1

Replacement Analysis
Should we replace an asset that we own now or later?
Reasons for replacing an asset
Physical Impairment
Altered Requirements
Technology
The replacement of assets often represents economic opportunity for the
firm. We compare the two alternatives:
The asset that we own: The Defender
The Asset that we might buy to replace it: The Challenger
Factors to consider (or ignore)
Sunk Costs
Existing Asset Value and the outsider viewpoint
Income Tax Considerations
Economic Life of the challenger and the defender
An asset has various types of lives
Useful Life
Tax Life
Economic Life
The Economic Life of an asset is
the period of time that minimizes the net annual cost (NAC) for the
investment (when it primarily consists of costs)
or
the period of time that maximizes the net annual worth (NAW) for
the investment (when it consists of costs and revenues)
Example 1
Investment in a machine: $15,000
Useful life 10 years
Salvage decreasing with time like the book value using SYD method.
Assume salvage after 10 years is zero
Operating cost is $500 in first year, but increases by 40% in each
subsequent year
What is the economic life? The MARR is 18%

Replacement

Computation of the Economic Life

Tim e

O perating
Cost

Salvage
Value

500
700
980
1372
1921
2689
3765
5271
7379
10331

15000
12273
9818
7636
5727
4091
2727
1636
818
273
0

0
1
2
3
4
5
6
7
8
9
10

Let A(n) = cost in year n

S(n) = Salvage in year n
P = Investment at time 0

NAC

5927
5669
5462
5307
5207
5162
5178
5256
5404
5627

PA = present worth of annual costs

= A(1)(P/F, i, 1) + A(2)(P/F, i, 2)
+ + A(n)(P/F, i, n)
NAC = (P + PA)(A/P, i, n)
S(n)(A/F, i, n)

The Economic Life Minimizes the NAC

Find NAC(1), NAC(2),, NAC(10).
The economic life is the life that minimizes NAC.
In this case the economic life = 6 years.
Economic Life
16000
14000
12000
10000

Operating Cost

8000

Salvage Value

6000

NAC

4000
2000
0
0

10

Economic Life Summary:

For many situations, the economic life and the useful life are the same.
When the economic life is different from the useful life, use the economic
life when determining the advisability of an investment.
When comparing two alternatives, compute and use the economic life of
each alternative in the comparison.

Replacement

Replacement Analysis: Example 2

It is 2003. Should we buy a new car to replace the old wreck? Your minimum acceptable
rate of return is 12%.
Old Car:
Initial cost was $4,500 in 1995. The car
was supposed to last for 8 years with a
trade-in value $500 at the end of 8 years.
Maintenance costs next year will be
$800, and are expected to go up by $400 a
year in the coming years (800, 1200, 1600,
. . .).
The car is now a death trap, not worth
more than $250. To trade it in, you're
going to have to clean it up for a cost of
$50. In the future, net salvage value is also
expected to be $200 at any time.

New car:
Cost is $8,250, less trade-in allowance of
$250. This car is supposed to last for 10
years with a trade-in value of $750 at the
end of that time. If you sell it before the end
of its useful life, you expect the trade-in
value to be the same as the book value
computed with straight-line depreciation.
Maintenance will be $100 per year for the
first three years and $300 per year
thereafter.

The Defender
Investment

The Challenger
Investment

Operating Costs and Revenues

Operating Costs and Revenues

Salvage Value

Salvage Value

Economic Life

Economic Life

Replacement

Investment for the Defender

The opportunity cost for the defender is the money that you give up by not
disposing of it. You must also add any costs at time 0 to make it equivalent
to the challenger. The investment consists of
the current market value for the defender,
less costs necessary for its disposal,
less taxes on the capital gain (when taxes are considered),
plus any real costs at time 0 necessary to keep the defender.
Beware
Don't use any defender characteristics to compute the challenger
investment, costs, or salvage. Don't use any challenger characteristics to
compute the defender investment, costs, or salvage.
The Defender

The Challenger

Investment: PD = $200.
Operating Cost: AD(n) = $800 + $400(n-1)
Salvage Value: SD(n) = $200

Investment: PC = $8,250
Operating Cost: AC(n) = $100, $100, $100, $300,
$300, $300, ...
Salvage Value: SC(n) = $8,250 $750n

NACD(n) = PD(A/P, i, n) + $800 +

$400(A/G, i, n) 200(A/F, i, n)

NACC(n) = PC(A/P, i, n) + 100 SC(n)(A/F, i, n)

for n = 1, 2, 3
NACC(n) = PC(A/P, i, n) + 300
200(P/A, i, 3) (A/P, i, n) SC(n)(A/F, i, n)
for n = 4,,10

Defender
Age, n
0
1
2
3

A(n)
800
1200
1600

Challenger
S(n)
200
200
200
200

NAC
824
1013
1194

Age, n
0
1
2
3
4
5
6
7
8
9
10

A(n)
100
100
100
300
300
300
300
300
300
300

S(n)
8250
7500
6750
6000
5250
4500
3750
3000
2250
1500
750

NAC
1840
1798
1757
1760
1747
1728
1705
1681
1657
1632

Replacement

Which do we select?
Defender cost for one more year: $824
Challenger cost per year: $1632
Notes
All parameters of the defender and challenger are independent.
Use economic lives in the analysis.
The economic life of the defender is often one year.
The economic life of the challenger is often its useful life.
Choose the winner on the basis of minimum NAC or maximum NAW
Replacement Analysis Examples
Do we replace now or later?
Case 1: When the useful lives of the defender and the challenger are
known and the same.
Case 2: When the useful lives of the defender and the challenger are
not known or are not the same.
Example 3: Known and Equal Useful Lives
Defender: Existing Pump A
Capital investment when purchased 5 years ago: $17,000
Useful life:

another 9 years

Depreciation:

SL with half-year convention

Tax Life:

9 yrs

Annual Expenses
Replacement of impeller and bearings =
Operating and maintenance =
Taxes and insurance = $17,000 2% =
Total

$1,750
$3,250
$340
$5,340

Present Market Value

$750
Estimated market value at the end of the 9 years = $200
Current book value =
$8500
Challenger: Replacement Pump B

Replacement

Capital investment =
Useful life =
Depreciation:
Tax Life:
Estimated market value at the end of 9 years =
Annual Expenses
Operating and maintenance =
Taxes and insurance = $16,000 2% =
Total

$16,000
9 years
MACRS
5 years
$3,200
$3,000
$320
$3,320

Effective income tax (capital gains) rate = 40%

MARR (before taxes) = 10%, MARR (after taxes) = 6%
Before Tax Analysis: 9 years study period
Defender Investment
Opportunity Cost = Current Market Value =
Salvage Value =
Yearly Total Expenses =
NAC(9) of Defender =
Challenger Investment
Initial Investment =
Salvage Value =
Yearly Total Expenses =
NAC(9) of Challenger =

Replacement

After Tax Replacement Analysis

Before-tax analysis is often not valid because of
the effect of depreciation
the effect of any significant gain or loss on disposal on income taxes.
Therefore, an after-tax analysis is often necessary to evaluate the benefit of
replacement.
Example 4 Computing the investment in the defender
General Case
BTMV = Market value of the
Defender when we are
considering disposal

Existing Pump A (defender)

BTMV =750

Before tax cash flow is BTMV

BTCF = 750

ATMV = After tax market value

of the Defender
ATMV = BTMV Tax
BV = Book value of the
Defender assuming we do
dispose of it
Taxable income if we
dispose of the defender =
BTMV BV
Tax = (BTMV BV)
(Tax Rate)

If we sell the asset at the end of the 5th year

of its tax life, then
Depreciation:
$944 in year 1
$1,889 in years 2 through 5
(assuming full depr. in year 5)
Accum. Depr. = $944 + 4 $1,889
= $8,500
BV = $17,000 $8,500 = $8,500
Taxable income = $750 $8,500 = $7,750
Tax = $7,750 0.4 = $3,100
ATMV = $750 ($3,100) = $3,850

After tax opportunity cost is the

ATMV.
Use ATMV for ATCF at time 0.

ATCF = $3,850

Replacement

Example 4:
In the table below for the defender, row 0 is the opportunity cost of not
disposing of pump A (what we would have received had we sold it).
Rows 1 through 9 assume that we do not dispose of the defender. Cash flows
and depreciation are as if we keep the defender for the 9 year horizon.
ATCF for the Defender
End of
Year k
0

Deprec.

Taxable
income
-$7750

Income
taxes
$3100

BTCF
-$750

ATCF
-$3850

1-4

-$5,340

$1,889

-7229

-2892

-2448

-$5,340

$944

-6284

-2513

-2826

6-9

-$5,340

$0

-5,340

-2136

-3204

200

80

120

9 Salvage

$200

BV = $0

Using 6%
After Tax Present Cost = $22,669
After Tax Net Annual Cost = $3,333
ATCF for the Challenger
Construct the challenger cash flow independently of the defender
End of
Year k
0
1
2
3
4
5
6
7-8
9

BTCF
-$16,000
-$3,320
-$3,320
-$3,320
-$3,320
-$3,320
-$3,320
-$3,320
-$120

MACRS
deprec.

Taxable
income

Income
taxes

$3,200
$5,120
$3,072
$1,843
$1,843
$922
$0
$0

-$6,520
-$8,440
-$6,392
-$5,163
-$5,163
-$4,242
-$3,320
-$120

-$2,608
-$3,376
-$2,557
-$2,065
-$2,065
-$1,697
-$1,328
-$48

After Tax NAC using 6% =$3,375

ATCF
-$16,000
-$712
+$56
-$763
-$1,255
-$1,255
-$1,623
-$1,992
-$72

Replacement

Lessons from Example 4

Before-Tax and After-Tax Analysis can yield different results. When
taxes play a role in cash flows, an after-tax analysis should be performed.
The after-tax NAC of the challenger and the defender are very close
($3,375 vs. $3,33s). In such cases, other factors (such as the improved
reliability of the new pump or productivity loss due to training) can be
considered.
Example 5: Comparing Projects with Unknown Lives
Challenger: New Forklift Truck
Capital investment = $20,000
For the next five years, we have
Year 1
2
3
4
5

Estimated Decline in MV
$5000
$3750
$2750
$2000
$1750

Estimated MV
$15,000
$11,250
$8,500
$6,500
$4,750

Annual Expenses
$2,000
$3,000
$4,620
$8,000
$12,000

Effective income tax rate = 40%

MARR (before taxes) = 10%, MARR (after taxes) = 6%
Economic Life
Recall that
NAC(k) = (MV(0) +
End of Year k
0
1
2
3
4
5

l=1

A(l)(P/F, i, l) MV(k)(P/F, i, k)) (A/P, i, k)

MV
$20,000
$15,000
$11,250
$8,500
$6,500
$4,750

Annual Expenses

NAC(k)

$2,000
$3,000
$4,620
$8,000
$12,000

$9,000
$8,643
$8,598
$9,083
$9,954

The minimum NAC is achieved if we keep the asset 3 years.

Compare against Defender

min

10

Replacement

Defender: Current Forklift

Capital investment = $13,000 two years ago; for the next five years, we
have
Annual Expenses
Estimated MV
Year 0
$5,000
1
$4,000
$5,500
2
$3,000
$6,600
3
$2,000
$7,800
4
$1,000
$8,800
MARR (before taxes) = 10%
Economic Life
NAC(1) = $5,000 (A/P, 0.1, 1) + $5,500 $4,000(A/F, 0.1, 1)
= $5,000 (1+0.1) + $5,500 + $4,000
= $1,500 + $5,500 = $7,000

Replacement

End of
Year k
0
1
2
3
4

MV
$5,000
$4,000
$3,000
$2,000
$1,000

Annual
expenses

NAC(k)

$5,500
$6,600
$7,800
$8,800

$7,000
$7,476
$7,967
$8,405

11

min

The minimum NAC is achieved if we keep the asset one more year.
Lessons from Example 5
Keep the old truck at least one more year.
We could have stopped computing after one year. For this economic life
the defender has a smaller NAC than the challenger.
We may keep the defender longer than one year. This analysis does not
tell how long to keep it. One could compute marginal costs to get some
idea on how long to keep the defender.

12

Replacement

Replacement Analysis Summary

The opportunity cost for the defender is the money that you give up by not disposing of
the defender.
The opportunity cost is the current market value for the defender, less costs necessary for
its disposal, less taxes on the capital gain.
The investment in the defender is the opportunity cost plus any real costs that must be
expended at time zero necessary to keep the defender.
The investment in the challenger is just the cost of purchasing the challenger.
Don't use any defender characteristics to compute the challenger investment, costs, or
salvage. Don't use any challenger characteristics to compute the defender investment,
costs, or salvage.
Use the economic lives for both the defender and challenger. The economic life
minimizes the NAC of operation (or maximizes NAW when benefits are considered).
Don't forget to use the proper investment and salvage values for the calculations.
In cases where the operating cost of the defender is increasing, the economic life of the
defender is often one year. To simplify, compute the NAC for one year. If the defender
wins on the basis of one year, keep it for one more year. Do the analysis again next year.
In cases where the operating costs of the challenger are constant and the salvage value is
not decreasing too rapidly, the economic life of the challenger is often the same as the
useful life.
When lives of the defender or challenger are different (the usual case),
use NAC or NAW to make the decision.
When considering taxes, use the after tax cash flows in the analysis. Note that the
investment in the defender may involve taxes. There is a tax effect if the book value of
the defender does not equal its net market value.

Replacement

13

Economic Life and Replacement Problems

1a.

The tables below show the operating cost and salvage value for a machine that
was purchased for $50,000 and has a useful live of 3 years. Find its economic life
using an MARR of 10%.
(a)
Year
1
2
3

Operating cost Salvage value

$10,000
0
$40,000
0
$70,000
0

Year
1
2
3

Operating cost
$10,000
$10,000
$10,000

(b)
Salvage value
$30,000
$20,000
0

14

Replacement

2. A piece of equipment was purchased one year ago for $100,000. The annual cost of
operating the equipment is $20,000. We expect it to last another 5 years and this
operating cost will remain constant during that time.
During the year, a remarkable new process was discovered that uses waste material to
run the equipment. The result is that the same output can be obtained with zero
operating cost. The cost of purchasing and installing the new equipment is $200,000,
and is expected to last 10 years. At that time, it will have zero salvage value. Note
that under these conditions the economic life of the new equipment is 10 years.
You must have either the new or old equipment. Both options perform the function
with equal quality. You are now considering selling the old equipment and replacing
it with the new one. There is a buyer that is willing to take the old equipment off
your hands for $30,000. If you don't make the deal now, you doubt that you will find
a buyer for any price in the future. After this year, you will have to pay $10,000 to
get rid of the old piece of equipment. The minimum acceptable rate of return is 10%.
a. What is the Net Annual Cost of the challenger?
b. What is the economic life of the defender?
Economic life

c. What is the best decision?

Replacement

15

3. Your company purchased a machine for $14,000 with a 6-year tax life. The sum-ofthe-years digits method is used for depreciation and the tax salvage value is zero.
a. After the third year of use, the machine is sold for $10,000. How much does the
company get from the sale after taxes assuming the tax rate on capital gains is
40%%.
b. Neglect taxes in this part. After the third year of life, the company is thinking
about replacing the machine with a new one. It can be sold now for $10,000.
Next year it will only be worth $6,000 and in two years, only $4,000. Three years
from now the machine will have no resale value. The operating cost of the
machine is expected to be constant for the next three years at $1,000 per annum.
The new machine has a life of 10 years with a NAC of $5,000. Should the old
machine be replaced with the new one if the companys MARR is 10%?

4. You are considering replacing your car with a new one. After much bickering, the
dealer offers you the new car for $10,000 with your car as a trade-in or $12,000
without your car. An acquaintance offers you $3,500 for your car if you fix the air
conditioner. That will cost you $1,000. The expected maintenance cost of your car
for the next year is $1200 not including the air conditioner. You think you can sell it
for $1,000 at this time next year without fixing the air conditioner.
Assume that the life of the new car is 10 years with annual maintenance cost of $800
per year. The new car will have $2,000 salvage value at the end of the 10 years.
Show the cash flows you would use in an analysis. Your MARR is 10%. What is
your most economic action?

16

Replacement

5. A company faces the following equipment replacement problem. An existing piece

of equipment is 4 years old and was originally bought for $8,000. The economic life
of this equipment is 8 years and it has no salvage at the end of its useful life. The
machine has been depreciated by the straight-line method and its current market value
is equal to its book value. If the machine is replaced, $500 must be spent to remove it
and ready it for sale. Neglect any tax effects associated with the sale or removal
costs. The net annual before tax benefit of $2,000 from the existing equipment is
expected to continue for another four years. Use four years as the economic life, and
assume the salvage value is zero at the end of four years.
The new machine being considered as a replacement costs $10,000. It has an
economic life of 10 years at the end of which it can be sold for $2,000. The net
annual before tax benefit expected from this machine is $3,000. Again the straightline method is used for depreciation using a tax salvage of $2,000.
The tax rate is given to be 50%. The after tax MARR is 10%. Should you replace
the existing machine with a new one? Show all calculations.
Existing Machine (Defender)
Year
0
1-4

BTCF

Depr.

TI

Tax

ATCF

BTCF

Depr.

TI

Tax

ATCF

Challenger
Year
0
1-9
10

Replacement

17

6. A milling machine (machine A) in your companys shop has a current market value
of $30,000. It was bought nine years ago for $54,000 and has since been depreciated
by the straight-line method assuming a 12-year tax life. If the decision is made to
keep the machine at this point it time it can be expected to last another 12 years
(measured from today). At the end of the 12 years it will be worthless. The operating
costs of this machine are $7,500 per year and are not expected to change for its
remaining life.
Alternatively, machine A can be replaced by a smaller machine B which costs
$42,000 and is expected to last 12 years. Its operating costs are $5,000 per year and
would be depreciated by the straight-line method over the 12-year period with no
salvage value expected.
Both income and capital gains are taxed at 40%. Compare the after-tax equivalent
uniform annual costs of the two machines and decide whether machine A should be
retained or replaced by machine B. Use a 10% after-tax MARR in your calculations.
Machine A:
Year
0
1-3
4-12

BTCF

Depr.

Taxable
Income

Income
tax

ATCF

Depr.

Taxable
income

Income
tax

ATCF

Machine B:
Year
0
1-12

BTCF

131

3/18/2003

Replacement