition and


Cost installation.
Challenger First Costs (special case):
• On occasion, an unrealistically high trade‐in value may be offered for the defender
compared to its fair market value. In this event, the net cash flow required for the
challenger is reduced.

• The correct amount to recover and use in the economic analysis for the challenger is
its first cost minus the difference between the trade‐in value (TIV) and market
value (MV) of the defender

The challenger First Cost = P‐ (TIV ‐ MV)


Performing a
Replacement Study
I. No Study Period Specified

AWc > AWd Replace Now


I. No Study Period Specified

AWd > AWc Keep for 3 years then replace


Example:
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 $10,000 after 1 year
or $9000 after two years. A suitable challenger will have an annual worth of $‐24,000
per year. At an interest rate of 10% per year, should the defender be replaced now, one
year from now, or two years from now?
(Defender)
(Challenger )
(Decision )

Lower AWD2 = $‐22,629 Keep defender for 2 years

Note: conduct one‐year‐later analysis next year


II. Specified Study Period
• Same procedure as before, except calculate AW values over study period instead of
over ESL

• It is necessary to develop all viable defender‐challenger options and calculate AW or


PW for each one over study period

• Select option with lowest cost or highest income


Example:
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 $10,000 after 1 year
or $9000 after two years. A suitable challenger will have an annual worth of $‐24,000
per year. At an interest rate of 10% per year and over a study period of exactly 3 years,
determine when the defender should be replaced
OPTION YEAR 1 YEAR 2 YEAR 3

1 C C C

2 D C C

3 D D C
Example:
Replacement study information for an equipment placed into service 5
years ago:
• The current equipment will have to serve for either 2, 3 or 4 more years before
replacement.
• The equipment has a current market value of $100,000; expected to decrease by
$25,000 per year.
• The AOC is $25,000 per year.
• The replacement challenger is a fixed‐price contract to provide the same services at
$60,000 per year for a minimum of 2 years and a maximum of 5 years.
• Use MARR of 12% per year to perform a replacement study over a 6‐ year period
to determine when to sell the current equipment and purchase the contract
services.
Since the defender will be retained for 2, 3 or 4 years, there are three
viable options. And the challenger shall be used 2, 3, 4, or 5 years

OPTION YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6

1 D D C C C C

2 D D D C C C

3 D D D D C C
Option 2: Cash Flow Diagram
Result Table:

Option 3 has the lowest cost PW value ($240,369). Keep the defender all 4
years, then replace it.
Thank you

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