POWER PLANT ECONOMICS (C0NTINUATION)

REPLACEMENT STUDIES

Four (4) Major Reasons for Replacement

1. Physical impairment
2. Inadequacy
3. Obsolescence
4. Rental possibilities

Sunk Cost due to Unamortized Value of an equipment or property is the difference

between its book value and its resale value when replaced. Unamortized value should be
considered as a sunk cost or a loss.

Example Problem: 1

A decision must be made whether to replace an old engine with a new one, or to
recondition it. The original cost of the old engine 10 years ago was P70,000; to recondition
it now will cost P28,000, but would extend its useful life for 5 years.
A new engine first cost is P62,000 with a useful life of 10years. It is expected that the
annual cost of fuel and lubricants with the reconditioned engine is P20,000 and that this
cost is 15% less with the new engine. It is also believed that repairs will be P2,500 a year
less with the new engine than with the reconditioned one. Assume that both engine has
no salvage value when retired.
If money is worth 16%, what would you recommend?

Solution:

BY ANNUAL COST METHOD

Reconditioned Engine
Annual Cost:
Depreciation = (FC – SV)i /[(1+i)n -1] =(28,000 -0)0.16/[1.165 -1] = P4071
Fuel and Lubricants = 20,000
Repairs (excess) = 2,500
Min. Reqd. Profit = 28,000 x0.16 = 4,480
________
Total annual costs P 31,051

New Engine
Annual cost:
DEPRECIATION =(62,000 -0)x0.16/[1.1610 -1] =P 2,908
Fuel and lubricants= 20,000x0.85 = 17,000
Min. Reqd. Profit = 62,000x0.16 = 9,920
________
Total Annual Cost P 29,828
Recommendation: The old engine should be replaced.

Example Problem: 2

A manufacturing firm supplies certain product which is being made on an engine lathe to a
car company. A turret lathe is now available. The data of two lathes are the following:

Engine lathe Turret lathe

First cost 36,000 48,000
Cost of installation 500 800
Salvage value 4,000 5,000
Trade-in value 12,500
Production time per piece, 30 20
min
Labor cost per hr 2 2.5
Overhead per hr 5 4.50
life 10 8
Present age 5 0
Taxes and insurance 4% 4%

There are 2,400 working hours per year on the old engine lathe. If money is worth 10% to
the company, should replacement be made now?

Solution

By ROR
Engine lathe

Depreciation = (12,500-4,000)/(F/A,10%,5) = 1,392

Labor =2x2400 =4,800
Overhead = 5 x 2400) 12,000
Taxes and insurance =(36,000+500)0.04 1,460
______
Total = 19,652

Turret LATHE
Depreciation =(48,000-5,000)/(F/A, 10%, 5) 3,830
Labor =2.5(2/3 x2400) 4,000
Overhead = 4.5(2/3 x 2400) 7,200
Taxes and insurance =(48,000+800)0.04 1,952
_______
Total = 16,982
Annual savings = 19652 – 16,982 =2,670
Additional investment =48000 +800 – 12500 = 36,300
ROR on investment = 2670/ 36,300 = 7.36%
Recommendation: replacement should not be made.

BY annual Cost Method

EXAMPLE PROBLEM: 3
EXAMPLE PROBLEM#4
AMORTIZATION