Replacement Analysis The result of an alter: of a project, asset, or service which has @ lacement? , replacement is commonly considered be- Whether unplanned or anticipated. cause of several reasons. Some are: Reduced performance —Due to the physical deterioration of parts, the ability to per- enon Man expected level of reliability (being available and perfortaing correctly Toy ete and productivity (performing at a given level of quality ana cree, schop and resent This usually results in increased costs of operarion, hicher Sorab and rework costs, lost sales, and larger maintenance cxpences Atcered requirements——New requirements of accuracy, specd, or other srecifications have been placed upon the owners. These requifements can not bene by the mont agiuipment or system. Often the analysis is between complete seciace quirernd cabancement through xctrofitting.which may result ix the ote quirements being met. Obsolescence _The rapidly changing technology of automation, computers, and com- Ios mentions makes currently used systems and assets perform acccntaniy tak Hinoonnuntely Sr productively {Han equipment ccming onto the menor Cot Riscement due to obsolescence is usually possible, but « formal anaiven i, per- formed when management determines that competitive forces OF news cinedU shape of the FUAW curve. Total EUAW curve Cost hte \uipment may force the company out of markets due to increased require- nts from consumers or contractors, The decrease in time of the development eycle of new products is the cause for much of the replacement analyses per- formed prior to the completion of the expected economic life.10.1 The Defender and Cha nger Concepts in Replacement Analysis Here, as in previous chapters, we can compare two or more alternatives; however, now own one of the assets, referred to as the defender, and are considering its Placement by one or more challengers. In the comparison we take the consultant's viewpoint. For evaluation purpos we assume that we own neither asset. In order to “purchase” the defender, therefo we must pay the going market value for this used asset. We then use the estimat market value as the first cost P of the defender. There will be an associated salva value SV, an economic life n, and annual operating cost AOC for the defender. E though the values may all differ from the original data, it makes no difference the evaluation because we are using the consultant's viewpoint and are thus mak} all previous data irrelevant to the present evaluation. In replacement analysis this irrelevant data is sometimes used to calcul what is known as a sunk cost. The sunk cost of an asset is computed as Sunk cost = present book value — present realizable value a ‘The present book value is the remaining investment after the total amount of ciation has been charged; that is, the book value is the current worth of the asi established by acceptable accounting procedures. (See Chap. 13 for a complete cussion of depreciation.) If incorrect estimates have been made about the utility or market value asset (as is possible, since no one can be perfect in their estimation of the future), is a positive sunk cost, which cannot be recovered. A sunk cost is a result of decision that was made at some time in the past, and past economic decisions not be allowed to influence decisions of the present. However, some analysts “recover” the sunk cost of the defender by erroneously adding it to the firs of the challenger. This penalizes the challenger, making its costs seem higher they really are, and thereby jeopardizing the validity of the conclusion. The sun rather, should be charged to an account entitled “Unrecovered Capital,” or which will ultimately be reflected in the company’s income statement for the which the sunk cost was incurred. Therefore, for replacement analysis a si should not be included in the economic comparison. The following example ill the correct data to use in a replacement analysis.ora. Wien using the consultant's viewpoint, only the most current information is bie. cost of $12,000, es for the defender, A sunk cost timated salvage of $1600, and remai only the current data applies incurred for the defender if it is replaced. By Eq. (10.1), e0st — 8100 — 7500 = $600 ing 5 years of life are st cost of the challenger, since this action would (1) try to mation, and (2) penalize the challenger since the capitel to be rroneously larger due to the increased first cone each year would be © Probe. 10.4 to 10.5 lacement Analysis Using @ Specified Planning Horizon ning horizon or study period is the number of years used i fo compare the defender and challenger. Typically, one of tuk (2) The anticipated remaining life of the defender equals the 'F (2) the life of the challenger both possibilities in order. the defender and challen; ly discussed can be used with leasing a van eee oes Emre, Vans which are deteriorating faster than expected. Owning the Mee oro t SUIy basis are the replacement options. The two vans were ne cnescd for $60,000 © (or 8 Zvear-old van is $42,000 and for a 12-year-old van, $8000, Annual Tah, tax, ete., costs are $12,000 per year. Lease cost is $9000 per veer Cone the economic o situations is jife of the chal- greater than that of the defender. We willDe Oe ei ee Solution Consider @ 10- ‘year life for the currently owned van (defender) and the leased van (challenger). etemtersos sun elbal a ‘P — $42,000 Lease cost = $ 9,000 per year aac = “13,000 ‘AOC = "141000 ‘sv — "R000 ER Thor bcm A Oypomen sets The EUAW, calculation for the defender uses the $42,000 as an ini EUAWp — PLA/P, 1%, n) — SV(A/F, %, 2) + AOC 42,000(4/P, 12%, 10) — 8000(4/F, 12%, 10) + 12,000 = 313,977 ‘The EUAW¢ for the challenger is EUAWe = 9000 + 14,000 = $23,000 Clearly, the firm should retain ownership of the two vans, Comment Recalculate the EUAW of the challen, wer, assuming the lease payments are beginning-of-year payments. You should get EU. JAW. — $23,900. in many instances, an asset is to be replaced by another having an estim: Hfe different from that of the defender’s remaining life. For analygis, the length of planning horizon must first be selected, frequently Coinciding with the lite op Kk is expected service life. For example, evaluating a challenger with a 10sec. life a defender with a 4-year life assumes that the service provided by the defender alt tive can be acquired for the same EUAW for the 6 years after the remaining # of defender life. If this assumption is not reasonable, the estimated cost of aes the equivalent service beyond year 4 should be included in the defondere ou and amortized over its 10-year life.ee wage value of $3800, life of 12 years, a: company uses a minimum aie or the new machine for its fall ind an annual operating cost Foturn of 1022 per year om cone anticipated life, ‘should the old as °f $720 per year. If investments and plans eset be replaced? A planning horize: 35210 25.00004/P, 10% = sa211 SE AP onprs io correspond with the chinlleapert imerisoaior ios 12) — sRo0cayr, 10%, 12) + 720 Bats Of the new assct is loss costly than is retention of the prese: iment If the planning horizon for diferent. is desired. you must realize that = hereon ntly owned machine. lived assets is used and a present-worth assumes that you plan to purchase 2 and its EUAW will be the same as during a defender-similar asset would be puttin !Pulations would be fords, in this problem 10 years. Present-worth cong fe = S2100P/A, 10%, 12) = $35,500 = 42110774, 10: 6. 12) = $28,603 urse, the decision to purchase the new machine is still made. of current technology are Hy high-technology. Skepticiom noaur in management's desire to impose cht cvaluations. This often forces the recovery TE aturn over a shorter perlod of time thant the aenecce, cases. the n values in all computations reficce ne, example explains the consequences of abbreving gs the data of Example 10.3, except 5 yours because i that has ssted capital and the re the alternatives. Ws leery Of the tex aie SPProach is as in the preceding example, except a capital-recovery period of is used for the challenger = $5210 i 25.000.4/r, 1072. 5) — s800¢4/r, 1022, 5) + 720 = $0003ee eee Comment By not allowing the full anticipated life of the challenger to be used, management has ruled out its use. However, the decision to not consider the use of this new asset past 5 years is one of management responsibility. The reason why the decision is reversed in this example is quite simple. The challenger is given only 5 years to recover the same invest- ment and a 10%;-per-year return, whereas in the previous example 12 years is allowed. Reasonably, EUAW, must increase. It would be possible to recognize unused value in the challenger by increasing the salvage value from $3800 to the estimated fair market value after 5 years of service, if such a value can be predicted, Selection of the planning horizon is a difficult decision, one which must be ba: on sound judgment and data. The use of a short horizon may often bias the econo! decision in that the capital-recovery period for the challenger may be abbreviated much less than the anticipated life. This is the case in Example 10.4, where 5 years were allowed for recovery of invested capital plus a 10%-per-year ret However, use of a long horizon is also often detrimental due to the uncertainty the future and its estimate. In this case, the direction of bias is less certain thal the case of a too-short horizon. A common practice is augmentation: that is, defender is augmented with a newly purchased asset to make it comparable ability (speed, volume, etc.) with the challenger. Since the analysis is similar to covered here, a sample solution is included in the Additional Examples. 10.3 Conventional and Cash-Flow Approach to Replacement Analy: There are two equally correct and equivalent ways to handle the first cost of natives in a replacement analysis. The conventional approach (used in Exam uses the defender’s current market value as the first cost of the defender and. initial cost of the replacement as the challenger’s first cost. Thus, for the ¥ is the highest value attainable through its disposal (sale, trade-in, scr: when it is compared with a given challenger. This approach is cumbersot there is. more than one challenger with each offering a different trade-in value defender, thus possibly causing a different P value for the defender when with each challenger. The second approach recognizes the fact that when a challenger is the defender’s market is a cash inflow to the challenger alternative; and fender is sclected, there is no actual outlay of cash. This is the cashflow to replacement analysis. In this approach, if the defender and challenger same life value, set the defender first cost to zero and subtract the trade-in ¥, the challenger first cost. It is important to recognize that this approach used when the lives of the defender and challenger are the same or when parison is to be made over a specified or preselected planning horizon. Ex! shows these calculations.assets. Current data for cach Use the cash-flow approach and a MARR = 189s per yee to ical decision. The firet-cost value used for the defender (D) in the 1 (C1) and challenger 2 (eo) eplacement analysis is s from the respective challenmers fi Using the cash-flow approach subtract rst Cost and compute the EUAW over OF 3 encroach alternative or the planning horizon, whichter aio se case 2erE En the ovaluation period for ail analyece: With Thin wo er Ider first cost is zero because the asect is wirecds oe 3000 — sooca/r, 182%, 5) 32930.11 ‘e1 — 0,000 — 3500) (4/P. 18%, 5) + 1500 1000(4/F, 18%. 5) — $3438.79 2: BUAWe, — (18,000 — 2500) (4/P, 1892, 5) + 1200 — 5004/4, 18%. 5) — $6086.70 Mefender has the smallest EUAW, it should be retained. Had the conventional approach been used, id be performed SaaMith the defender Hirst cost oF $4500: want Ca, with the defender first Results (that you should verify) wre |. two analyses wou! Bhe decision is to retain the defender because it offers the ama ES Bethe ‘softra the comventional approach to determine the replacement Re rscader that will make its retention or tenia neee ‘equally Be DAW — BUAW¢ is used whersin the Unknown wate ey Bip aSeender fmt cost. This is the breakeven maser vate BY. Dina wo nav® £0 Be cxcesded to make the challongon anon arn ede * find RV for the defender 1 Should be in Example 10.2. Your answerInflation and Cost Estimation iA2 increase or decrease in the amount of money or credit without mount of goods and services causes Changes im the beh of the currency has chanted the value increase or decrease in the of those goods and services. This occurs Decne by those connie GR, deflation are used to describe price shinee Benge aoa Iyuis nase natign® In this chapter. the mechanism for Conducting Cone ooo tho rmethous ions of varying currency values Is prosonted: Mae eae Supected plant or equipment costs from past cone mes we will be focusing only nflation, the concepu Win a deflationary economy, should be able to do the following: you Sent worth of specified future Section Objectives After completing this chapter, 12.1 Define inflated interest rate and calculate the pre: pms. given the interest rate, inflation rate, and tine pene, ea eeey nas, ie meant by real interass rate and calouines the future worth off Setauin ee tee enn} Biven the interest rate, inflation rare Gna Eee ceed Fe Cea tne uniform -maausl_smupunteahmonay, ia chen aie ae oe inflation rate grt to, 2 specified present or future sum, given the inte: wat inflation rate, and time period Sx Reed eres MEAN’ by a cost index and use a spscified index to determine an EAPected present cost from relevant data of previous wenn Sate TIOn OF the ee ee pOnent system, or plant by using = cost-capaciey equation or the factor method of cout eotinat 24-Worth Calculations with Inflation Considered living today is well aware of the fact that $1 now will not purchase the same ‘of goods or services as would $1 in 1930, This is because the value of the decreased as a result of more dollars chasing fewer goods (inflation). In make Comparisons between dollar amounts which occur in different time the different-valued dollars must first be converted into dollars which have buying power (.c., constant value dollars) ney in one period of time can be brought to the same value as currency jer period of time through the use of the following generalized equation: ws! torabl inflation in period ¢5 ween f, and f, ame ws in period r, are called today’s dollars and dollars in period ¢, are called lars, and f represents the inflation rate per period, Eq. (12.1) becomes 42.2) nis the number of time periods between f, and £2. ‘After the dollar amounts in different time periods have been expressed as t-value dollars per Eq. (12.2), the equivalent present, future, or annual amounts be determined by using the regular interest rate / in any of the formulas derived p. 2. The calculations involved in this procedure are illustrated in Table 12.1 inflation rate of 8% per year is assumed, then col, 2 shows the increase in cost th of the next 5 years for an item that has a cost of $3000 today. Column 3 8 the cost in then-current dollars with col. 4 showing the cost in constant-value irs (today’s) through the use of Eq. (12.2). Column 5 shows the present-worth lation at 7 — 10% per year. Observe from col. 4 that when the future dollars of 3 are converted into today's dollars, the cost is $3000, the same as the cost at start. This will always be true when the costs are increasing by an amount exactly iL to the inflation rate. The actual cost of the item 4 years from now will thus be 3; but in today’s dollars, the cost at that time will be $5000, which at an interest Of 10°% per year has a present worth of $3415, 19 12.1 Present-worth calculation using today's dollars (rounded) = GEIR, 0%, , 55,000(0.08) ~ $400 ‘S200, '$5.400/(1-08)" — $5,000 esas 32000.08) — "492 Sas2 ‘Sigsa/t1_om? — “s.000 2933 Sissm00s) — 367 e299 6299/1 08° = S000 S737 6299008) —_ 504 eis03 Sis03/1o8y — 5.000 33,os el, asireor] fe i Ott a Ooh tise alert th enisation: becomes ; Ba 5 Bai tS pa Ra Bsa The expression 1; is called the inflated interest rate and is defined as rene a Fotolia doceneneas 7 Wentiatee sane 1 anne eee mee rate Feat estate eG 00c ra year cer sco rae ndog go> yuc (12.5) give 1, = 008 + 0.10 + 0.080.103 Sotes” Gees ig aoe 97 Ca ihe preetistswaries Sancgineie ot one 2a oi of Tabie 153 tne rch the, $2 CRIS ee item considered in ‘As shown inc the ltgm for cach year Is the same as that caloinind in no) 2 Geen a aiet, Worth (of d uniform serio; graciane oe Percentage cash flow can fone, anuerly. That is; either ! or 1, should be used te cee PIA, P/G, Or Py Gepending upon whether the cash How Is expressed te teacyre dollars of Table 12.2 sho. ‘able 12.1 be fo equations, Table 12.2 Present-worth catcur a @ year, Future cont in = then-current dottars IF. 18.8%, mn) Present worth ° ‘$5,000 "$5,000 : $5.200, Sasa 2 35.32 sanae 3 Se.209 sa737 4 Se.oa 33.403Oe a Lee ee Worth is simply the discounted cash-flow value using the regular interest rate cash flow is expressed in then-current dollars, however, the amount today Id be equivalent to the inflated then dollars could be obtained by using ty mulas (or by converting the then dollars inte teday’s dollars and then using ples 12.1 and 12.2 illustrate these present-worth calculations BME sesessreer os W ADP ONE RS PO RSE nus of Taco Tech who “made good” has decided to donate to the college's Excel fund and has offered the couege any one of the following three plans: $60,000 now f $16,000 per year for 12 years beginning 1 year from now $50,000 three years from now and another $80,000 five years from now ly Condition placed on the donation i= that the college agree to spend the money arch related to the advancement of robotics. The college would like to sclect the plan Maximizes the buying power of the dollars received, so it has instructed the engi. professors evaluating the plans to account for inflation in their calculations. 1f the ican carn 12°, per year on its ready-assct=s account and the inflation rate is expected 11% per year, which plan should the college accept? ‘The simplest method of evaluation is to calculate the present worth of each plan jay's dollars. For plans and C, the casiest way to obtain the present worth f Bh the use of the Inflated interest rate fy, By Ea. (12-3). 0.12 + 0.11 + 0.120011) = 0.243 (24.3%) pute the P value by Eq. (12.4) — $60,000 = $16,000(7/4, 24.3%, 12) — $61,003.46 = $50,000(P/F, 24.3%, 3) 1 80,0000P/F, 24.3' ce Py is the largest in today’s do 5) = $52,995.84 ars, accept plan 2. ment "The present worths of plans 5 and C could also have been found by first converting cash flows into today's dollars and then using the regular 1. This procedure is obviously, jious and time-consuming, but you may want to satisly yourself that the answers are a Ioulate the present worth of a uniform series of payments of $1000 per year for 5 years if the interest rate is 10° per year and the inflation rate is 8% per year, assuming that the Payments are in terms of (a) today's dollars and (b) then-current dollars: Solution (@) Since the dollars are already expressed in today’s dollars, the present worth is simply P = 10000P/A, 10%, 5) — $3790.80f= 10% 72 8s Pao wes BG ony 5 $1,000 eo OOO, 1.000.” 5.000 "40 8252 Sar 3P” Foe Pas GS, ST enas BU? An 79583 tenes Gaga? Then” clontars «> © inacred¢ dollars are expressed in then-current dollars, as shows insted Interest rata in the unifores see: Ree m in Fig. 12.14, use the t-worth facton Um tt THe = 18.8% P = 1000(%74, 18.8% P= 925.93P/P, 102, 1 > 10%, 33091 OYE 10%. 4) + 680.58CR/r, 16%. 5) = 33071 ‘This ja the same result obtained using 1, Comment imarize, if future dollars are ex; renee Rvetted into today's dollars tae yegular interest rate fin the prow in then-current dollars, Pressed in today’s doll Present worth should be “worth formulaJculations, it must b it one of four different amounts: The actual amount o} The buying power, in uumulated at time r f money that will be accumulated at time n terms of today’s dollars, of the actual amount of dolla 1+ 1” PUP, 1%, n) a+s" a+r" illustration, if $1000 is deposited into a savings account at 10%-per-year interest Baines ine ipfiation rate is 82% per year, the amount of money that oii re ulated with today’s buying power will be a2) D CL OOS = $1137 ere is no inflation (/ — 0), in 7 years the 10: y's buying power as follows: 1000(F/P, 102%, 7) = $1948 The future amount of mo: i rate will accumulate $1948 with ney that would be accumulated with today's buying Br co wi cauivalently, be determined by using a real incerest rate ttn the Tye Fer ence mpensate for the decreased purchasing power of the dollar Tinie sai DE tenn be obtained by equating the singlo-payment compound amount hee, CE aston) with the middle expression in Eq. (12.6), which converts Beanant lars into future dollars with today’s buying power. Pe gbiae Boor [een] a27‘The real interest rate i, represents the rate at which present dollars will expand wit) thelr same buying power into equivalent future dollars. The use of this interest rate Rppropriate when calculating the future worth of a Savings account, for exampl Qhen the effects of inflation must be taken into consideration. Thus, for the $1¢ Geposit mentioned previously. __ 0.10 — 0.08 i 0.08 F = 1000F/P, 1.85%. 7) = $1137 0018s (1.85%) Note that the interest rate of 10% per year has been reduced to only 1.85% per yes Decuuse of the crosive effects of inflation. Also note that an inflation rate larger ty the interest rate, f > {, leads to a negative real interest rate f, in Eq. (12.7). ‘Case 3 also recognizes that prices increase during inflationary periods a1 therefore, purchasing something at a future date will require more dollars than wo be required now for the same thing. The future dollars are worth less and. therefé fore are needed. ‘This is the type of calculation you would make if someone Uyfow much will a car cost in 3 years if its current cost is $15,000 and its price increase by 6°, per year?” (The answer is $20,073.38.) For this calculation, / is ui fnstead of / in the single-payment compound-amount formula as follows: = PO +S = PIP. Se. ‘Thus, if the $1000 deposit considered above represented the cost of an item wl Gecalated in price exactly in accordance with the inflation rate of 8% per year, Cost 7 years from now would be: 1000UF/P, 8%, 7) = $1713.80 “The calculation associated with case 4, maintaining purchasing power and ing interest. takes into account both increasing prices and the time value of mé that is, if real growth of capital is to be obtained, funds must grow at a rate not lato the interest rate f, but also at a rate equal to the price increases f. ‘Thy faliSed in the equivalence formulas. Using the same $1000 deposit as above, i, = 0.10 + 0.08 + 0,100.08) = 0.188 (18.8%) F = 10000F/P, 18.8%, 7) = $3340 This calculation shows that $3340 of then-current dollars would be equival $1000 now when the interest rate is 10% per year and the inflation rate is 8% per: In summary, the calculations made in this section reveal that $1000 now: interest rate of 105. per year would accumulate to $1948 in 7 years: the $1948 hase the purchasing power of $1137 of today’s dollars; an item with a cost of, RES would cost $1713.80 in 7 years at an inflation rate of 8% per year: and it take $3340 of then-current dollars to be equivalent to the $1000 now when it js taken into account. ‘Table 12.3 summarizes which / value is to be used in the alence formulas as a function of which F value is desired,P= $500.7 — 5. Method calculation P10, a ‘Use # in equivalence formulas F = SOOF/P. 1072. 3) Use f in equivalence formulas and p= SOOCE/P. 102%. 5) divide answer by Gon year ‘+ 0.08)> use (, in formulas F = S00UF/P, 1.22. 9) dollars required for Use / in place of (in equivalence F = S00 /P. 82%. 5) purchasing power Tornauine maintain purchasing Use f, in equivalence foreman F = 500K /P, 18.8%, 5) BB 00 1002. ponent me 9 RONEN 1 EER EI RE TERE tur-Kan-Do Shect Metal Company is trying to decide whether it should pay now later for upgrading its production facilities. If the company selected plant for the necessary equipment would be purchased now for $20,000. Flowever, if the selected plan 1 for “inaction,” the equipment purchase would be deferred for 3 the cost would be $34,000. The minimum attractive fate of return fs 18: the inflation rate is expected to be 12% per yer the real interest rate for these plans. line whether the company should purchase now or purchase later when inflation # considered, and when inflation is taken into account (2.7) the real interest rate is 18 — 0.12 Ge 0.0536 (5.36%) ans that an effective MARR of 5.36% per year is used when inflation is nt In not considered. ‘The stated rate is 18% per year, so we can compute P at time three years from now and select the plan with the lower cost F/P, 18%. 3) = $32,860.64 000 action plan 4 because it costs less. considered. Compute the inflated rate by Eq. (12.5). + 0.12 + 0.18(0.12) — 0.322 compute the F values 3 years from now to determine the then-current dollars E/P, 32.2%, 3) = $46,208.77 000ee me err nent emer nateemnnenene ene tree dollars. Comment This example illustrates that when inflation is taken into account, the more economic alternative may be different from the one selected if inflation is ignored ‘A present-worth analysis can be used here with the same results flation cons ‘P= $20,000 4 = $20,000 Py = 34.0000P/F, 18%, 3) Py = 34,000(P/F., 32.22%, 3) = $20,695.45 = $1471.82 Select plan I 12.3 Capital-Recovery and Sinking-Fund Calculations with Inflation Gonsidered It is particularly important for capital-recovery calculations to include inflation co: siderations because present dollars must be recovered with future inflated doll ‘There is little significance in considering capital recovery in terms of today’s dolla so only then-current dollars will be considered in this section. Since then-curi dollars have less buying power than do today’s dollars, it is obvious that more dol will be required to recover the present investment. This recovering suggests the Of the inflated interest rate in the 4/P formula. For example, if $1000 is inves! today when the interest rate is 10% per year and the inflation rate is 8% per the annual amount of capital that must be recovered each year for 5 years then-current dollars will be A = 1000(4/P, 18.8%, 5) = $325.59 On the other hand, the decreased value of dollars through time means investors would be willing to spend fewer present (high-value) dollars to accum! a specified amount of future then-current (inflated) dollars by way of a sinking Ge., 4). This suggests the use of a higher interest rate (i,) to produce a lower 4 in the 4/F formula. The annual equivalent (when inflation is considered) of F = $ five years from now in then-current dollars is thus A = 1000(4/F, 18.82%, 5) = $137.59 When inflation is not considered, the equivalent annual amount for F = SI i= 10% is 1000(4/F, 10%, 5) — $163.80. So when F is fixed, uniform future should be spread over as iong a time period as possible so that inflation will the effect of reducing the payment involved ($137.59 versus $163.80 here). mind that only the buying power of the payment is reduced, not its amount. A situation which sometimes arises in economic calculations involves the mination of the amount.of uniinaendiaaee eaquired to aacuniulnte afsnc en eres career ao og enna oe strates the calculations involved, OER SR ee aa ee pov FB cy pra METER SET AAS IEEE 2 {annual deposit will be required for 5 years to accumulate an amount of money that the same buying power as $680.58 today if the interest rate is 10%, per year and the dation rate is 8% per year? lon The actual number of then-current (inflated) dollars required in 5 years is 680.58(1.08°) — $1000 fore, the actual amount of the annual deposit is 1000(4/1", 10%, 5) — $163.80 ent This example shows that if $163.80 is deposited cach year for 5 years at an f fate of 10%, per year, S1000 will be accumulated after the filth deposit. However, lan cconomic analysis point of view, $163.80 for 5 years is mor cquivalent to $1000 ‘S when inflation is considered. As shown above, $137.59 for 5 years is equivalent in year 5 at 1, — 18.8%. The discrepancy between the $163.80 and the $137.59 is by the use of two different interest rates (7, and #) in the A/F factor, The use of 8.8% accounts for the fact that the dollars spent in years I through 4 have greater power than dollars spent in year 5. We would therefore not want to spend as many ‘The use of i = 10%. on the other hand, cusentially ignores the greater buying power Mollars spent in carlicr years, so the higher “equivalent” amount ($163.80) is obtained, ied in this example. most of the calculations associated with comparing alternatives ring-economic studies require the use of the inflated interest rate when inflation red. ursory study of recent world history reveals that the currency values of vir- 'y country on earth are in a constant state of change. For engineers involved lanning and design, this makes the difficult job of cost estimation even jeult. One method of obtaining preliminary cost estimates is by looking at of similar projects that were completed at some time in the past and updating, -cost figures. Cost indexes represent a convenient tool for accomplishing this. st index is a ratio of the cost of something today to its cost at some time ft JOne such index that most people are familiar with is the consumer price D, Which shows the relationship between present and past costs for many gs that “typical” consumers must buy. This index, for example, includes S rent, food, transportation, and certain services. However, other indexes relevant to the engineering profession because they track the costs of goods which are more pertinent to engineers. Table 12-4 is a listing of some‘Source Bureau of Labor Statistics Producer (wholesale) U'S. Department of Labor Construction ‘Chemical plant overall Chemical Engineering Equipment, machinery, and supports Construction labor Engineering and supervision Engineering News Record overall Engineering News Record (ENR) Building Common labor Materials Large-city advanced treatment (LCAT) : y conventional treatment (CCT) Equipment ‘Marshall and Swift (M&S) overall Marshall & Swift MAS specific industries of the more common indexes and, as shown, some are applicable to a wide variety of goods and services (CPD while others aré more directed toward the needs of a specific user (federal highway index). Generally. the indexes are made up of a mix of components which are assign certain weights, with the components sometimes further subdivided into more bas items. For example, the equipment, machinery, and support component of the ch ical plant cost index is subdivided further into process machinery, pipes, valves ani fittings, pumps and compressors, and so forth. These subcomponents, in turn, are built up from even more basic items like pressure pipe, black pipe, and galvanized pipe. Table 12.5 shows the Chemical Engineering plant cost index, the Engineert News Record (ENR) construction cost index, and the Marshall and Swift (Mé& equipment cost index for the years 1970 through mid-1987, with the base period 1957-1959 assigned a value of 100 for the Chemical Engineering (CE) plant cot index, 1913 = 100 for the ENR index, and 1926 — 100 for the M&S equipment cost index. ‘Phe general equation for updating costs through the use of any cost index over a period from time 0 (base) to another time ¢ isSRofS028ealaanane estimated cost at present time cost at previous time f0, index value at time r maluating the feasibility of a major construction project, an engineer is interested in lating the cost of skilled labor for the job. The engineer finds that a project of similar exity and magnitude was completed 5 years apo when the ENR skilled labor index 3496.27, The skilled labor cost for that project was $360,000. If the ENR skilled, index now stands at 4038.44, what would the expected skilled labor cost be for mhew project? tion ‘The base time t is 5 years ago. Using Eq. (12.8), the present cost estimate is, Gol, c 4038.44 3496.27 $415,825 360,000Component/system/piant Size range Exponent Activated sludge plant 7-100 Map Ona Asrobic digesse 02-40 Mon ors Blower 1,000~7,000 ft/enin O46 Centrifuge "30-65 in om Chlorine plane 3.000-350000 tons per yea: ona Siaritier Ot i00 ete 3a Compressor 200-3:100 hp O32 Cyclone separator 208.000 8 /min Sea Filter and 0.5200 mer ox Heat exchanger 300-3000 1 oss Hydrogen plant 300 20,000 sera ose Taboratary 03-0 res tos Pump, centrifugal 10-00 "np oo Reactor 50-4,000' pat O58 Sludge drying beds 0.08 an 33 Stabilization pond 801-02 Map ons ‘Tank, staintoce 1002.00 ga 8.67 12.5 Cost Estimating Pac oF plant to its capacity. Since many cont seen: on log-log paper, one of the most common ou o.-e(BY a where C, — cost at capacity O, 2 = cost at capacity OF = — exponent Soeaineg OF ihe exponent for various components: systcins, cr entice plants opi Foden ro enved, from a number of sources, inchiding Chenicey a Pronecnes Sghnical journals (especially Chemical Engineer), Ure eine mone oon Agency. professional or trade organizations, conecine arn ee eq ypical values of the exponent various units. The next example illustrates the use of the Ea. Ci2-e)#lon From Eq. (12.9), the cost of the pond in 1977 dollars would be rats 870 Be -90( cos, = $100,768 ($101,000 in 1977 dollars) ty"s cost can be obtained through the use of Eq. (12.8) as follows: : 25) = 101,000 G29) $173,900 (today’s dollars) A different widely used, simplified approach for obta: ing preliminary cost es- es Of process plants is called the factor method. While Ee 'q. (12.9) can be used for ihe total plant costs, the The method is who first proposed the method in 1947, In its simplest form, the factor method of cost estimation can be expressed as her , = total plant cost ft = overall cost factor or summation of individual cost factors Cx — summation of cost of major items of equipment 42.10) In bis original work, Lang showed that construction cost factors and overhead factors can be combined into one overall factor for various types Of plate aa H Solid process plants, 3.10; solid-fluid process plants, 3.63; and fluid process 2:74. These factors reveal that the total installed-plant cost in many tines dhe ase cost of the major items of equipment. Example 12.7 illustrates the wee or LAluid process plant is expected to have a delivered-cquipment cost of $565,000. If the Il cost factor for this type of plant is 3.63, estimate the Plante coal cect jon From Eq. (12.10), the total plant cost is estimated as 3.63(565,000) $2,051,000wi After-Tax Economic Analysis zhis chapter will help you incorporate some of the effects of income taxes im economic-based decision analysis. Rather than utilizing an inflated betore tax a of return, details of income tax impacts are included in the computation of the to economically justify a project will be computed using after-tax analesie, As you already realize, the tax laws and guidelines change continuously. Oy the impact from the large tax advantages and burdens should be considered in tailed, and driven by de more detailed tax law effects.completing this chapter, you should be able to do the following: Determine the annual income taxes due and the estimated cash flow after taxes (CFAT) considering depreciation and debt financing, given the cash flow before taxes (CF BT), and the details for taxes, depreciation, and borrowed funds Select the better of two alternatives using after-tax PW or EUAW analysis: given the alternatives, tax rate, and required after-tax return. Use after-tax rate-of-return analysis to compute the return of a single project and sclect the better of two alternatives, given the alternatives, tax rate, and required after-tax return. ‘Choose between challenger and defender alternatives using after-tax replacement @nalysis, given the plans, defender market valuc. and effective tax rate, Compute the equivalent annual revenue requirement for a project, using the project data, specified depreciation method, and effective tax rate, Effect of Income Taxes on Cash Flow portant that you understand and be able to tabulate the effect of income taxes s of CFAT. The formulas were first introduced in Chap. 14, but are reviewed for easy reference. Concentration is upon the estimation of CEAT to be udlned ent worth, EUAW, and rate-of-return Computations, IT — gross income — expenses asap ‘FBT — depreciation ef 2a ble Ireennge (S23 Dr 33 orp Pear ee samy as.3) T= CFBT — taxes «as.4) Bere are two ways to finance a yenture: through the investment of the Fation-owned funds (equity financing) or through the use of borrowed funds are acquired from some source outside the corporation ownership (debt finance, A combination of these two is the most common mechanism. When any debe ing is involved, the associated interest is tax deductible and Eq, (15.2) ton ki lect this tax advantage. Additionally, CFAT in Eq. (15.4) must be reduced by and principal payments. For debt financing these relations will take the forme. = CFBT — depreciation — interest as.s) ‘T= CFBT — taxes — spect of debt and equity financing is introduced here and is examined more hly in Chap. 18 Hf Ea. (15.2) or Eq. (15.5) results in a negative TI value, we will assume the { negative tax offsets taxes for the same year attributable to other income: & assets in the corporation. Any negative tax, therefore, increases the CEAT. by corresponding amount for the year in which the tax advantage occurs Plifying procedure is commonly used in lieu of complex carry-forward carey. tax laws similar to those overviewed in See. 14.4 interest — principal 5.6)‘Table 15.1 Tabulation of CFAT for Exam! 310 =, @ @-o-@ A=a-o ° = "$50,000, = 2 $27,000 70.000 $10,000 $7,000 2 ‘25:00 10:300 1e.000 3300, 3 38:000 125000, 19,000 509 3 33,000, 13°00 000 ooo A Kamelot 5.7 A proposal has been made that a new piece of equipment be purchased this year. foristicn Of the purchase plan are B= $50,000 sv-o0 n= 5 years Expected income — 28,000 — 10007 (@ = 1.2.3.4.5) Expected expenses — 9500 + 500 Use an effective tax rate of 40% and straight-line depreciation to tabulate the CFs Solution Table 15.1 details all tax information and CFAT for the asset using, to (15.4), Straight-line depreciation iz 50,000 ~ 5 — $10,000 per year. Emeric 1S. Fifth Ave. Cleaners plans to invest in a new dry cleaner sv-o0 Expenses — $1000 per year Incremental effective tax rate = 50° If straight-line depreciation is used. tabulate CFAT for the following cos $15,000 is from company funds (100%, equity financing) and () one-half is borrowed from a bank (50°, equity 50%, debt Bnancing) at 10%, per Assume that the 10%, is simple interest on the total amount borrowed Wil be in five equal payments of accrued interest and principal Solution (@ Por 100% equity financing, CFBT = $6000 per year. Annual dep: $3000. Table 15.2 details CAT.2 _ CAT for 100% equity financing (Example 15.2a) Depreciation Sa Taxes rar o = = 'S— 15,000 53,000 33,000 $1,500 4.300 57:500_. 57.500 18.3 CFAT for 50% eauity—50% debt financing (Example 15.2) my @ @) ay @ , crer Depreciation __interent Principat ar orar =~ 7.500 rr = = $— 7.500 61000 53,000 $750 51,500 32.250 $2628 §-22:500 53,750 57.500 = S625 Tis column notation, @)—G) — Gy Ba O59) Ee ST Cor a. aS, ‘The 50% debt financing requires that $7500 be borrowed from outside the company and its stockholders. The loan repayment plan will be as follows: ae a 7500 7 Principal = $1500 per year Interest: 7500(0.10) — $750 per year ‘The $750 interest ix tax deductible; however, the principal is nor deductible. Therefore, the debi-financing formulas for TI and CFAT, Eqs. (15.3) and (15-6), are used. Table 15.3 presents CFAT computation for 50% debt — 50% equity financing. You can sec that the annual CFAT has decreased from $4500 to $2625 because of 302, debe financing. The $7500 equity cash outflow in year O is used because only S05" of the first cost comes from company funds while the remaining is from the lending bark Comment if only equity financing is involved, as in part (a), we can use the relation FAT = depreciation + TI — T) as. Where TIM — 7) is the profit, that is Table 15.2 CFAT — 3000 + 3000(1 — 0.50) — $4500 could be used in licu of the method presented. But you must be careful because, if there is any debt financing whatsocver, as in part (4), this simple approach will not work. Let's try tin Table 15.3. FAT = 3000 + 2250(1 — 0.50) = $4125 $2625 Why doesn't it work? Simple. This method neglects the fact that interest is tax deductible and that CFAT is computed in a completely different way in the two cases. You might compare Eqs. (15.7) and (15.6) to verify thi the portion of TI not absorbed by taxes. Thus, inis known, the CFAT values are used 's in previous chapters. If mutually exclu ject using the following guidelines: If the required after-tax rate of return compute the PW or EUAW for a project a: alternatives are compared, select the proj In sithet.case. « negative PW or BUAW value indicates that the eltennat aire ane Teduired return. Additionally, if only costs are involved. the associated it advantages are assumed to be appl Example 15.3 For the estim: EUAW analysi ed CFAT values presented below. use a 726. is to select the economically favorable plan, Solution Use the revenue and cost positive value at #— 9%. per year BUAW x — [— 28,800 + S400(P/A, 7%, 6) + 2040(P/A, 72%, 4P/F, 7%, 6) + 2792UP/F, 1%, LOYICA/P, 7%, 10) = 8421.78 estimates in EUAW relations and select the larger « assy BUAW, — [— 50,000 + 14,2000P/F. 7%, 1) + 13,300(P/F, 7%, 2) + 12,.4000P/F, 7%. 3) + 11,500(P/F, 72%, 4) + 10,6001P/F, 7%. 5)KA/P, 7%. 5) = $327.01 Plan X is selected since both EUAW values If present-worth analysis were tncd. PW = BUAW(P/4. 7%, 10). Of course, Ph PW Value. are positive and EUAW, is larger. 4 10-year horizon would be used to compute jan X would again be selected for its larace27 EUAW relations are used to compute the rate of return of GFAT values the same procedures as in Chaps. 7 and 8. For a single project, set the PW oe Prd NS. ,CEAT scauence cqual to zero and solve for the i valus bp the rapid method. worth: O = 3) CFAT,(P/F as.10) 0 = [8 craneyn. 26. 0 ]ear. 26.0 asin ENE RTEGcnt Of @ fiber optics manufacturing company plans to spend 550,000 for a Flife, straight linc-depreciated machine which will have « projeciea Soo C00 tual and carry an effective incremental tax rate of 30%, Compute the f vehen fan ne on The CFAT in year zero is $50,000 and for years ¢— 1 through 5 is, S (15.1) through (15-4), according T— CEBT — taxes — 20,000 — (20,000 — 10,000)0.5 = $15,000 the annual revenue CFAT values are © = — 50,000 + 15,000(P/4, 1° 5) = 3.3333 ation gives /* — 15.259 edual, Ea. (15.10) is abbreviated to compute > #8 the after-tax rate of return. ect _Th you use an exaggerated before-tax rate to approximate the tax effect on this ef aenct, you can use Ea. (14.10) to obtain f@/1 — 7) O1SE5A1 O50) On oe ee Actual before-tax return using the CFT figures cam be fouAd irons tno eae $— 50,000 + 20.00007/4, 19%, 5) Ich gives a value of 1 — 28.72%. Comparison show: mated by using a 30.5%, before-tax return s that the tax effect is slightly over- er oekor, more) alternatives. use a PW or EUAW relation to compute the thare- eat return on the incremental CFAT series of the larger alternative over the ation 5: they are summarized in venues are estimated or is performed on the incremental or net CFAT. values,