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Replacement & Assessment

Engineer ing
INE 428
Lec 3

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3- Defender And
Challengers With Unequal
Lives
Example 1
An existing machine is worth $2,500 today and will lose
$1,000 in value by next year plus $500 per year therefore.
Its $8,000 operating cost for this year is predicted to
increase by $1000 annually, owing to deterioration. It will be
retired in 4-years, when its salvage value will be zero.

A new, improvement machine that satisfactorily performs the


same function as the existing machine can be purchased for
$16,000 and is expected to have relatively constant annual
operating costs of $6,000 to the end of its 7-year economic life,
at which time the salvage value will be $1,500. No major
improvements are expected in the designs for machines of this
type within 7 years. If the minimum attractive rate of return is
12 %. Should the existing machine be replaced? If so, when?
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Data
An existing machine (Defender) is worth $2,500 today

will lose $1,000 in value by next year plus $500 per year,
and life cycle = 4 year , salvage value = 0

$8,000 OC for this year , increase by $1000 annually

New machine ( Challenger) purchased for $16,000

annual operating costs of $6,000

life cycle = 7 year

salvage value will be $1,500.


minimum attractive rate of return is 12 %.
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Solution

$2500 ,$1500, $1000, $500, $0


Defender Challenger

$1,500
7 years

0 0 1 2 3 4 5 6 7
1 2 3 4
A=$8,000
$2500 A=$ 6000
G=$1000
$16,000

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Solution
For challenger
EAC=$6,000+(P-S)(A/P,12%,7)+Si
=6,000 + (16,000-1,500) (0.21912) +1500(0.12)
=$9,357
One-year cost of defender:
OC= $8,000
Capital recovery is (P-S)(A/P,12%,1)+Si=
=(2500-1500)1.12+1500(0.12) =1300
EAC def = $8000+$1300=$9,300
the defender has a lower cost for the next
year $9,300< $9,357
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Solution
the defender has a lower cost for the next
year $9,300< $9,357

At the beginning of year 2


Operating costs=$8,000+$1,000=$9,000

Equivalent annual cost of defender during


year 2:

Capital recovery is (1500-1000)(1.12)+1000(0.12)=


=$680

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Solution
Two years cost of defender
EAC=(2500- 1000)(A/P,12%,2)+1000(0.12)+
[(8000*(P/F,12%,1)+9000*(P/F,12%,2)](A/P,12%,2)

EAC=1500)(0.5917)+1000(0.12)+
[(8000*(0.8929)+9000*(0.7972)](0.5917) =9479.5

This indicates that it should replace the defender at


the end of the first year

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Example 2
The purchase price truck is $25,000, and the
anticipated schedule of future operating cost and
salvage value is given as
Cost Year
1 2 3 4 5 6
Operating cost 6,100 6,800 7,800 9,300 11,400 14,600
Resale value 15,000 12,000 9,300 7,100 5,400 4,300

Find n=? 1. If no interest 2. If i=10%

Capital cost =$25,000 - resale value

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Solution
1. If no interest
Capital C Cumulative Total C Average total costs/year
Year Operating C

1 10,000 6,100 16,100 16,100


2 13,000 12,900 25,900 12,950
3 15,700 20,700 36,400 12,133
4 17,900 30,000 47,900 11,975
5 19,600 41,400 61,000 12,200
6 20,700 56,000 76,700 12,783

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Solution
2. If interest 10%
EAC=capital recovery + equivalent annual operating cost
= (P-S) (A/P,i,N)+ Si + FV(operating costs for N years)*(A/F,i,N)
15,000
12,000
9,300
7,100 5,400
4,300
0 1 2 3 4 5 6

6,100
6,800
7,800
9,300
11,400
25,000 14,600
EAC (N=1) = (25,000-15,000)(A/P,10%,1) +15,000(0.1)
+6100(A/F, 10, 1) = 18,600
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15,000
Solution 12,000
9,300
7,100 5,400
4,300
25,000 0 1 2 3 4 5 6

6,100
6,800 7,800
9,300
11,400
14,600
EAC (N=2) = (25,000-12,000) (A/P, 10%,2)+12,000(0.1)
+ [6100(F/P, 10, 1) +6800] (A/F, 10, 2) =13,000(0.57619)
+1200+[6100(1.1)+6800](0.47619)=15,123
EAC (N=3) = (25,000-9,300) (A/P,10%,3)+9,300(0.1) +[6100
(F/P,10, 2)+ 6800(F/P, 10, 1) +7800](A/F, 10, 3)=15,700
(0.40211) +930+ [6100(1.21) +6800(1.1)+7800] (0.30211)
=14,090
EAC (N=4) =13,732
EAC (N=5) =13,745
EAC (N=6) =14.068 12
Solution
Comparison (EAC, 10%) And EAC at (0%)

Asset life, EAC Average Annual Cost


years (10%) (0%)
1 18,600 16,100
2 15,124 12,950
3 14,090 12,133
4 13,732 11,975
5 13,745 12,200
6 14,068 12,783
n=4
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Cost
Economic Life for Cyclic Replacements

Total cost Operating and


maintenance costs

Capital costs

Age (year)
N

Economic life
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Economic Life for Cyclic Replacements
Economic life is the period of time over which a
prudent owner will retain an existing facility to
minimize costs.

Physical life is the period of time after which an


asset can no longer be repaired or refurbished so
that it can perform a useful function.

Service life is the period of time after which an


asset cannot perform its intended function without a
major overhaul. Such an overhaul is an investment
for which a new economic life has to be determined.

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Optimum Replacement Interval

If ATC equation as:


P m
ATC = + O + (n 1)
n 2
Where P = initial cost of the asset
O = annual operating costs for the first year
m = the amount by which maintenance costs
increase each year

n =life of the asset in years


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Optimum Replacement Interval
ATC P m
= + =0
n n 2
2
2P
n=
m
j =k
AWK = -P(A/P, i, k) + SVK (A/F, i, k) - [ AOC j ( P / F , i, j )]( A / P, i, K )
j =1

Where P =initial investment or asset first cost

SVk = Salvage value after retaining the asset K years

AOCj = annual operating cost for year j (j=1,2,3,K)


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Example 3
Machine A costs $80,000 Annual operating
costs are $2000 for the first year, and they
increase by $15,000 every year. Determine
the age at which to replace the machine
assuming that it has no resale value.
What will be the average yearly cost of
operating and owning the machine, if the
optimal replacement policy is followed?

Find n=? 1. If no interest 2. If i=12%

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Solution
1. If no interest
Using the table
The Capital O&M Cumulative Total Average
end of cost Cost O&M cost cost
year 1000$ 1000$
1 80 2 2 82 82.00
2 80 17 19 99 49.50
3 80 32 51 131 43.67
4 80 47 98 178 44.50
5 80 62 160 240 48.00

The minimum average cost occurs when the machine is


replaced at the end of three years.
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Solution
using the equation
2P
n =
m
Where P= $ 80,000, m= $ 15,000

2 * 80,000
n= = 3.26
15,000
replace M/C at the end of three years
Also the previous table can be calculated using
this equation
P m
ATC = + O + (n 1)
n 2 20
Solution
Using the equation
ATC1= (80/1) + 2+ (0)*(15/2)=$ 82,000
ATC2= (80/2) + 2+ (1)*(15/2)=$ 49,500
ATC3= (80/3) + 2+ (2)*(15/2)=$ 43,666
ATC4= (80/4) + 2+ (3)*(15/2)=$ 44,500
ATC5= (80/5) + 2+ (4)*(15/2)=$ 48,000
ATC6= (80/6) + 2+ (5)*(15/2)=$ 52,833
Replace M/C at the end of three years
2. If interest 10% Report
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Example 4
An inexpensive, low-volume office coping machine was
purchased 2 years ago for $1200. At the time of purchase
it was believed that the machines would have an
economic life of 5 years and salvage value of $100
operating costs over the first 2 years for material, labor,
and maintenance have average $4200 annual and are
expected to continue at the same level. Some type of
copier will be needed for the next several years. The
same company that manufactured the presently used
copying machine has a new model that cost of $1500 but
will perform the current workload with operating costs of
$3500 per year. The company is offering $500 for the old
model as a trade-in on the new machine. The expected
salvage value for the new model is $400 at the end of 5
years.
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Example 4
Another company has a different type of copier that is
available only on a lease basis. The company claims
that leasing its copier at $1000 per year will reduce the
operating expense for the present amount of work to
$2750. Since this company does not accept trade-ins,
the machine now in use would have to be sold on the
open market, where it is expected to bring only $300.
If the minimum accepted rate of return is 10% before
taxes, should the defending copier be replaced by one of
the challengers?

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Solution $300 $100

Defender 1 3 4 5

$1200
$4200

Equivalent annual cost of defender:


Operating costs are $4200;
capital recovery is
=(P-S)(A/P, 10%, 3)+S (0.1) = ($300-$100)
(0.40211) +$100(0.1) =$90
EAC (def.) =$4200+$90 = $4290

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Solution
From the same company
500-300
400

1500
OC=3500

EAC from the same vendor:


OC = $3500;
Capital recovery is
=(P-S)(A/P, 10%, 5)+S (0.1)= [(1500-200)-400]
(0.2638) +400(0.1) =$227
EAC (chal/new) =3500+277=$3777
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Solution
Another company Offer:
Equivalent annual cost of the leased challenger:
Operating costs are $2750;
annual lease contract is $1000:
EAC (chal/lease) =2750+1000 = $3750

D Cha (New) chal/lease

$4290 $3777 $3750

A lease is less expensive


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Solution
Defender
Equivalent annual cost of defender when
P= trade-in value=$500
OC= $4200.
Capital recovery is
=(P-S)(A/P, 10%, 3)+S (0.1)
=(500-100)(0.40211)+100(0.1) = $171
EAC (def) =4200+171= $4371
500 100

$4200

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Solution
From the same company 400

3500
1500

OC= $3500.
Capital recovery is
=(P-S)(A/P, 10%, 5)+S (0.1)
=(1500 - 400)(0.2638)+400(0.1)=$330
EAC(chal/ven)=3500+330= $3830

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Solution
Another company Offer:
Equivalent annual cost of the leased challenger:
Operating costs are $2750;
annual lease contract is $1000:
EAC (chal/lease) =2750+1000 = $3750

D Cha (New) chal/lease

$4371 $3830 $3750

Also, a lease is less expensive


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Example 5
A company owns several moving vans which are
deteriorating faster than expected. The vans were
all purchased 2 years ago for $60,000 each. The
company currently plans to keep the vans for 10
more year. Fair market value for a 2-year old van
is $42,000 and for 12-year-old van is $8,000.
Annual fuel, maintenance, tax, etc. costs, that is
AOC, is $12,000 per year. The replacement
option is to lease on a yearly basis. The annual
lease cost is $9,000 (year-end-payment) with
annual operating cost of $14,000. Should the
company lease its van if the MARR is 12%?
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Solution

Data

Defender D Challenger C
P=$42,000 Least cost=$9,000 per year
AOC=$12,000 AOC=$14,000
Sv=$8,000 Sv=0
n=10years n=10years

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Solution
The annual worth of Defender is
AWD=-P(A/P,i,n)+SV(A/F,i,n)-AOC

=-42,000(A/P, 12%, 10) +8000(A/F, 12%, 10)-12,000


=42,000 (0.17698) +8000(0.05698)-12,000
=-$18,977

The annual worth of challenger is


AWC=-9,000 -14,000= -$23,000

Clearly the firm should retain ownership of the vans


since AWD is numerically larger than AWC.
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Quiz 1
1. Define the Replacement and Why
Replacement Studies are Performed?

2. The cost of a machine is $6100 and the


scrap value is $100 at any time. The
maintenance costs found from experience
are as follows:

year 1 2 3 4 5 6 7 8
Maintenance
100 250 400 600 900 1200 1600 2000
cost $

When should the machine be replaced?


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