Chapter-5

Replacement Analysis
 Replacement Terms
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Defender: an old machine
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Challenger: a new machine
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Current market value: selling price of the defender in the market
place
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Defender first cost: Initial investment amount used for defender
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Challenger first cost: Initial investment amount used for
challenger
 Replacement
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Replacement analysis is the economic analysis to compare existing
and new facilities. It is the decision situation encountered in firm in
which an existing asset should be retired from use or continued in
service or replaced with new asset.
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Replacement study provides the information for sound decision that
improve the operating efficiency and the competitive position of
enterprise.
 Reason for Replacement Analysis
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Physical impairment of asset- Ageing of asset
results operation of asset becoming less efficient.
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Altered requirement- When goods or services
either increases or decreases or
changes,replacement analysis is required.
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Technology change- Obsolescence(Out of Date)
●
Financing- Rent become attractive than ownership
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Depletion- Gradual loss in market value of asset
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Inadequacy- The equipment does not have sufficient
capacity to meet the present demands
 Defender and Challenger Concept
In Replacement
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Up to this point, when two (or more) alternatives were available for comparison, it was
assumed that neither one was currently owned. However, when one of the alternatives under
evaluation is presently owned, the evaluation is called a replacement (or retirement) analysis.
In such a study, the presently-owned asset is called the defender and its possible
replacement is called the challenger. The analyst then takes the viewpoint of an outsider or
consultant whose perspective is that neither asset is currently owned. Therefore, to acquire
the services of the defender, it would have to be 'purchased' at a price equal to its market
value. This market value would then represent the defender's first cost, P, with all other
estimates (operating costs, salvage value, and life) made just as if the defender were to be
purchased now by the company.
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The economic analysis is then conducted using any of the alternative comparison techniques
discussed thus far. However, an AW analysis is usually selected because the alternatives
(i.e. the defender and challenger) typically have different lives.
 Economic Life
Any asset will have following cost components:
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Capital Recovery Cost- Earning back of the
initial funds.
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Average operating and maintenance cost
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Total cost
●
The point where the total cost is minimum is called
economic life of machine
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Economic life is the period of time that results in the
minimum equivalent uniform annual cost of owning
and operating an asset
Approaches for comparing Defender
and Challenger
Cash Flow Approach
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In this approach,proceeding from the sale of
old machine is treated as down payment
towards purchasing the new machine.
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This approach is meaningful when both
defender and challenger have same useful life.
 Opportunity Cost Analysis
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In this approach,both old machines and new machines
should be purchase for analysis.
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After the analysis has been done, we select appropriate
machines for operation.
Incremental Analysis
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In this analysis we need to calculate the present worth
using C-D
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After calculating PW, if PW>0 then Use challenger else
Use Defender.
 Replacement Analysis When
Required Service Life is Long
For this,we need to consider following factors,
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Planning Horizon
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Technology
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Relevant Cash Flow Information
 Planning Horizon
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It refers required economic service period by
defender and a sequence of future challengers.
 Types of Planning Horizon
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Infinite Planning Horizon
It is used when we are simply unable to predict when
the activity under consideration will be terminated.
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Finite Planning Horizon
It is used when the project will have a definite and
predictable duration.
 Technology
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It refers to the development of types of challengers that
may replace the defender. If we assume that all future
machines will be the same as those now in use,we are
saying that no technological progress will occur.
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If available machine get better & better over time,we
should investigate the possibility of delaying asset’s
replacement for a couple of years.
 Relevant Cash Flow Information
●
Many prediction can be used to estimate the
pattern of revenue,cost and salvage value over
the life of an asset. We will focus whether
replacement analysis is directed towards cost
minimization or profit maximization.
●
We formulate a replacement policy for an asset
whose salvage value does no increase with age.