Chapter 13 Replacement Analysis

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The Replacement Problem

Obsolescence occurs when an assets technology is surpassed by newer and/or different technologies (PC) Depletion is the gradual loss of market value of an asset as it is being consumed or exhausted (Oil well, Timber) Deterioration is the general loss in value of an asset due to aging process (Production machinery)
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The Replacement Problem

Planned replacements can be scheduled to minimize the time and cost of disruptions. Variations of replacement problems, such as abandonment, retirement, improvements of defender or keeping defender as spare, can be considered as potential new challenger. Since replacement problems usually are considered with fixed output, only costs of defender and challengers are analyzed. Due to the lives of the defender and challengers are usually different, most calculations focus on annual marginal costs or on EUAC.
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Replacement Analysis Decision Map

Defender
Available

Identify Alternatives

Best Challenger
Not Available

Defender Marginal Cost Data? No

Defender Marginal Cost Increasing? Yes

Find lowest EUAC for Defender Analysis Technique 2: Defenders lowest EUAC Challengers EUAC at its minimum cost life
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Find EUAC over given life Analysis Technique 3: Defenders EUAC over its remaining life Challengers EUAC at its min. cost life

Analysis Technique 1: Defenders next year marginal cost Challengers EUAC

Minimum Cost Life of a New Asset

The minimum cost life of any new asset is the
number of years at which the EUAC of ownership is minimized.

Because of increasing operating and maintenance costs, the minimum cost life is often shorter than the assets useful life. EUAC for each possible life, less than or equal to the useful life, is determined. The number of years at which the EUAC is minimum can then be identified.

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Example 13-1 Minimum Cost Life of a New Asset

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Maint. $0 900 1,800 2,700 3,600 4,500 5,400 6,300 7,200 8,100 9,000 9,900 10,800 11,700 12,600 Operating $500 900 1,300 1,700 2,100 2,500 2,900 3,300 3,700 4,100 4,500 4,900 5,300 5,700 6,100 O&M EUAC(O&M) CR EUAC(Total) $500 $500 $8,100 $8,600 1,800 1,125 4,206 5,331 3,100 1,733 2,910 4,644 4,400 2,325 2,264 4,590* 5,700 2,900 1,878 4,779 7,000 3,459 1,622 5,082 8,300 4,002 1,441 5,442 9,600 4,528 1,305 5,833 10,900 5,038 1,201 6,239 12,200 5,533 1,118 6,650 13,500 6,011 1,051 7,062 14,800 6,474 995 7,470 16,100 6,922 949 7,871 17,400 7,355 910 8,265 18,700 7,773 876 8,649

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Example 13-1 Minimum Cost Life of a New Asset

10000 8000 Cost 6000 4000 2000 0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Total EUAC

O&M

Capital Recovery

Year
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Replacement Analysis Decision Map

Defender
Available

Identify Alternatives

Best Challenger
Not Available

Defender Marginal Cost Data? No

Defender Marginal Cost Increasing? Yes

Find lowest EUAC for Defender Analysis Technique 2: Defenders lowest EUAC Challengers EUAC at its minimum cost life
Copyright Oxford University Press 2009

Find EUAC over given life Analysis Technique 3: Defenders EUAC over its remaining life Challengers EUAC at its min. cost life

Analysis Technique 1: Defenders next year marginal cost Challengers EUAC

Defenders Marginal Cost Data

Are the defender marginal cost data available? Are the defender marginal costs increasing? The total marginal cost for any year can include:

Capital recovery cost (loss in market value and loss interest for the year) Yearly operating and maintenance costs Yearly taxes and insurance Any other expenses that occurs during that year

The marginal cost is calculated as an equivalent end-of-year cash flow

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Example 13-2 Marginal Cost Calculation

Year 1 2 3 4 5 6 7 Market Value $18,000 13,000 9,000 6,000 4,000 3,000 2,500 Capital Recovery $10,750 7,700 5,950 4,350 2,900 1,600 950 O&M $2,000 2,500 3,000 3,500 4,000 4,500 5,000 Cost of Breakdown Risk $5,000 5,000 5,000 6,500 8,000 9,500 11,000 Total Marginal Cost $17,750 15,200 13,950 14,350 14,900 15,600 16,950

Capital Recovery Cost = MVN-1(A/P, 15%, 1) MVN(A/F, 15, 1) = MVN-1(1+15%) MVN(1) = (MVN-1 MVN) + MVN-1(15%)
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Example 13-3 Marginal Cost Calculation

Year 0 1 2 3 4 5 Market Value $15,000 14,000 13,000 12,000 11,000 10,000 Capital Operating Recovery Cost $3,250 3,100 2,950 2,800 2,650 $10,000 11,500 13,000 14,500 16,000 Total Marginal Cost $13,250 14,600 15,950 17,300 18,650

Capital Recovery Cost = MVN-1(A/P, 15%, 1) MVN(A/F, 15, 1) = MVN-1(1+15%) MVN(1) = (MVN-1 MVN) + MVN-1(15%)
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Replacement Analysis Technique 1: Defender Marginal Cost Increasing Maintain the Defender as long as the marginal cost of ownership for one more year is less than the Challengers minimum EUAC. When the Defenders marginal cost becomes greater than the Challengers minimum EUAC, then replace the Defender with the Challenger.

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Example 13-4 Replacement Analysis Technique 1

Challenger Marginal Year Cost 1 $17,750 2 15,200 3 13,950 4 14,350 5 14,900 6 15,600 7 16,950
N

Present Challenger Cost EUAC 15,435.40 $17,750.00 26,928.12 16,563.95 36,100.25 15,811.20 44,305.58 15,518.57 51,713.86 15,426.83* 58,457.74 15,446.61 64,829.25 15,582.46

Year 1 2 3 4 5

Defender Marginal Cost $13,250 14,600 15,950 17,300 18,650

EUAC ! [ j!1(Marginal Cost j )(P F , 15%, j)]( A P ,15%, N)

PC2 = PC1 + MC2(P/F, 15%, 2) EUAC = PC2(A/P, 15%, 2)
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Replacement Repeatability Assumption Currently available best Challenger will continue to be available in subsequent years and will be unchanged in its economic costs. When the Defender is ultimately replaced, it will be replaced with this Challenger. The period of needed services of the asset is indefinitely long.

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Replacement Analysis Technique 2: Defender Marginal Cost Not Increasing Calculate the Defenders minimum EUAC. If the Defenders minimum EUAC exceeds the Challengers minimum EUAC, then replace immediately. If the Defenders minimum EUAC is lower than the Challengers minimum EUAC, then the Defender will be kept at least the minimum cost life. After the minimum cost life, then replace when the Defenders increasing marginal cost exceeds the Challengers minimum EUAC. (Technique 1)
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Example 13-5 Replacement Analysis Technique 2

Challenger Marginal Challenger Year Cost EUAC 1 $17,750 $17,750.00 2 15,200 16,563.95 3 13,950 15,811.20 4 14,350 15,518.57 5 14,900 15,426.83* 6 15,600 15,446.61 7 16,950 15,582.46
N

Year 1 2 3 4 5

Defender Marginal Cost $16,000 14,000 13,500 15,300 17,500

Defender EUAC $16,000.00 $15,069.77 $14,617.71* $14,754.35 $15,161.57

EUAC ! [ j!1(Marginal Cost j )(P F , 15%, j)]( A P ,15%, N)

Replace at year 5 due to Defender Marginal Costs > Challenger EUAC Copyright Oxford University Press 2009

Example 13-6 Finding Minimum Cost Life

Year 0 1 2 3 4 5 6 7 8 9 10 11 Market Value $5,000 4,000 3,500 3,000 2,500 2,000 2,000 2,000 2,000 2,000 2,000 2,000 Capital Recovery $1,500 900 850 800 750 200 200 200 200 200 200 O&M $0 100 200 300 400 500 600 700 800 900 1,000 Marginal Cost $1500 1000 1050 1100 1150 700 800 900 1000 1100 1200 EUAC $1,500.00 1,261.90 1,197.89 1,176.79 1,172.41 1,111.18 1,078.38 1,062.78 1,058.16* 1,060.78 1,068.29

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Example 13-7 Replacement Analysis Technique 2

Challenger Year EUAC $8,600 1 5,331 2 4,644 3 4,590* 4 4,779 5 Defender Overhaul Cost $4,000 Defender O&M $1,800 1,800 2,800 3,800 4,800 Defender Marginal Cost $6,120 1,800 2,800 3,800 4,800 Defender EUAC $6,120.00 4,043.08 3,660.17* 3,691.20 3,880.20

Year 0 1 2 3 4 5

EUAC ! [ j!1(Marginal Cost j )(P F , 8%, j)]( A P ,8%, N)

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Bring to Class Wednesday

Pick a car you want to buy
Get Current Market Value Estimate Annual Maintenance for 15 years Calculate Market Value for 15 years

Find data on your current car

Market value Annual maintenance Estimate market value for 15 years

Use www.kbb.org www.nada.com

Use private party value

Replacement Analysis Technique 3: Defender Marginal Cost Not Available Calculate the Defenders EUAC over its stated useful life. If the Defenders EUAC exceeds the Challengers minimum EUAC, then replace immediately. If the Defenders EUAC is lower than the Challengers minimum EUAC, then the Defender will be kept.

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Defining First Costs of Defender and Challenger

Present market value, not the trade-in value, should be assigned as the first cost of the Defender. The first cost of the Challenger should include the purchase price, sales tax, installation cost, and other items that occur initially on a one-time basis if the Challenger is selected. The Defenders potential market (or salvage) value should not be subtracted from the Challengers first cost.
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Example 13-8 Defining Defender First Cost

Defender: SK-30, purchased 2 years ago for $1600, was depreciated with SL using 4-year life and 0 salvage. Challenger: EL-40, $1200 with a trade-in allowance of $350 for the SK-30; $1050 without a trade-in. Current price for new SK-30 is $995.

Defender: SK-30, Original cost: $1600 (Basis for SL depreciation) Present cost: $995 (Irrelevant) Book value: $800 (Useful in determining depreciation recapture or loss) Trade-in value: $350 (Irrelevant) Market value: $200 (First cost assigned to Defender)
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Repeatability Assumption Not Acceptable

Circumstances where Repeatability Assumption may not apply: When there is a specific study period instead of an indefinite need for the asset When future Challengers are not assumed to be identical to the current best Challenger

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A Closer Look at Future Challengers

Present It seems likely that Challenger future challengers will Uniform Decline be better than the present Challenger The prospect of better future challengers may make it more desirable Rapid Improvements to retain the Defender In Technology and to reject the present Challenger Selecting the current best Challenger could 0 1 2 3 4 be risky if 1) high cost Year and/or 2) long economic Copyright Oxford University Press 2009 life
EUAC at Economic Life

After-Tax Replacement Analysis

Ordinary taxes Gains and losses due to asset disposal

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Example 13-9 Marginal Costs on After-Tax Basis

Year 0 1 2 3 4 5 6 7 Market Value $25,000 18,000 13,000 9,000 6,000 4,000 3,000 2,500 Book Value $25,000 20,000 15,000 10,000 5,000 Recaptured Depr. or Loss -$2,000 -2,000 -1,000 1,000 4,000 3,000 2,500 Tax -$800 -800 -400 400 1,600 1,200 1,000 After-Tax Market Value $25,000 18,800 13,800 9,400 5,600 2,400 1,800 1,500

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Example 13-9 Marginal Costs on After-Tax Basis

AfterTax Market Capital O&M+ Ins. Year Value Recovery 0 $25,000 1 18,800 $8,700 $7,000 2 13,800 6,880 7,500 3 9,400 5,780 8,000 4 5,600 4,740 10,000 5 2,400 3,760 12,000 6 1,800 840 14,000 7 1,500 480 16,000 Taxable Income -$12,000 -12,500 -13,000 -15,000 -17,000 -14,000 -16,000 After-Tax Marginal Cost $10,900 9,380 8,580 8,740 8,960 9,240 10,080

Tax -$4,800 -5,000 -5,200 -6,000 -6,800 -5,600 -6,400

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Example 13-10 After-Tax Minimum Cost Life

Market MACRS Book Year Value Depr. Value $100,000 $100,000 0 50,000 $14,290 85,710 1 45,000 24,490 61,220 2 40,000 17,490 43,730 3 35,000 12,490 31,240 4 30,000 8,930 22,310 5 25,000 8,920 13,390 6 20,000 8,930 4,460 7 15,000 4,460 0 8 10,000 0 9 5,000 0 10 Recaptured Depr. or Loss -$35,710 -16,220 -3,730 3,760 7,690 11,610 15,540 15,000 10,000 5,000 Tax -$14,284 -6,488 -1,492 1,504 3,076 4,644 6,216 6,000 4,000 2,000 After-Tax Market Value $100,000 64,284 51,488 41,492 33,496 26,924 20,356 13,784 9,000 6,000 3,000

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Example 13-10 After-Tax Minimum Cost Life

Yr. 0 1 2 3 4 5 6 7 8 9 10 After-tax Market Capital Taxable Value Recovery O&M Income $100,000 64,284 $41,716 $10,000 -$24,290 51,488 16,653 14,000 -38,490 41,492 13,085 18,000 -35,490 33,496 10,486 22,000 -34,490 26,924 8,582 26,000 -34,930 20,356 8,183 30,000 -38,920 13,784 7,793 34,000 -42,930 9,000 5,611 38,000 -42,460 6,000 3,540 42,000 -42,000 3,000 3,360 46,000 -46,000 Tax -$9,716 -15,396 -14,196 -13,796 -13,972 -15,568 -17,172 -16,984 -16,800 -18,400 After-Tax Marginal Cost $42,000 15,257 16,889 18,690 20,610 22,615 24,621 26,627 28,740 30,960 EUAC $42000 29018 25208 23718 23167 23088* 23270 23610 24056 24580

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Example 13-11 Before-Tax Minimum Cost Life

Yr. 0 1 2 3 4 5 6 7 8 9 10 11 12 Market Value $19,999 13,999 11,199 8,960 7,168 6,092 5,179 4,402 3,742 3,180 2,703 2,298 1,953 Capital Recovery $8,281.62 6,174.98 5,232.66 4,623.71 4,113.17 3,740.77 3,452.78 3,221.47 3,030.81 2,870.70 2,734.39 2,617.10 O&M $50 50 50 450 850 1,250 1,650 2,050 2,450 2,850 3,250 3,650 EUAC(O&M) $50.00 50.00 50.00 138.77 260.00 394.95 535.61 677.99 819.89 960.03 1,097.60 1,232.10 Total EUAC $8,331.62 6,224.98 5,282.66 4,762.48 4,373.17 4,135.72 3,988.39 3,899.45 3,850.69 3,830.73 3,831.99 3,849.20

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Example 13-11 Before-Tax Minimum Cost Life

CRN ! (19,999  400)( A P ,8%, N)  (MVN  250)( A F ,8%, N)
N

EUAC(O & M)N ! [ (O & M) j (P F,8%, j)]( A P,8%, N)

j!1

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