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Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Engineering Economy

Chapter 9: Replacement Analysis

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The objective of Chapter 9 is to

address the question of whether a

currently owned asset should be

kept in service or immediately

replaced.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Some important terms for

replacement analysis

• Economic life: the period of time (years) that

yields the minimum equivalent uniform annual

cost (EUAC) of owning and operating as asset.

• Ownership life: the period between acquisition and

disposal by a specific owner.

• Physical life: period between original acquisition

and final disposal over the entire life of an asset.

• Useful life: the time period an asset is kept in

productive service (primary or backup).

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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 it’s apparent economic life as long as it’s marginal cost is less than the minimum EUAC of the

challenger over it’s economic life.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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?

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Example solution Defender

Challenger

PW of the challenger is greater than PW of the defender

(but it is close).

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Eq. 9-1.)

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Total marginal cost formula

The total marginal cost is the equivalent worth, at the

end of year k, of the increase in PW of total cost from

year k-1 to year k.

This can be simplified to (eq. 9-2)

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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

Year 1 Year 2 Year 3 Year 4

EUAC $63,500 $62,453 $60,019 $57,512

TC (defender) $53,600 $56,800 $59,900 $62,000

REPLACE

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The economic life of the 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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

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

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Abandonment solution

Keep for two years

Keep for one year

Keep for three years (BEST!) Keep for four years

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Taxes can affect replacement decisions.

• Most replacement analyses should consider

taxes.

• Taxes must be considered not only for each

year of operation of an asset, but also in

relation to the sale of an asset.

• Since depreciation amounts generally

change each year, spreadsheets are an

especially important tool to use.

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

The effect of taxes.

The economic life of an asset becomes, after taxes, (eq. 9-

which reflects not only annual taxes but also tax effects

of the sale of the asset. The total marginal cost, for

each year, is (eq. 9-4)

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

We must also consider the possible tax

effects of the sale of the defender.

The MV of the asset must be compared to the BV to

assess the possible tax implications, and this should be

reflected in the opportunity cost of keeping the

defender. The net ATCF, if the defender is kept, after

taxes, is

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Acme Cycles purchased a bending machine two years ago

for $45,000. Depreciation deductions have followed the

MACRS (GDS, 3-year recovery period) method. Acme can

sell the bending machine now for $12,000. Assuming an

effective income tax rate of 45% compute the after-tax

investment value of the bending machine if it is kept.

Pause and solve

Upper Saddle River, New Jersey 07458

Engineering Economy, Sixteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

First, find the current book value.

Solution

BV = $45,000 (1 – 0.3333 – 0.4445) = $10,000

Next, find the ATCF if the machine is kept.

BTCF Depreciation Taxable income

Cash flow for

tax ATCF

-$12,000 $0 -($12,000-

$10,000)=$2,00

-0.45*$2,000 =

-$900

-$12,900