Chapter 11

Replacement Decisions

 Replacement Analysis
Fundamentals

 Economic Service Life

 Replacement Analysis
When a Required
Service is Long

1
 Replacement Terminology

 Defender: an old machine  Sunk cost: any past cost

unaffected by any future
decisions
 Challenger: a new machine
 Trade-in allowance: value
 Current market value: selling offered by the vendor to
price of the defender in the reduce the price of a new
market place equipment

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Sunk Cost associated with an Asset’s Disposal
(Example 11.1 Macintosh Printing Inc.)

Original investment (printing machine)

$20,000

Lost investment
Market value (economic depreciation) Repair cost
$10,000 $10,000 $5000

Sunk costs = $15,000

$0 $5000 $10,000 $15,000 $20,000 $25,000 $30,000

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 Replacement Analysis Fundamentals
 Replacement projects are decision problems involve the
replacement of existing obsolete or worn-out assets.
 When existing equipment should be replaced with more
efficient equipment.

Examine replacement analysis fundamentals

1) Approaches for comparing defender and challenger
2) Determination of economic service life
3) Replacement analysis when the required service period is
long

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 Replacement Decisions
 Cash Flow Approach
 Treat the proceeds from
sale of the old machine as
down payment toward
purchasing the new
machine.
 This approach is
meaningful when both the
defender and challenger
have the same service life.
 Opportunity Cost
Approach
 Treat the proceeds from
sale of the old machine as
the investment required to
keep the old machine.
 This approach is more
commonly practiced in
replacement analysis.
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 Example 11.2
 Defender  Challenger
 Market price:  Cost: $15,000
$10,000  Useful life: 3 years
 Remaining useful  Salvage value:
life: 3 years $5,500
 Salvage value:  O&M cost: $6,000
$2,500
 O&M cost: $8,000

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Replacement Analysis – Cash Flow Approach

Sales proceeds
from defender
$10,000
$5500
$2500
0 1 2 3 0 1 2 3

$6000
$8000

(a) Defender $15,000 (b) Challenger

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Annual Equivalent Cost - Cash Flow Approach

Defender:
PW(12%)D = $8,000 (P/A, 12%, 3) -$2,500 (P/F, 12%, 3)
= $17,434.90

AEC(12%)D = PW(12%)D(A/P, 12%, 3)

= $7,259.10
Challenger:
PW(12%)C = $5,000 + $6,000 (P/A, 12%, 3)
- $5,500 (P/F, 12%, 3) Replace
= $15,495.90 the
defender
AEC(12%)C = PW(12%)C(A/P, 12%, 3) now!
= $6,451.79
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 Example 11.2
Comparison of Defender and Challenger Based on
Opportunity Cost Approach

9
 Annual Equivalent Cost - Opportunity
Cost Approach
Defender:
PW(12%)D = -$10,000 - $8,000(P/A, 12%, 3) + $2,500(P/F, 12%, 3)
= -$27,434.90
AEC(12%)D = -PW(12%)D(A/P, 12%, 3)
= $11,422.64

Challenger:
PW(12%)C = -$15,000 - $6,000(P/A, 12%, 3) + $5,500(P/F, 12%, 3)
= -$25,495.90 Replace the
AEC(12%)C = -PW(12%)C(A/P, 12%, 3) defender now!
= $10,615.33
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 Economic Service Life

 Definition: Economic service Minimize

life is the remaining useful life
of an asset that results in the

Annual Equivalent Cost

minimum annual equivalent
cost.
Ownership (Capital)
cost
 Why do we need it?: We
should use the respective
+
economic service lives of the
defender and the challenger Operating
when conducting a cost
replacement analysis.

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 Economic Service Life Continue….

 Capital cost have two components: Initial investment (I) and

the salvage value (S) at the time of disposal.

 The initial investment for the challenger is its purchase

price. For the defender, we should treat the opportunity cost
as its initial investment.

 Use N to represent the length of time in years the asset will

be kept; I is the initial investment, and SN is the salvage
value at the end of the ownership period of N years.

 The operating costs of an asset include operating and

maintenance (O&M) costs, labor costs, material costs and
energy consumption costs.

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 Mathematical Relationship
Objective: Find n* that minimizes total AEC
AE of Capital Cost:
CR (i )  I ( A / P , i , N )  S N ( A / F , i , N )

AE of Operating Cost:
N
OC (i )   OC
n 1
n ( P / F , i , n) ( A / P , i , N )

Total AE Cost:

AEC  CR(i )  OC(i )

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 AEC

OC (i)

CR(i)

n*
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Example 11.4 Economic Service Life for a
Lift Truck

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 Steps to Determine an Economic Service Life

 N = 1 (if you replace the asset every year)

AEC1 = $18,000(A/P, 15%, 1) + $1,000 - $10,000
= $11,700

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 N = 2 (if you replace the asset every other year)
AEC2 = [$18,000 + $1,000(P/A, 15%, 15%, 2)](A/P, 15%, 2)
- $7,500 (A/F, 15%, 2)
= $8,653

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AEC if the Asset were Kept N Years
N = 3, AEC3 = $7,406

N = 4, AEC4 = $6,678

N = 5, AEC5 = $6,642

N = 6, AEC6 = $6,258 Minimum cost

N = 7, AEC7 = $6,394 If you purchase the asset,

it is most economical to replace
the asset for every 6 years
Economic Service Life

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 Required Assumptions and Decision
Frameworks
 Now we understand how the economic service life of an asset is
determined.
 The next question is to decide whether now is the time to replace the
defender.
Consider the following factors:

Planning horizon (study period)

 By planning horizon, it is mean that the service period required by the
defender and a sequence of future challengers. The infinite planning
horizon is used when we are unable to predict when the activity under
consideration will be terminated. In other situation, the project will
have a definite and predictable duration. In these cases, replacement
policy should be formulated based on a finite planning horizon.

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 Decision Frameworks continue…….
Technology
 Predictions of technological patterns over the planning horizon refer to the
development of types of challengers that may replace those under study.
 A number of possibilities exist in predicting purchase cost, salvage value, and
operating cost as dictated by the efficiency of the machine over the life of an
asset.
 If we assume that all future machines will be same as those now in service,
there is no technological progress in the area will occur.
 In other cases, we may explicitly recognize the possibility of future machines
that will be significantly more efficient, reliable, or productive than those
currently on the market. (such as personal computers)

Relevant cash flow information

 Many varieties of predictions can be used to estimate the pattern of revenue,
cost and salvage value over the life of an asset.

Decision Criterion
 The AE method provides a more direct solution when the planning horizon is
infinite (endless). When the planning horizon is finite (fixed), the PW method
is convenient to be used.
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 Replacement Strategies under the Infinite Planning Horizon
 Compute the economic lives of both defender and challenger. Let’s use ND* and
NC* to indicate the economic lives of the defender and the challenger,
respectively. The annual equivalent cost for the defender and the challenger at
their respective economic lives are indicated by AED* and AEC* .
 Compare AED* and AEC*. If AED* is bigger than AEC*, we know that it is more
costly to keep the defender than to replace it with the challenger. Thus, the
challenger should replace the defender now.
 If the defender should not be replaced now, when should it be replaced? First,
we need to continue to use until its economic life is over. Then, we should
calculate the cost of running the defender for one more year after its economic
life. If this cost is greater than AEC* the defender should be replaced at the end
of is economic life. This process should be continued until you find the optimal
replacement time. This approach is called marginal analysis, that is, to
calculate the incremental cost of operating the defender for just one more
year.

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Example 11.5 Relevant Cash Flow
Information (Defender)

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 ECONOMIC SERVICE LIFE OF DEFENDER
General equation for AE calculation for the defender is as follows:

AE (15%) = $6,200(A/P, 15%, N) + 2000 + $1,500 (A/G, 15%, N)

– 1,000 (5 – N) (A/F, 15%, N) for N = 1,2,3,4, and 5

Cash flow diagram for defender When N = 4 years

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 ECONOMIC SERVICE LIFE OF DEFENDER
N=1
AE (15%)1 = $6,200 (A/P, 15%, 1) + 2000 + $1,500 (A/G, 15%, 1)
– 1,000 (5 – 1) (A/F, 15%, 1)
AE (15%)1 = 7,130 + 2,000 + 0 – 4,000 = $5,130

OR

CR (15%)N = I (A/P, 15%, N) – SN (A/F, 15%, N)

AEOC =Σ [OCn (P/F, 15%, N)] (A/P, 15%, N)

CR (15%)1 = 6,200 (1.15) – 4,000 (1.0) = 7,130 – 4,000 = $3,130

AEOC1 = 2,000 (0.8696) (1.15) = 1739.2 x (1.15) = $2,000

Σ AE1 = CR (15%)1 + AEOC1 = 3,1,30 + 2,000 = $5,130

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Objective is : Find n* that minimizes total AEC
AE of Capital Cost:
CR (i )  I ( A / P , i , N )  S N ( A / F , i , N )

AE of Operating Cost:
N
OC (i )   OC
n 1
n ( P / F , i , n) ( A / P , i , N )

Total AE Cost:

AEC  CR(i )  OC(i )

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N=2
AE (15%)2 = $6,200 (A/P, 15%, 2) + 2000 + $1,500 (A/G, 15%, 2)
– 1,000 (5 – 2) (A/F, 15%, 2)
AE (15%)2 = 3,813.62 + 2,000 + 697.65 – 1,395.3 = $5,116

OR

CR (15%)2 = I (A/P, 15%, 2) – S2 (A/F, 15%, 2)

CR (15%)2 = 6,200 (0.6151) – 3,000 (0.4651) = $2,418.32

AEOC2 =Σ [ OC1 (P/F, 15%, 1) + OC2 (P/F, 15%, 2) ] (A/P, 15%, 2)

AEOC2 = [2,000 (0.8696) + 3,500 (0.7561)] (0.6151) = $2,697.55

Σ AE2 = CR (15%)2 + AEOC2 = 2,418.32 + 2,697.55 = $5,116

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 N=3
AE (15%)3 = $6,200 (A/P, 15%, 3) + 2000 + $1,500 (A/G, 15%, 3)
– 1,000 (5 – 3) (A/F, 15%, 3)
AE (15%)3 = 2,715.6 + 2,000 + 1,360.65 – 576 = $5,500

OR

CR (15%)3 = I (A/P, 15%, 3) – S3 (A/F, 15%, 3)

CR (15%)3 = 6,200 (0.4380) – 2,000 (0.2880) = $2,139.6

AEOC3 =Σ [ OC1 (P/F, 15%, 1) + OC2 (P/F, 15%, 2) + OC3 (P/F, 15%, 3) ]
x (A/P, 15%, 3)
AEOC3 = [2,000 (0.8696) + 3,500 (0.7561) + 5,000 (0.6575)] (0.6151)
AEOC3 = $3,360.7

Σ AE3 = CR (15%)3 + AEOC3 = 2,139.6 + 3,360.7 = $5,500

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 N=4
AE (15%)4 = $6,200 (A/P, 15%, 4) + 2000 + $1,500 (A/G, 15%, 4)
– 1,000 (5 – 4) (A/F, 15%, 4)
AE (15%)4 = 3,813.62 + 2,000 + 697.65 – 1,395.3 = $5,961

OR
CR (15%)4 = I (A/P, 15%, 4) – S4 (A/F, 15%, 4)
CR (15%)4 = 6,200 (0.3503) – 1,000 (0.2003) = $1,971.56

AEOC4 =Σ [ OC1 (P/F, 15%, 1) + OC2 (P/F, 15%, 2) + OC3 (P/F, 15%, 3)
+ OC4 (P/F, 15%, 4)] x (A/P, 15%, 4)
AEOC4 = [2,000 (0.8696) + 3,500 (0.7561) + 5,000 (0.6575) + 6,500 (0.5718) ]
x (0.6151)
AEOC4 = $3,989.75

Σ AE4 = CR (15%)4 + AEOC4 = 1,971.56 + 3,989.75 = $5,961

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 ECONOMIC SERVICE LIFE OF DEFENDER
N=5
AE (15%) 5 = $6,200 (A/P, 15%, 5) + 2000 + $1,500 (A/G, 15%, 5)
– 1,000(5 – 5) (A/F, 15%, 3)
AE (15%)5 = 1,849.46 + 2,000 + 2,584.2 + 0 = $6,434
OR
CR (15%)5 = I (A/P, 15%, 5) – S5 (A/F, 15%, 5)
CR (15%)5 = 6,200 (0. 2983) – 0 (0.1483) = $1,850

AEOC5 =Σ [ OC1 (P/F, 15%, 1) + OC2 (P/F, 15%, 2) + OC3 (P/F, 15%, 3)
+ OC4 (P/F, 15%, 4) + OC5 (P/F, 15%, 5)] x (A/P, 15%, 5)
AEOC5 = [2,000 (0.8696) + 3,500 (0.7561) + 5,000 (0.6575) + 6,500 (0.5718) +
+ 8,000 (0.4972)] x (0.2983)
AEOC5 = $4,584

Σ AE5 = CR (15%)5 + AEOC 5 = 1,850 + 4,584 = $6,434

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For N = 1 to 5, the results are as follows:

N = 1: AE (15%) = $5,130
N = 2: AE (15%) = $5,116
N = 3: AE (15%) = $5,500
N = 4: AE (15%) = $5,961
N = 5: AE (15%) = $6,434
 When N = 2 years, we get the lowest AE value. Thus
the defender’s economic life is two years.
AEC as a Function of the Life of the Defender
(Example 11.5)

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ECONOMIC SERVICE LIFE OF CHALLENGER
(Example 11.5)

 Investment cost = $10,000

 Salvage value
 N = 1: $6,000

 N > 1: decreases at a 15% over previous year

 Operating cost
 N = 1: $2,000

 N > 1: increases by $800 per year (G = $800)

 Rate of return 15%

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ECONOMIC SERVICE LIFE OF CHALLENGER
General equation for AE calculation for the challenger is as follows:
AE (15%)N = $10,000(A/P, 15%, N) + 2000 + $800 (A/G, 15%, N)
– $6,000(1 – 15%)N-1 (A/F, 15%, N) for N = 1,2,3,4, and 5
 N =1
AE (15%)1 = $10,000(A/P, 15%, 1) + 2000 + $800 (A/G, 15%, 1)
– $6,000(0.85)1-1 (A/F, 15%, 1)
AE (15%)1 = 11500 + 2,000 + 0 – 6,000 = $7,500
OR
CR (15%)N = I (A/P, 15%, N) – SN (A/F, 15%, N)
AEOC =Σ [OCn (P/F, 15%, N)] (A/P, 15%, N)

CR (15%)1 = 10,000 (1.15) – 6,000 (1.0) = 11,500 – 6,000 = $5,500

AEOC1 = 2,000 (0.8696) (1.15) = 1739.2 x (1.15) = $2,000

Σ AE1 = CR (15%)1 + AEOC1 = 3,130 + 2,000 = $7,500

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N =2
AE (15%)2 = $10,000(A/P, 15%, 2) + 2000 + $800 (A/G, 15%, 2)
– $6,000(0.85)2-1 (A/F, 15%, 2)
AE (15%)1 = 6151 + 2,000 + 372.08 – 2,372 = $6,151

OR

CR (15%)2 = I (A/P, 15%, 2) – S2 (A/F, 15%, 2)

CR (15%)2 = 10,000 (0.6151) – 5,100 (0.4651) = $3,779

AEOC2 =Σ [ OC1 (P/F, 15%, 1) + OC2 (P/F, 15%, 2) ] (A/P, 15%, 2)

AEOC2 = [2,000 (0.8696) + 2,800 (0.7561)] (0.6151) = $2,372

Σ AE2 = CR (15%)2 + AEOC2 = 2,418.32 + 2,697.55 = $6,151

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N =3
AE (15%)3 = $10,000(A/P, 15%, 3) + 2000 + $800 (A/G, 15%, 3)
– $6,000(0.85)3-1 (A/F, 15%, 3)
AE (15%)3 = 4380 + 2,000 + 625.68 – 1,248.48 = $5,857

OR

CR (15%)3 = I (A/P, 15%, 3) – S3 (A/F, 15%, 3)

CR (15%)3 = 10,000 (0.4380) – 4335 (0.2880) = $3,132

AEOC3 =Σ [ OC1 (P/F, 15%, 1) + OC2 (P/F, 15%, 2) + OC3 (P/F, 15%, 3) ]
x (A/P, 15%, 3)
AEOC3 = [2,000 (0.8696) + 2,800 (0.7561) + 3,600 (0.6575)] (0.4380)
AEOC3 = $2,725

Σ AE3 = CR (15%)3 + AEOC3 = 2,139.6 + 3,360.7 = $5,857

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N =4
AE (15%)4 = $10,000(A/P, 15%, 4) + 2000 + $800 (A/G, 15%, 4)
– $6,000(0.85)4-1 (A/F, 15%, 4)
AE (15%)4 = 3,503 + 2,000 + 1,061.04 – 738 = $5,826

OR

CR (15%)4 = I (A/P, 15%, 4) – S4 (A/F, 15%, 4)

CR (15%)4 = 10,000 (0.3503) – 3,685 (0.2003) = $2,765

AEOC4 =Σ [ OC1 (P/F, 15%, 1) + OC2 (P/F, 15%, 2) + OC3 (P/F, 15%, 3)
+ OC4 (P/F, 15%, 4)] x (A/P, 15%, 4)
AEOC4 = [2,000 (0.8696) + 2,800 (0.7561) + 3,600 (0.6575) + 4,400 (0.5718) ]
x (0.3503)
AEOC4 = $3,061

Σ AE4 = CR (15%)4 + AEOC4 = 2,765 + 3,061 = $5,826

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N =5
AE (15%)5 = $10,000(A/P, 15%, 5) + 2000 + $800 (A/G, 15%, 5)
– $6,000(0.85)5-1 (A/F, 15%, 5)
AE (15%)5 = 2,983 + 2,000 + 1378.24 – 464.48 = $5,897

OR
CR (15%)5 = I (A/P, 15%, 5) – S5 (A/F, 15%, 5)
CR (15%)5 = 10,000 (0. 2983) – 3,132 (0.1483) = $2,519

AEOC5 =Σ [ OC1 (P/F, 15%, 1) + OC2 (P/F, 15%, 2) + OC3 (P/F, 15%, 3) + OC4 (P/F,
15%, 4) + OC5 (P/F, 15%, 5)] x (A/P, 15%, 5)
AEOC5 = [2,000 (0.8696) + 2,800 (0.7561) + 3,600 (0.6575) + 4,400 (0.5718) + 5,200
(0.4972)] x (0.2983)
AEOC5 = $3,378

Σ AE5 = CR (15%)5 + AEOC 5 = 2,519 + 3,378 = $5,897

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 N = 1 year: AE(15%) = $7,500

The economic service life N = 2 years: AE(15%) = $6,151

of the challenger is four
years. N = 3 years: AE(15%) = $5,857

N = 4 years: AE(15%) = $5,826

NC*=4 years N = 5 years: AE(15%) = $5,897

AEC*=$5,826

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 Replacement Decisions

N D*  2 years  Should replace the

defender now? No,
because AECD < AECC
AECD*  $5,116
 If not, when is the best
NC*= 4 years time to replace the
defender? Need to
conduct the marginal
AEC*=$5,826 analysis.
 Marginal Analysis –
When to Replace the Defender
Question: What is the additional (incremental) cost for keeping the defender
one more year from the end of its economic service life, from Year 2 to Year 3?

Financial Data:

• Opportunity cost at the end of year 2: $3,000 (market value of the

defender at the end year 2)
• Operating cost for the 3rd year: $5,000

• Salvage value of the defender at the end of year 3: $2,000

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 Step 1: Calculate the equivalent
cost of retaining the defender one $2000
more from the end of its economic 2
service life, say 2 to 3. 3

$3,000 (F/P,15%,1) + $5,000

- $2,000 = $6,450 $3000
$5000

 Step 2: Compare this cost with AEC

= $5,826 of the challenger. 2 3
 Conclusion: Since keeping the
defender for the 3rd year is more
expensive than replacing it with the
challenger, DO NOT keep the $6,450
defender beyond its economic
service life.

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