Replacement

and Retention
Decisions
Economic Service Life
• The economic service life (ESL) is the
number of years n at which the equivalent
uniform annual worth (AW) of costs is the
minimum, considering the most current cost
estimates over all possible years that the
asset may provide a needed service.
 Total AW = capital recovery - AW of annual operating
costs
= CR - AW of AOC

 Capital recovery = - P ( A/P , i,n ) + S ( A/F , i,n )

The complete equation for total AW of costs over k

years (k = 1, 2, 3, . . . ) is
EXAMPLE 1
• A 3-year-old backup power system is being
considered for early replacement. Its current
market value is $20,000. Estimated future
market values and annual operating costs for
the next 5 years are given in Table 1, columns
2 and 3. What is the economic service life of
this defender if the interest rate is 10% per
year? Solve by hand and by spreadsheet.
Solution
• Equation [11.3] is used to calculate total A W k
for k = 1, 2, . . . , 5. Table 1, column 4, shows
the capital recovery for the $20,000 current
market value ( j = 0) plus 10% return. Column 5
gives the equivalent AW of AOC for k years. As
an illustration, the computation of total AW
for k = 3 from Equation
Total AW3 = - P(A/P,i,3) + MV3(A/F,i,3) + [PW of AOC1,AOC2,
and AOC3](A/P,i,3)
= - 20,000(A/P,10%,3) + 6000(A/F,10%,3) +
[5000(P/F,10%,1)
+ 6500(PF,10%,2) +
8000(P/F,10%,3)](A/P,10%,3)
= + 6230 + 6405 = $ - 12,635
A similar computation is performed for each year 1
through 5. The lowest equivalent cost ( numerically
largest AW value) occurs at k = 3. Therefore, the
defender ESL is n = 3 years, and the AW value is $ -
12,635. In the replacement study, this AW will be
compared with the best challenger AW determined
by a similar ESL analysis.
Independent Projects with
Budget Limitation
• Capital Rationing Using PW Analysis
of Unequal-Life Projects
• EXAMPLE
For MARR = 15% per year and b = $20,000,
select from the following independent projects.
Solve by hand
Solution by Hand
The unequal-life values make the net cash flows vary
over a bundle’s life, but the selection procedure is the
same as above.
 Of the 2 4 = 16 bundles, 8 are economically feasible. Their PW
values by Equation [1] are summarized in Table 2. As an illustration, for bundle 7:

PW 7 = - 16,000 + 5220( P/A ,15%,4) + 2680( P/F ,15%,5) = $235

Select bundle 5 (projects A and C) for a

$16,000 investment.
TABLE 3
Present Worth Analysis for Unequal-Life
Independent Projects,
compute the bundle PW value in the initial year. This is the
bundle PW = PW A+ PW B . In general form, the bundle j
present worth is
PW j = NCF j ( F/A ,MARR, n j )( F/P ,MARR, n L - n j )( P/F ,MARR, n L )

FW = 5220( F/A ,15%,4)( F/P ,15%,5) + 2680( F/P ,15%,4) = $57,111

The present worth at the initial investment time is
PW = - 16,000 + 57,111( P/F ,15%,9) = $235

If this assumption is not realistic, the PW analysis must

be conducted using the LCM of all project lives.
 Breakeven and
Payback Analysis
 Breakeven Analysis for a Single Project

• Profit = revenue - total cost

= R - TC
= R - (FC + VC)
where r = revenue per unit
v = variable cost per unit
Solve for the breakeven quantity Q = QBE for
linear R and TC functions.
EXAMPLE
• Indira Industries is a major producer of diverter
dampers used in the gas turbine power industry
to divert gas exhausts from the turbine to a side
stack, thus reducing the noise to acceptable levels
for human environments. Normal production level
is 60 diverter systems per month, but due to
significantly improved economic conditions in
Asia, production is at 72 per month. The following
information is available.
Fixed costs FC = $2.4 million per month
Variable cost per unit v = $35,000
Revenue per unit r = $75,000

Req :
(a) How does the increased production level of 72 units
per month compare with the current breakeven point?
(b) What is the current profit level per month for the
facility?
(c) What is the difference between the revenue and
variable cost per damper that is necessary to break even
at a significantly reduced monthly production level of 45
units, if fixed costs remain constant?
Solution
• (a) Use Equation to determine the breakeven
number of units. All dollar amounts are in
$1000 units.
Breakeven graph
(b) To estimate profit (in $1000 units) at Q 72 units per month, use Equation
Profit = R TC = rQ (FC + vQ)
= (r v)Q FC
= (75 35)72 2400
= $480
There is a profit of $480,000 per month currently.
(c) To determine the required difference r v, use Equation with profit = 0,
Q = 45,
and FC = $2.4 million. In $1000 units,
0 = (r v) (45) 2400

The spread between r and v must be $53,330. If v stays at $35,000, the

revenue per damper must increase from $75,000 to $88,330 (i.e., 35,000
53,330) just to break even at a production level of Q = 45 per month.