Replacement Analysis

Dr. Hassan Ashraf

Engineering Economics _ CU Islamabad _ Wah Campus _ BS Program in
1
Civil Engineering_ Class of 2020 _ FA16 Session
 Example No.1
The purchase price of a certain new automobile (challenger) being
considered for use in your business is $21,000. Your firm’s present
automobile (defender) can be sold on the open market for $10,000.
The defender was purchased with cash three years ago, and its current
BV is $12,000. To make the defender comparable in continuous
service to the challenger, your firm would need to make some repairs
at an estimated cost of $1,500.

Based on this information,

(a) What is the capital investment in the defender, using the outsider
view point?
(b) What is unamortized value of the defender?

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 2
 Solution to Example No.1
(a) The total capital investment in the defender (if kept) is its current
MV ( an opportunity cost) plus the cost of upgrading the car to
make it comparable in service to the challenger. Hence, the total
capital investment in the defender is $10,000 + $1,500 = 11,500
( from an outsider’s view point). This represents a good starting
point for estimating the cost of keeping the defender.

(b) The unamortized value of the defender is the book loss (if any)
associated with disposing of it. Given that the defender is sold for
$10,000, the unamortized value ( loss) is $12,000 - $ 10,000 =
$2,000. This is the difference between the current MV and the
current BV of the defender. This amount represents the sunk cost
and has no relevance to the replacement decision, except to the
extent that it may impact income taxes.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 3
 Example No.2
A firm owns a pressure vessel that it is contemplating replacing. The
old pressure vessel has annual operating and maintenance expenses of
$60,000 per year and it can be kept for five more years, at which time
it will have zero MV. It is believed that $30,000 could be obtained for
the old pressure vessel if it were sold now.

A new pressure vessel can be purchased for $120,000. The new

pressure vessel will have an MV of $50,000 in five years and will
have annual operating and maintenance expenses of $30,000 per year.
Using a before-tax MARR of 20% per year, determine whether or not
the old pressure vessel should be replaced. A study period of five
years is appropriate.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 4
 Solution to Example # 02
Defender: PW (20%) = -$30,000 - $60000 (P/A,20%,5)
= -$209,436.

Challenger: PW (20%) = -120,000 – 30,000 (P/A, 20%,5)

+ $50,000 (P/F,20%,5) = -$189,623

The PW of the challenger is greater (less negative) than

the present worth of the defender. Thus, the old pressure
vessel should be replaced immediately.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 5
 Example No.3
The manager of a carpet manufacturing plant became concerned
about the operation of a critical pump in one of the processes. After
discussing this situation with the supervisor of plant engineering, they
decided that a replacement study should be done, and that a nine year
study period would be appropriate for this situation. The company
that owns the plant is using a before-tax MARR of 10% per year for
its capital investment projects.

The existing pump, Pump A, including driving motor with integrated

controls, cost $17,000 five years ago. An estimated MV of $750 could
be obtained for the pump if it were sold now. Some reliability
problems have been experienced with Pump A, including annual
replacement of the impeller and bearings at a cost of $1,750. Annual
operating and maintenance expenses have been averaging $3,250.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 6
 Example No.3
Annual insurance and property tax expenses are 2% of the initial
capital investment. It appears that the pump will provide adequate
service for another nine years if the present maintenance and repair
practice is continued. It is estimated that if this pump is continued in
service, its final MV after nine more years will be about $200.

An alternative to keeping the existing pump in service is to sell it

immediately and to purchase a replacement pump, Pump B, for
$16,000. An estimated MV at the end of the nine-year study period
would be 20% of the initial capital investment. O & M expenses for
the new pump are estimated to be $3,000 per year. Annual taxes and
insurance would total 2% of the initial capital investment.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 7
 Example No.3
Based on these data, should the defender (Pump A) be kept [and the
challenger (Pump B) not purchased], or should the challenger be
purchased now ( and the defender sold)? Use a before-tax analysis
and the outsider viewpoint in the evaluation.

In an analysis of the defender and challenger, care must be taken to

correctly identify the investment amount in the exiting pump. Based
on the outsider viewpoint, this would be the current MV of $750; that
is, the opportunity cost of keeping the defender. Note that the
investment amount of pump A ignores the original purchase price of
$17,000. Using the principles discussed thus far, a before-tax analysis
of EUAC of Pump A and Pump B can now be made.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 8
 Solution to Example No.3
In an analysis of the defender and challenger, care must be taken to
correctly identify the investment amount in the exiting pump. Based on
the outsider viewpoint, this would be the current MV of $750; that is,
the opportunity cost of keeping the defender. Note that the investment
amount of pump A ignores the original purchase price of $17,000.
Using the principles discussed thus far, a before-tax analysis of EUAC
of Pump A and Pump B can now be made.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 9
 Solution to Example No.3

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 10
 Solution to Example No.3
EUAC (10%) Pump A = 5340 + 750 (A/P,10%,9) – 200 (A/F,10%,9)
= $5455
EUAC (10%) Pump B = 3320 + 16,000 (A/P,10%,9) – 3200
(A/F,10%,9) = $5862

Because Pump A has the smaller EUAC (5455 < 5862), the
replacement is not justified and defender should be kept at least one
more year.

Dr. Hassan Ashraf _ Engineering Economics _ CU Islamabad _ WAH Campus _ CLASS OF 2020 11
 Thank you !!!

Dr. Hassan Ashraf _ Advanced Project Management _ CU Islamabad _ WAH Campus _ CLASS OF 2020 12