Depreciation

ISE 182112 – Ekonomi Teknik

Reference
❑ Donald G. Newnan, Engineering Economic Analysis, Engineering
Press Inc. (Chapter 12)
❑ Leland T. Blank & Anthony J. Tarquin, 2012, Engineering Economy,
7th ed., Mc-Graw Hill. (Chapter 11)
Replacement Analysis
❑ The basic of replacement analysis is designed to determine if a
currently used asset should be replaced.
❑ In replacement study, the terms defender and challenger are used :
• The existing asset being considered for replacement is called defender.
• The asset proposed to be the replacement is called challenger.

❑ The fundamental replacement analysis question:

Shall we replace the defender now, or keep it for one or more
additional years?
Outsider’s Viewpoint
❑ In order to make a proper comparison of alternatives, the analysis may be
undertaken from the stand point of a person who has a need for the service but
owns neither : an outsider’s viewpoint.

❑ Outsider’s viewpoint concept :

• The outsider currently own or use neither asset.
• To acquire defender, the outsider must ‘buy’ this used asset according to its
value.
• This value becomes the first cost of the defender.
• The outsider may make new estimates for the remaining life, annual operating
cost, and salvage value of the defender.
 To acquire defender, the outsider must ‘buy’ this used asset according to its value.
Is this assumption reasonable?

Example 1
Present market value of defender = $2,000, and this same SV can also be obtained in future years.
Suppose we keep the defender for 1 more year.
→ We ‘buy’ the defender for $2,000, and sell it next year for $2,000. Assume i = 10%.

2,000 AW = -2,000(A/P,10%,1) + 2,000(A/F,10%,1)

= -2,000(1.1) + 2,000(1.0)
= -$200
0 1
Do we really spend this $200?
2,000
 2,000

0 1
2,000

When we decide to keep the defender, we lose the opportunity to gain $2,000
now.
→ This is represented in the assumption : the outsider must ‘invest’ the market
value in the defender.

When we don’t have the $2,000 now, instead we have the $2,000 one year from
now, we lose the opportunity to gain $200 as the interest earn at 10%.
→ This is represented in the $200 we ‘spend’.
Opportunity Cost
When a decision is made to retain rather than sell of an asset already
owned, an opportunity to receive compensation has been foregone.
This foregone compensation must be associated to the alternative.

→ Opportunity cost : cost of invested capital, capital cost, etc.

This principle is satisfied by using the outsider’s viewpoint.

Information Used in Replacement Analysis
The defender is already in the plant, what value should be assigned to it?

Example 2
A calculator was purchased 2 years ago for $1,600, has a 4 yr life with no SV.
The calculator price now is $995.
With SL depreciation : BV = $1,600 – $800 = $800.
A supplier offered a new better calculator for $1,200, with trade-in allowance of $350.
Actually, without a trade-in, the new calculator can be purchased for $1,050.
The actual market value of the old calculator is only $200.
What value should we assign to the calculator?
The relevant cost is the present market value : $200.
Example 3
A tropical hotel purchased an ice making machine 3 yrs ago for $12,000 with an
estimated life of 10 yrs, SV $2,400 and operating cost $3,000/yr. Current BV is $8,000.
A new model, selling for $11,000 has just been announced. It has 10 yr useful life,
$2,000 SV, and operating cost $1,800/yr.
The salesperson offers a trade in amount of $7,500 which is the fair market value.
Based on experience, revised estimates are : remaining life : 3 yrs and SV : $2,000.
Which values should be used in replacement analysis?
Defender Challenger
Initial cost $7,500 $11,000
Opt. cost/yr $3,000 $1,800
SV $2,000 $2,000
n 3 yrs 10 yrs
The Value of Defender
❑ The value of defender that should be used in a study of
replacement is what it is worth at the present time.
❑ In replacement analysis, sunk cost, which has no effect on future
action is not relevant to be used.

The cash flow representing the defender begins at the present and
considers only present and future cash flows.
This principle is also satisfied by using the outsider’s viewpoint.
Replacement Analysis Techniques
 Defender’s Life = Challenger’s Life
When the remaining lives are equal, the method analysis is flexible :
PW, EUAC, ROR, etc.

 Defender’s Life  Challenger’s Life

EUAC analysis is proper.
Replacement Analysis: Equal Lives
Example 4
Calculator A was bought 2 years ago for $1,600. It has market value of $200 now.
Calculator B worth for $1,050 has just been announced. Should A be replaced by B? (MARR
= 10%)
A B
Maintenance cost $80/yr -
n 5 yrs 5 yrs
SV - $250
Benefit - $120/yr
Calculator A : market value now $200, Calculator B : worth for $1,050, MARR = 10%
A B
Maintenance cost $80/yr -
n 5 yrs 5 yrs
SV - $250
Benefit - $120/yr
Keep the defender :
Initial cost = $200, maintenance cost = $80/yr
EUACA = $200(A/P,10%,5) + $80 = $132.76

Replace the defender now, buy the challenger :

Initial cost = $1,050, SV = $250, annual benefit = $120
EUACB = $1,050(A/P,10%,5) - $250(A/F,10%,5) - $120
= $116.04
→ Replace the defender now
Example 5
Moore Transfer company currently owns several moving vans which are
deteriorating faster than expected. The vans were all purchased 2 years ago for
$60,000 each. The company plans to keep the vans for 10 more years now. Fair
market value for the van is $42,000 each with SV $8,000 each. Annual operating
cost is $12,000 each.
The replacement option is to lease on a yearly basis. The lease cost is $9,000/yr
each with $14,000/yr operating cost for each van.
Should the company lease its vans if the MARR is 12%? Use 10 years analysis
period.
 Defender Challenger
Initial/lease cost $42,000 $9,000/yr
AOC $12,000 $14,000
SV $8,000 -
n 10 yrs 10 yrs

Keep the defender :

EUACD = $42,000(A/P,12%,10) - $8,000(A/F,12%,10) + $12,000
= $18,977

Replace the defender, buy the challenger :

EUACC = $9,000 + $14,000
= $23,000

→ Keep the defender (retain ownership of the vans)

Replacement Analysis: Unequal Lives
Example 6
An $4,000 of overhaul must be done now if the defender is to be retained in service.
Maintenance is estimated at $1,800 in each of the next 2 yrs, and $2,800 in the third yr. It has 3
yrs remaining life and no present or future SV.
The present challenger is a machine costs $10,000 and has no SV. The maintenance cost is zero
in yr 1 and will increase by $600/yr. It is predicted that the useful life is 6 yrs.
Make a replacement analysis if MARR = 8% is used.

EUACD = $4,000(A/P,8%,3) + $1,800 + $1,000(A/F,8%,3)

= $3,660
EUACC = $10,000(A/P,8%,6) + $600(A/G,8%,6)
= $3,528.6
→ Replace the defender now
Exercise
Exercise 1
A city has owned and used a recyclable material sorter for 3 yrs. Based on recent
computations, the asset has an EUAC of $5,200/yr for its 5 yrs remaining life.
An upgraded replacement has a first cost of $25,000, estimated SV of $3,800, 12
yrs projected life, and annual operating cost of $720.
If MARR = 10%, should the city replace the old sorter?

(EUACD = $5,200, EUACC = $4,212.16 → Replace the defender now)

Economic Life of Defender
❑ How long can an equipment be kept operating?
❑ Almost anything can operate indefinitely, but the cost may prove to
be excessive.
→ What important is not the operating life, but the economic life.

Economic life = Life where the EUAC is minimum

Economic Life of Defender (2)

❑ The capital recovery is the AW

of investment; it decreases
with each year of ownership.
❑ Since the AOC (or M&O)
estimates usually increase over
the years, the AW of AOC
increases.
Example 7
An 11 yr old equipment is being considered for replacement. It can be sold for $2000 now
(it is believed this SV will be the same in the future). The maintenance cost is $500/yr and
is expected to increase $100/year. If the equipment is retained in service, compute the
economic life.

If the equipment is retained for 1 year :

2,000

0 1
2,000 500

EUAC1 = cost of invested capital + cost of maintenance

= [2,000(A/P,10%,1) - 2,000(A/F,10%,1)] + 500(A/F,10%,1)
= $200 + $500 = $700
 Keep asset in EUAC of EUAC of Total EUAC
n year Capital Maintenance
1 $200 $500 $700
2 $200 $548 $748
3 $200 $594 $794
4 $200 $638 $838
5 $200 $681 $881

The economic life at which EUAC is minimum is 1 year.

Economic Life of Challenger
Example 8
A piece of machinery costs $10,000 and has no salvage value. The manufacturer’s warranty
will pay all first year maintenance and repairs.
In the second year, maintenance and repairs will be $600, and they will increase $600/yr. If
MARR = 8%, compute the economic life of the equipment.
Useful life EUAC of capital EUAC of maint. Total
n $10,000(A/P,8%,n) $600(A/G,8%,n)
1 10,800 0 10,800
2 5,608 289 5,897
3 3,880 569 4,449
4 3,019 842 3,861
5 2,505 1,108 3,613
6 2,163 1,366 3,529
7 1,921 1,616 3,537
8 1,740 1,859 3,599
Exercise
Exercise 2
A 3-yr old asset is being considered for early replacement. Its current market value
is $13,000. Its estimated SVs and operating costs are given in the table. Calculate
the asset’s economic life! (MARR = 10%)
Remaining life SV Op. cost
1 $9,000 $2,500
2 8,000 2,700
3 6,000 3,000
4 2,000 3,500
5 0 4,500
>5 0 Increasing
$1,000/yr

(Answer : EUAC is minimum for 3 years life ($6,132.07) → asset’s economic life is 3 yr)
Series of Challengers
Exercise 3
Defender Challenger 1 Challenger 2
Market value - $6,500 $15,500
Annual cost $3,000 $1,500 $1,200
SV $500 $1,000 $500
n 5 5 5
*Use MARR = 18%

Alt. 1 : Keep the defender now

EUACD = $2,930.1
Alt. 2 : Replace the defender, buy challenger 1 now
EUACC1 = $3,438.9
Alt. 3 : Replace the defender, buy challenger 2 now
EUACC2 = $5,289.14
→ Keep the defender now
to be continued…
Terima Kasih
Yani Herawati
Program Studi Teknik Industri
UNPAR
yani.herawati@unpar.ac.id