Replacement Decisions

Replacement
Decisions
Lecture No. 30
Chapter 11
Contemporary Engineering Economics
Third Canadian Edition
Copyright 2012
2012 Pearson Canada Inc., Toronto, Ontario
30-1
Chapter Opening Story: Johnson Street

Bridge in Victoria, B.C.
Issue: Substantial investment in the bridge is required by

2012 to avoid further deterioration, operation cost
increase, and possible closure. The bridge carries
approximately 30,000 trips per day, including vehicles,
pedestrians, and cyclists.
Based on the bridge condition assessment report, the city
council ruled out the option of do-nothing due to risk,
liability, and economic impact.
Option 1: The Replacement option would adopt the
Rolling Bascule design with an estimated investment of
$63 million and an estimated life of 100 years.
Option 2: Technical work on the Rehabilitation option is
yet to be completed. The total investment required for
this option is not yet available.
30-2
Chapter 11 Objectives
What makes the replacement decision problems differ

from the other capital investment decisions?
What types of financial information should be collected to
conduct a typical replacement decision problem?
How do you compare a defender with a challenger on
the basis of opportunity cost concept?
How do you determine the economic service life for any
given asset?
How do you determine the optimal time to replace a
defender?
30-3
Lecture 30 Objectives
What makes the replacement decision problems differ

from the other capital investment decisions?
What types of financial information should be collected to
conduct a typical replacement decision problem?
How do you compare a defender with a challenger on
the basis of opportunity cost concept?
30-4
Basic Concepts and Terminology
Replacement projects are decision problems involving

the replacement of existing obsolete or worn-out assets.
The continuation of operations is dependent on these
assets.
Defender: is an existing asset
Challenger: is the best available replacement candidate
Current market value: is the value to use in preparing a
defenders economic analysis
Sunk cost: past costs that cannot be changed by any
future investment decision and should not be considered
in a defenders economic analysis
30-5
Example 11.1: Information Relevant to

Replacement Analysis
Macintosh Printing Inc. purchased a $20,000 printing

machine two years ago. The company expected this
machine to have a five-year life and a salvage value of
$5,000. The company spent $5,000 last year on repairs,
and current operating costs are running at the rate of
$8,000 per year. The anticipated salvage value of the
machine has been reduced to $2,500 at the end of the
machines remaining useful life. In addition, the company
has found that the current machine has a market value of
$10,000 today. The equipment vendor will allow the
company this full amount as a trade-in on a new machine.
What values for the defender are relevant to our analysis?
30-6
Example 11.1: Solution
Original cost: The printing machine was purchased for

$20,000.
Current market value: The company estimates the old
machines current market value at $10,000.
Trade-in allowance: This is the same as the market
value.
Repair cost: $5,000 was spent last year to repair the
machine.
Operating costs: If kept, the machine costs $8,000 per
year to operate.
Future salvage value: The machine has a salvage value
of $2,500 three years from today.
30-7
Example 11.1: Solution: Sunk Cost

Associated with an Assets Disposal
Original investment
$20,000
Current market value
Lost investment
$10,000
Repair cost
$5000
$10,000
Sunk costs = $15,000

$0
$5000
$10,000
$15,000
$20,000
$25,000
$30,000
30-8
Opportunity Cost Approach to Comparing

Defender and Challenger
Opportunity Cost Approach
The opportunity cost approach views the net proceeds

from the sale of the defender as an opportunity cost of
keeping the defender. That is, instead of deducting the
salvage value from the purchase cost of the challenger,
we consider the net proceeds as an investment required to
keep the asset.
30-9
Example 11.2: Replacement Analysis

Using the Opportunity Cost Approach
Consider again Example 11.1. Another printing machine

is being offered for $15,000. Over its three-year useful
life, the new machine will reduce operating costs from
$8,000 a year to $6,000. It is estimated that the new
machine can be sold for $5,500 at the end of year 3. If
the new machine were purchased, the old machine
would be sold to another company rather than traded in
for the new machine.
Assuming that the firms interest rate is 12%, decide
whether replacement is justified now.
30-10

Using the Opportunity Cost Approach
Defender
Market price: $10,000

Remaining useful life: 3
years
Salvage value: $2,500
O&M cost: $8,000
Challenger
Cost: $15,000
Useful life: 3 years
Salvage value: $5,500
O&M cost: $6,000
30-11
30-12
Defender: PEC stands for Present Equivalent Cost

PEC(12%)D = $10,000 + $8,000(P/A, 12%, 3) - $2,500(P/F, 12%, 3)
= $27,434.90
AEC(12%)D = PEC(12%)D(A/P, 12%, 3)
= $11,422.64
Challenger:
PEC(12%)C = $15,000 + $6,000(P/A, 12%, 3) - $5,500(P/F, 12%, 3)
= $25,495.90
AEC(12%)C = PEC(12%)C(A/P, 12%, 3)
= $10,615.33
Replace the
defender now!
30-13
Summary
Replacement projects are decision problems involving the

replacement of existing obsolete or worn-out assets. In
replacement analysis, the defender is the existing machine
(or system), and the challenger is the best available
replacement equipment.
30-14
Economic
Service Life
Lecture No. 31
Chapter 11
Copyright 2012
30-15
How do you determine the economic service life for any

given asset?
30-16
Economic Service Life
Definition: Economic service life is the remaining useful

life of an asset that results in the minimum annual
equivalent cost.
Cost of owning and operating an asset can be divided
into two categories: capital costs and operating costs.
Capital costs: comprised of two components: the initial
investment and the salvage value at the time of disposal
of the asset. The initial investment for the challenger is
simply its purchase price. For the defender, we should
treat the opportunity cost as its initial investment.
30-17
Mathematical Relationship
Annual Equivalent Capital (Recovery) Cost:

CR i P A / P, i ,N SN A / F, i ,N
Annual Operating Cost:

N
OC(i) OCn P / F, i , n A / P, i ,N
n 1
Annual Equivalent Cost (total of above):
AEC(i) = CR(i) +OC(i),"n N
Objective: Find (N=)n* that minimizes AEC

(We assume a unique minimum for simplicity)
30-18
Schematic Illustrating the Trends of Capital Recovery Cost,

Annual Operating Cost, and Total Annual Equivalent Cost
n*
30-19
Example 11.3: Economic Service Life of

a Lift Truck
A new forklift truck would cost $18,000, have operating

costs of $1,000 in the first year, and have a salvage
value of $10,000 at the end of the first year. For the
remaining years, operating costs increase each year by
15% over the previous years operating costs. The
salvage value declines each year by 25% from the
previous years salvage value. The lift truck has a
maximum life of seven years. An overhaul costing
$3,000 and $4500 will be required during the fifth and
seventh years of service, respectively. The firms
required rate of return is 15%. Find the economic service
life of this new machine.
30-20
30-21
Example 11.3: Solution: AEC If the Asset

Is Kept for Just 1 or 2 Years
N=1
AEC1 = $18,000(A/P, 15%, 1)
+ $1,000 - $10,000
= $11,700
N=2
AEC2 = [$18,000 +
$1,000(P/A,15% 15%, 2)]
(A/P, 15%, 2)
- $7,500 (A/F, 15%, 2)

= $8,653
30-22
Example 11.3: Solution: 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
Economic Service Life
30-23
Summary
The economic service life is the remaining useful life of a

defender or a challenger that results in the minimum
equivalent annual cost or maximum annual equivalent
revenue. We should use the respective economic service
lives of the defender and the challenger when conducting a
replacement analysis.
30-24
Replacement Analysis
When the Required
Service Is Long
Lecture No. 32
Chapter 11
Copyright 2012
30-25
How do you determine the optimal time to replace a

defender?
30-26
Required Assumptions and Decision

Frameworks
1. Planning Horizon: the service period required by the
defender and a sequence of future challengers
Infinite planning horizon is used when we are simply unable to

predict when the activity under consideration will be terminated.
Finite planning horizon is used when the project will have a
definite and predictable duration.
2. Technology: No technology improvement is anticipated

over the planning horizon. However, technology
improvement cannot be ruled out.
3. Revenue and Cost Patterns Over the Life of an Asset
30-27

Frameworks (continued)
4. Decision Frameworks
To illustrate how a decision framework is developed, we indicate

a replacement sequence of assets by the notation
(j0,n0), (j1,n1), (j2,n2), ..., (jK,nK)
Each pair of numbers ( j, n) indicates a type of asset and the

lifetime over which that asset will be retained. The defender,
asset 0 is listed first; if the defender is replaced now, n0 = 0.
The sequence (j0,2), (j1,5), (j2,3) indicates retaining the defender
for two years, then replacing the defender with an asset of type
j1 and using it for five years, and then replacing j1 with an asset
of type j2 and using it for three years.
30-28
Types of Typical Replacement

Decision Frameworks
30-29

Frameworks (continued)
5. Decision Criterion
The AE or AEC method provides a more direct solution when

the planning horizon is infinite.
When the planning horizon is finite, the PW or PEC method is

more convenient to use.
30-30
Replacement Strategies Under the

Infinite Planning Horizon
Procedure to follow:
1. Compute the economic lives of both the defender and the
challenger. Denote ND* and NC* as the economic lives of the
defender and challenger and AECD* and AECC* as the annual
equivalent costs for the defender and challenger at their
respective economic lives.
2. Compare AECD* and AECC*. If AECD* > AECC*, the challenger
should replace the defender now. If AECD* < AECC*, the
defender should not be replaced now. The defender should
continue to be used at least for the duration of its economic life if
there are no technological changes over that life.
30-31

Infinite Planning Horizon (continued)
3. If the defender should not be replaced now, when should it be
replaced?
i.
We need to continue to use the defender until its economic life
is over. Then calculate the cost of running the defender for one
more year. If this cost is greater than AECC*, the defender
should be replaced at the end of its economic life.
ii. Calculate the cost of running the defender for the second year
after its economic life. If this cost is bigger than AECC* the
defender should be replaced before that year. The process
should be continued until we find the optimal replacement time.
This approach is called marginal analysis; that is, we

calculate the incremental cost of operating the defender
for just one more year.
30-32

Under an Infinite Planning Horizon
Defender:
Challenger:
Current salvage value = $5,000, decreasing at an annual rate of

1000$ from the previous years value
Required overhaul = $1,200
O&M = $2,000 in year 1, increasing by $1,500 per year
I = $10,000
Salvage value = $6,000 after one year, will decline 15% each
year
O&M = $2,000 in the first year, increasing 800$ per year after.
Find: (a) Economic service lives for both defender and

challenger, (b) when to replace the defender
30-33
Example 11.4: Solution (a)

Defender
N = 4 years: AEC 15%

$6200 A / P,15%,4
$2000 $1500 A / G,15%,4
-$1000 A / F ,15%,4
$5961
Cash flow diagram for defender
When N = 4 years
30-34
Example 11.4: Solution (a) Defender
Defender: Find the

remaining useful
(economic) service life.
ND* 2 years
N
N
N
N
N
1: AEC(15%) $5130
2 : AEC(15%) $5116
3 : AEC(15%) $5500
4 : AEC(15%) $5961
5 : AEC(15%) $6434
AECD* $5,116
30-35

Defender
30-36

Challenger
Investment cost = $10,000
Salvage value
N = 1: $6,000
N > 1: decreases at a 15%
over previous year
Operating cost
N = 1: $2,000
N > 1: increases at 800$
annually
N = 1 year: AEC(15%) = $7500

N = 2 years: AEC(15%) = $6151
N = 3 years: AEC(15%) = $5847
N = 4 years: AEC(15%) = $5826
N = 5 years: AEC(15%) = $5897
NC*=4 years
AECC*=$5,826
30-37
Example 11.4: Solution (b)
Should replace the

defender now? No,
because AECD*< AECC*
If not, when is the best

time to replace the
defender? Need to
conduct the marginal
analysis.
ND* 2 years
AECD* $5,116
NC*= 4 years
AECC*=$5,826
30-38
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?
Data:
Opportunity cost at the end of year 2: Equal to the market value

of $3,000 (this is the investment for the machine)
Operating cost for the 3rd year: $5,000
Salvage value of the defender at the end of year 3: $2,000
30-39
Step 1: Calculate the equivalent cost of retaining the

defender one more from the end of its economic service
life, say 2 to 3.
$3,000(F/P,15%,1) + $5,000 - $2,000 = $6450
Step 2: Compare this cost with AECC* = $5,826 of the

challenger.
Conclusion: Since keeping the defender for the 3rd year

is more expensive than replacing it with the challenger,
DO NOT keep the defender beyond its economic service
life.
30-40

Infinite Planning Horizon
An annual cash flow analysis with unequal service life

alternatives are not valid in the usual defender
challenger situation. The unequal-life problem is resolved
because we really are comparing the following two
options in replacement analysis:
1. Replace the defender now: The cash flows of the challenger

estimated today will be used. An identical challenger will be used
thereafter if replacement becomes necessary in the future. This
stream of cash flows is equivalent to a cash flow of AECC* each year
for an infinite number of years.
2. Replace the defender, say, x years later: The cash flows of the
defender will be used in the first x years. Starting in year x+1,the
cash flows of the challenger will be used indefinitely thereafter.
30-41

Under the Finite Planning Horizon (PW
Approach)
Consider again the defender and the challenger in

Example 11.4. Suppose that the firm has a contract to
perform a given service, using the current defender or
the challenger for the next eight years. After the contract
work, neither the defender nor the challenger will be
retained. What is the best replacement strategy?
30-42

Given: Economic service
lives for both defender and
challenger , and i = 15%
Some Likely Replacement Patterns
Find: the most

plausible/economical
replacement strategy
30-43
Option 1:
(j0, 0), (j, 4), (j, 4)

PW(15%)1=$5,826(P/A, 15%, 8)
=$26,143
Option 2:
(j0, 1), (j, 4), (j, 3)
PW(15%)2=$5,130(P/F, 15%, 1)
+$5,826(P/A, 15%, 4)(P/F, 15%, 1)
+$5,847(P/A, 15%, 3)(P/F, 15%, 5)
=$25,573
30-44
Option 3
(j0, 2), (j, 4), (j, 2)

PW(15%)3=$5,116(P/A, 15%, 2)
+$5,826(P/A, 15%, 4)(P/F, 15%, 2)
+$6,151(P/A, 15%, 2)(P/F, 15%, 6)
= $25,217
minimum cost
Option 4
(j0, 3), (j, 5)

PW(15%)4= $5,500(P/A, 15%, 3)
+$5,897(P/A, 15%, 5)(P/F, 15%, 3)
=$25,555
30-45
Option 5:
(j0, 3), (j, 4), (j, 1)
Option 6:
PW(15%)5= $5,500(P/A, 15%, 3)

+ $5,826(P/A, 15%, 4)(P/F, 15%, 3)
+ $7,500(P/F, 15%, 8)
= $25,946
(j0, 4), (j, 4)
PW(15%)6= $5,961(P/A, 15%, 4)

+ $5,826(P/A, 15%, 4)(P/F, 15%, 4)
= $26,529
30-46
Example 11.5: Graphical Representation of

Replacement Analysis Under the Finite Planning
Horizon
30-47
Summary
In replacement analysis, the AEC method provides a

marginal basis on which to make a year-by-year decision
about the best time to replace the defender. As a general
decision criterion, the PEC method provides a more direct
solution to a variety of replacement problems, with either
an infinite or a finite planning horizon, or a technological
change in a future challenger.
30-48

Replacement Decisions

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Replacement

Chapter Opening Story: Johnson Street

Issue: Substantial investment in the bridge is required by

What makes the replacement decision problems differ

2012 Pearson Canada Inc., Toronto, Ontario

What makes the replacement decision problems differ

2012 Pearson Canada Inc., Toronto, Ontario

Basic Concepts and Terminology

Replacement projects are decision problems involving

Example 11.1: Information Relevant to

Macintosh Printing Inc. purchased a $20,000 printing

Example 11.1: Solution

Original cost: The printing machine was purchased for

Example 11.1: Solution: Sunk Cost

Current market value

Sunk costs = $15,000

2012 Pearson Canada Inc., Toronto, Ontario

Opportunity Cost Approach to Comparing

Opportunity Cost Approach

The opportunity cost approach views the net proceeds

2012 Pearson Canada Inc., Toronto, Ontario

Example 11.2: Replacement Analysis

Consider again Example 11.1. Another printing machine

2012 Pearson Canada Inc., Toronto, Ontario

Example 11.2: Replacement Analysis

Market price: $10,000

2012 Pearson Canada Inc., Toronto, Ontario

Example 11.2: Solution

2012 Pearson Canada Inc., Toronto, Ontario

Example 11.2: Solution

Defender: PEC stands for Present Equivalent Cost

Replacement projects are decision problems involving the

2012 Pearson Canada Inc., Toronto, Ontario

2012 Pearson Canada Inc., Toronto, Ontario

How do you determine the economic service life for any

2012 Pearson Canada Inc., Toronto, Ontario

Economic Service Life

Definition: Economic service life is the remaining useful

2012 Pearson Canada Inc., Toronto, Ontario

Annual Equivalent Capital (Recovery) Cost:

Annual Operating Cost:

Annual Equivalent Cost (total of above):

AEC(i) = CR(i) +OC(i),"n N

Objective: Find (N=)n* that minimizes AEC

Schematic Illustrating the Trends of Capital Recovery Cost,

Example 11.3: Economic Service Life of

A new forklift truck would cost $18,000, have operating

Example 11.3: Solution

2012 Pearson Canada Inc., Toronto, Ontario

Example 11.3: Solution: AEC If the Asset

- $7,500 (A/F, 15%, 2)

2012 Pearson Canada Inc., Toronto, Ontario

Example 11.3: Solution: AEC If the Asset

The economic service life is the remaining useful life of a

2012 Pearson Canada Inc., Toronto, Ontario

How do you determine the optimal time to replace a

2012 Pearson Canada Inc., Toronto, Ontario

Required Assumptions and Decision

Infinite planning horizon is used when we are simply unable to

2. Technology: No technology improvement is anticipated

2012 Pearson Canada Inc., Toronto, Ontario

Required Assumptions and Decision

To illustrate how a decision framework is developed, we indicate

(j0,n0), (j1,n1), (j2,n2), ..., (jK,nK)