C H A P T E R

13
REPLACEMENT
ANALYSIS
The $7 Billion Upgrade

I
n 2009 Intel Corporation announced it was
spending $7 billion in 2009 and 2010 to
modernize and update its silicon wafer man-
ufacturing plants in the U.S. The upgrade
will allow Intel to manufacture 32-nm chips
in fabs originally built for 45-nm and 65-nm
chips. Upgrade work will include remodeling
the plant’s interior and purchasing new wafer
fabrication tools.
Despite the price tag for the project, Intel
planned on saving money overall by upgrad-
ing the existing plants instead of designing and
building a new one. The upgraded plants use
newer processes that allow chips to hold smaller and faster transistors, and the new larger
wafer accommodates more chips. All these changes lead to lower production costs.
The company also noted that by deciding to remain in its current locations, it was able to
retain its highly skilled workforce. I I I
 1. Intel made the decision to upgrade existing plant facilities versus building new ones.
In their analysis they claimed to have saved money by doing so. Use the Internet and
search for articles that discuss what new manufacturing plants cost in industries of
different types. Does Intel’s $7 billion upgrade decision seem in line? What issues
are you not considering if you think the cost seems very high?
2. Companies that upgrade existing production assets may or may not scrap their current
assets. Give a realistic scenario for each case.
3. The upgrade vs. replace decision often includes economic as well as noneconomic
factors. List three economic and three noneconomic factors that may have been at
the top of Intel’s list in making the decision.
4. Companies that build new manufacturing plants often site them outside the U.S.
Discuss the ethical impacts that are or should be part of a firm’s decision process.

After Completing This Chapter. . .

The student should be able to:
• Recast an equipment reinvestment decision as a challenger vs. defender analysis.
• Use the replacement analysis decision map to select the correct economic analysis
technique to apply.
• Calculate the minimum cost life of economic challengers.
• Incorporate concepts such as repeatability assumption for replacement analysis and
marginal cost data for the defender to select the correct economic analysis techniques.
• Perform replacement problems on an after-tax basis, utilizing the defender sign
change procedure when appropriate.
• Use spreadsheets for solving before-tax and after-tax replacement analysis problems.

441
442 CHAPTER 13: REPLACEMENT ANALYSIS

Up to this point in our economic analysis we have considered the evaluation and selection of
new alternatives. Which new car or production machine should we buy? What new material
handling system or ceramic grinder should we install? More frequently, however, economic
analysis weighs existing versus new facilities. For most engineers, the problem is less likely
to be one of building a new plant; rather, the goal is more often keeping a present plant
operating economically. We are not choosing between new ways to perform the desired task.
Instead, we have equipment performing the task, and the question is: Should the existing
equipment be retained or replaced? This adversarial situation has given rise to the terms
defender and challenger. The defender is the existing equipment; the challenger is the
best available replacement equipment. Economically evaluating the existing defender and
its challengers is the domain of replacement analysis.

THE REPLACEMENT PROBLEM

Replacement of an existing asset may be appropriate due to obsolescence, depletion,

and deterioration due to aging. In each of these cases, the ability of a previously imple-
mented business asset to produce a desired output is challenged. For cases of obsolescence,
depletion, and aging, it may be economical to replace the existing asset. We define each of
these situations.
Obsolescence: occurs when an asset’s technology is surpassed by newer and/or
different technologies. As an example, today’s personal computers (PCs) with
more RAM, faster clock speeds, larger hard drives, and more powerful central
processors have made older, less powerful PCs obsolete. Thus, obsolete assets
may need to be replaced with newer, more technologically advanced ones.
Depletion: the gradual loss of market value of an asset as it is being consumed or
exhausted. Oil wells and timber stands are examples of such assets. In most cases
the asset will be used until it is depleted, at which time a replacement asset will
be obtained. Depletion was treated in Chapter 11.
Deterioration due to aging: the general condition of loss in value of some asset
due to the aging process. Production machinery and other business assets that were
once new eventually become aged. To compensate for a loss in functionality due
to the aging process, additional operating and maintenance expenses are usually
incurred to maintain the asset at its operating efficiency.
Aging equipment often has a greater risk of breakdowns. Planned replacements can be
scheduled to minimize the time and cost of disruptions. Unplanned replacements can be
very costly or even, as with an airplane engine, potentially catastrophic.
There are variations of the replacement problem: An existing asset may be aban-
doned or retired, augmented by a new asset but kept in service, or overhauled to reduce its
operating and maintenance costs. These variations are most easily considered as potential
new challengers.
Replacement problems are normally analyzed by looking only at the costs of the exist-
ing and replacement assets. Since the assets typically perform the same function, the value
of using the vehicle, machine, or other equipment can be ignored. If the new asset has new
features or better performance, these can be included as a cost savings.
Alternatives in a replacement problem almost always have different lives, and the prob-
lem includes picking the best one. This is because an existing asset will often be kept for
 Replacement Analysis Decision Map 443

at most a few years longer, while the potential replacements may have lives of any length.
Thus replacement problems are focused on annual marginal costs and on EUAC values. We
can calculate present costs, but only as a step in calculating EUAC values.
In industry, as in government, expenditures are normally monitored by means of
annual budgets. One important facet of a budget is the allocation of money for new
capital expenditures, either new facilities or replacement and upgrading of existing
facilities.
Replacement analysis may recommend that certain equipment be replaced, with the
cost included in the capital expenditures budget. Even if no recommendation to replace is
made, such a recommendation may be made the following year or subsequently. At some
point, existing equipment will be replaced, either when it is no longer necessary or when
better equipment is available. Thus, the question is not if the defender will be replaced,
but when it will be replaced. This leads us to the first question in the defender–challenger
comparison:
Shall we replace the defender now, or shall we keep it for one or more additional years?

If we do decide to keep the asset for another year, we will often reanalyze the problem
next year. The operating environment and costs may change, or new challengers with lower
costs or better performance may emerge.

REPLACEMENT ANALYSIS DECISION MAP

Figure 13-1 is a basic decision map for conducting a replacement analysis.

Identify
Defender Alternatives Best Challenger

Defender
Available Not Available
Marginal
Cost Data

Defender Find Lowest Find

Marginal No
EUAC for EUAC Over
Cost Increasing Defender Given Life

Yes
Analysis Technique 2 Analysis Technique 3
Analysis Technique 1
Compare the defender's Lacking defender marginal cost data,
Compare the defender's
lowest EUAC with the compare the defender's EUAC over its
next-year marginal cost
challenger's EUAC at remaining useful life with the challenger’s
with the challenger's EUAC.
its minimum cost life. EUAC at its minimum cost life.

FIGURE 13–1 Replacement analysis decision map.

444 CHAPTER 13: REPLACEMENT ANALYSIS

Mutually Exclusive Set of Challengers

Challenger-1 Challenger-2

“Current Champion” Asset Challenger-3 Challenger-k

(previously implemented)
vs “Winner” of Challengers Comparison

Defender Challenger

FIGURE 13–2 Defender–challenger comparison.

Looking at the map, we can see there are three replacement analysis techniques that can
be used under different circumstances. The correct replacement analysis technique depends
on the data available for the alternatives and how the data behave over time.
By looking at the replacement analysis map, we see that the first step is to identify the
alternatives. Again, in replacement analysis we are interested in comparing the previously
implemented asset (the defender) against the best current available challenger.
If the defender proves more economical, it will be retained. If the challenger proves more
economical, it will be installed.

In this comparison the defender is being evaluated against a challenger that has been
selected from a set of mutually exclusive competing challengers. Figure 13-2 illustrates
this concept as a drag race between the defender and a challenger. The challenger that is
competing against the defender has emerged from an earlier competition among a set of
potential challengers. Any of the methods previously discussed in this text for evaluating
sets of mutually exclusive alternatives could be used to identify the “best” challenger to race
against the defender. However, it is important to note that the comparison of these potential
challenger alternatives should be made at each alternative’s respective minimum cost life.
This concept is discussed next.

MINIMUM COST LIFE OF A NEW ASSET—THE CHALLENGER

The minimum cost life of any new asset is the number of years at which the equivalent
uniform annual cost (EUAC) of ownership is minimized. This minimum cost life is often
shorter than either the asset’s physical or useful life, because of increasing operating and
 Minimum Cost Life of a New Asset—The Challenger 445

maintenance costs in the later years of asset ownership. The challenger asset selected to
“race” against the defender (in Figure 13-2) is the one having the lowest minimum cost of
all the competing mutually exclusive challengers.
To calculate the minimum cost life of an asset, we determine the EUAC for each pos-
sible life less than or equal to the useful life. As illustrated in Example 13-1, the EUAC
tends to be high if the asset is kept only a few years; then it decreases to some minimum
value, and then increases again as the asset ages. By identifying the number of years at
which the EUAC is a minimum and then keeping the asset for that number of years, we are
minimizing the yearly cost of ownership.

EXAMPLE 13–1

A piece of machinery costs $7500 and has no salvage value after it is installed. The manufacturer’s
warranty will pay the first year’s maintenance and repair costs. In the second year, maintenance
costs will be $900, and they will increase on a $900 arithmetic gradient in subsequent years.
Also, operating expenses for the machinery will be $500 the first year and will increase on a $400
arithmetic gradient in the following years. If interest is 8%, compute the machinery’s economic
life that minimizes the EUAC. That is, find its minimum cost life.

SOLUTION

If Retired at the End of Year n

EUAC of Capital EUAC of Maintenance EUAC of

Recovery Costs: and Repair Costs: Operating Costs: EUAC
Year, n $7500(A/P, 8%, n) $900(A/G, 8%, n) $500 + $400(A/G, 8%, n) Total

1 $8100 $ 0 $ 500 $8600

2 4206 433 692 5331
3 2910 854 880 4644
4 2264 1264 1062 4589←
5 1878 1661 1238 4779
6 1622 2048 1410 5081
7 1440 2425 1578 5443
8 1305 2789 1740 5834
9 1200 3142 1896 6239
10 1117 3484 2048 6650
11 1050 3816 2196 7063
12 995 4136 2338 7470
13 948 4446 2476 7871
14 909 4746 2609 8265
15 876 5035 2738 8648

The total EUAC data are plotted in Figure 13-3. From either the tabulation or the figure, we see
that the machinery’s minimum cost life is 4 years, with a minimum EUAC of $4589 for each of
those 4 years.
446 CHAPTER 13: REPLACEMENT ANALYSIS

$11,000
10,000
9,000
8,000
7,000 Total EUAC
6,000
Cost

5,000 EUAC of Maintenance and

Repair
4,000
EUAC of Capital
3,000 Recovery EUAC of Operating

2,000
1,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Year
FIGURE 13–3 Plot of costs for Example 13-1.

Looking at Figure 13-3 a bit more closely, we see the effects of each of the individ-
ual cost components on total EUAC (capital recovery, maintenance/repair, and operating
expense EUACs) and how they behave over time. The total EUAC curve of most assets
tends to follow this concave shape—high at the beginning due to capital recovery costs and
high at the end due to increased maintenance/repair and operating expenses. The minimum
EUAC occurs somewhere between these high points.
Like many pieces of installed equipment, the item considered in Example 13-1 had
no salvage value. However, some assets, like your car, can easily be sold for a value that
depends on the car’s age and condition. Another possible complication is that repair costs
may be reduced in early years by a warranty. The resulting cost curves will look like Figure
13-3, but the calculations are more work and a spreadsheet is very helpful. Example 13-11
in the last section of this chapter illustrates finding the minimum cost life for a new vehicle
using spreadsheets.

DEFENDER’S MARGINAL COST DATA

Once the basic participants in the defender–challenger comparison have been identified
(see Figure 13-1), two specific questions regarding marginal costs must be answered: Do we
have marginal cost data for the defender? and Are the defender’s marginal costs increasing
on a year-to-year basis? Let us first define marginal cost and then discuss why it is important
to answer these two questions.
Marginal costs, as opposed to an EUAC, are the year-by-year costs of keeping an
asset. Therefore, the “period” of any yearly marginal cost of ownership is always 1 year.
In our analysis, marginal cost is compared with EUAC, which is an end-of-year cash flow.
Therefore, the marginal cost is also calculated as end-of-year cash flow.
On the other hand, an EUAC can apply to any number of consecutive years. Thus, the
marginal cost of ownership for any year in an asset’s life is the cost for that year only. In
replacement problems, the total marginal cost for any year can include the capital recovery
 Defender’s Marginal Cost Data 447

cost (loss in market value and lost interest for the year), yearly operating and maintenance
costs, yearly taxes and insurance, and any other expense that occurs during that year. To
calculate an asset’s yearly marginal cost of ownership, it is necessary to have estimates of
an asset’s market value on a year-to-year basis over its useful life, as well as ordinary yearly
expenses. Example 13-2 illustrates how total marginal cost can be calculated for an asset.

EXAMPLE 13–2

A new piece of production machinery has the following costs.

Investment cost = $25, 000
Annual operating and maintenance cost = $2000 in Year 1 and then increasing by
$500 per year
Annual cost for risk of breakdown = $5000 per year for 3 years, then
increasing by $1500 per year
Useful life = 7 years
MARR = 15%
Calculate the marginal cost of keeping this asset over its useful life.

SOLUTION
From the problem data we can easily find the marginal costs for O&M and risk of breakdowns.
However, to calculate the marginal capital recovery cost, we need estimates of each year’s market
value.
Year Market Value

1 $18,000
2 13,000
3 9,000
4 6,000
5 4,000
6 3,000
7 2,500

We can now calculate the machinery’s marginal cost (year-to-year cost of ownership) over its
7-year useful life.
Cost of Total
O&M Breakdown Marginal
Loss in Market Interest Cost in Risk Cost
Year, n Value in Year n in Year n Year n in Year n in Year n

1 $25,000 − 18,000 = $7000 $25,000(0.15) = $3750 $2000 $ 5,000 $17,750

2 18,000 − 13,000 = 5000 18,000(0.15) = 2700 2500 5,000 15,200
3 13,000 − 9,000 = 4000 13,000(0.15) = 1950 3000 5,000 13,950
4 9,000 − 6,000 = 3000 9,000(0.15) = 1350 3500 6,500 14,350
5 6,000 − 4,000 = 2000 6,000(0.15) = 900 4000 8,000 14,900
6 4,000 − 3,000 = 1000 4,000(0.15) = 600 4500 9,500 15,600
7 3,000 − 2,500 = 500 3,000(0.15) = 450 5000 11,000 16,950

Notice that each year’s total marginal cost includes loss in market value, interest, O&M cost,
and cost for risk of breakdowns. For example, the Year-5 marginal cost of $14,900 is calculated
as 2000 + 900 + 4000 + 8000.
448 CHAPTER 13: REPLACEMENT ANALYSIS

Do We Have Marginal Cost Data for the Defender?

Our decision map indicates that it is necessary to know whether marginal cost data are
available for the defender asset to determine the appropriate replacement technique to use.
Usually in engineering economic problems, annual savings and expenses are given for all
alternatives. However, as in Example 13-2, it is also necessary to have year-to-year salvage
value estimates to calculate total marginal costs. If the total marginal costs for the defender
can be calculated, and if the data are increasing from year to year, then replacement analysis
technique 1 should be used to compare the defender to the challenger.

Are These Marginal Costs Increasing?

We have seen that it is important to know whether the marginal cost for the defender is
increasing from year to year. This is determined by inspecting the total marginal cost of
ownership of the defender over its remaining life. In most replacement analyses the defender
is nearing the end of its economic life. The question usually is, Should we replace it now,
next year, or perhaps the year after? In the early years of an asset’s life we rarely ana-
lyze whether it is time for replacement. Thus, the defender’s marginal costs are usually
increasing, as shown in Example 13-3.

EXAMPLE 13–3

An asset purchased 5 years ago for $75,000 can be sold today for $15,000. Operating expenses
will be $10,000 this year, but these will increase by $1500 per year. It is estimated that the asset’s
market value will decrease by $1000 per year over the next 5 years. If the MARR used by the
company is 15%, calculate the total marginal cost of ownership of this old asset (that is, the
defender) for each of the next 5 years.

SOLUTION
We calculate the total marginal cost of maintaining the old asset for the next 5-year period as
follows:
Operating Marginal
Loss in Market Interest Cost Cost in
Year, n Value in Year n in Year n in Year n Year n

1 $15,000 − 14,000 = $1000 $15,000(0.15) = $2250 $10,000 $13,250

2 14,000 − 13,000 = 1000 14,000(0.15) = 2100 11,500 14,600
3 13,000 − 12,000 = 1000 13,000(0.15) = 1950 13,000 15,950
4 12,000 − 11,000 = 1000 12,000(0.15) = 1800 14,500 17,300
5 11,000 − 10,000 = 1000 11,000(0.15) = 1650 16,000 18,650

We can see that marginal costs increase in each subsequent year of ownership.
When the condition of increasing marginal costs for the defender has been met,
then the defender–challenger comparison should be made with replacement analysis
technique 1.
 Replacement Analysis Technique 1 449

REPLACEMENT ANALYSIS TECHNIQUE 1: DEFENDER MARGINAL COSTS CAN BE

COMPUTED AND ARE INCREASING

When our first method of analyzing the defender asset against the best available chal-
lenger is used, the basic comparison involves the defender’s marginal cost data and the
challenger’s minimum cost life data.
When the defender’s marginal cost is increasing from year to year, we will maintain
that defender as long as the marginal cost of keeping it one more year is less than the
challenger’s minimum EUAC. Thus our decision rule is as follows:
Maintain the defender as long as the marginal cost of ownership for one more year is less
than the challenger’s minimum EUAC. When the defender’s marginal cost becomes greater
than the challenger’s minimum EUAC, then replace the defender with the challenger.

One can see that this technique assumes that the current best challenger, with its
minimum EUAC, will be available and unchanged in the future. However, it is easy to
update a replacement analysis when marginal costs for the defender change or when there
is a change in the cost and/or performance of available challengers. Example 13-4 illustrates
the use of this technique for comparing defender and challenger assets.

EXAMPLE 13–4

Taking the machinery in Example 13-2 as the challenger and the machinery in Example 13-3 as
the defender, use replacement analysis technique 1 to determine when, if at all, a replacement
decision should be made.

SOLUTION
Replacement analysis technique 1 should be used only in the condition of increasing marginal
costs for the defender. Since these marginal costs are increasing for the defender (from Example
13-3), we can proceed by comparing defender marginal costs against the minimum EUAC of the
challenger asset. In Example 13-2 we calculated only the marginal costs of the challenger; thus
it is necessary to calculate the challenger’s minimum EUAC. The EUAC of keeping this asset
for each year of its useful life is worked out as follows.

Challenger
Total Marginal Present Cost if Kept EUAC if Kept
Year, n Cost in Year n Through Year n (PCn ) Through Year n

1 $17,750 [17,750(P /F ,15%, 1)] × (A /P ,15%, 1) = $17,750

2 15,200 PC1 + 15,200(P /F ,15%, 2) × (A /P ,15%, 2) = 16,560
3 13,950 PC2 + 13,950(P /F ,15%, 3) × (A /P ,15%, 3) = 15,810
4 14,350 PC3 + 14,350(P /F ,15%, 4) × (A /P ,15%, 4) = 15,520
5 14,900 PC4 + 14,900(P /F ,15%, 5) × (A /P ,15%, 5) = 15,430
6 15,600 PC5 + 15,600(P /F ,15%, 6) × (A /P ,15%, 6) = 15,450
7 16,950 PC6 + 16,950(P /F ,15%, 7) × (A /P ,15%, 7) = 15,580
450 CHAPTER 13: REPLACEMENT ANALYSIS

A minimum EUAC of $15,430 is attained for the challenger at Year 5, which is the challenger’s
minimum cost life. We proceed by comparing this value against the marginal costs of the defender
from Example 13-3:
Defender Total
Marginal Cost Challenger Comparison
Year, n in Year n Minimum EUAC Result and Recommendation

1 $13,250 $15,430 Since $13,250 is less than $15,430,

keep defender.
2 14,600 15,430 Since $14,600 is less than $15,430,
keep defender.
3 15,950 15,430 Since $15,950 is greater than $15,430,
replace defender.
4 17,300
5 18,650

Based on the data given for the challenger and for the defender, we would keep the defender for
2 more years and then replace it with the challenger because at that point the defender’s marginal
cost of another year of ownership would be greater than the challenger’s minimum EUAC.

REPLACEMENT REPEATABILITY ASSUMPTIONS

The decision to use the challenger’s minimum EUAC reflects two assumptions: the best
challenger will be available “with the same minimum EUAC” in the future; and the period
of needed service is indefinitely long. In other words, we assume that once the decision
has been made to replace, there will be an indefinite cycle of replacement with the current
best challenger asset.These assumptions must be satisfied for our calculations to be correct
into an indefinite future. However, because the near future is economically more important
than the distant future, and because our analysis is done with the best data currently avail-
able, our results and recommendations are robust or stable for reasonable changes in the
estimated data.
The repeatability assumptions together are much like the repeatability assumptions that
allowed us to use the annual cost method to compare competing alternatives with different
useful lives. Taken together, we call these the replacement repeatability assumptions.
They allow us to greatly simplify comparing the defender and the challenger.
Stated formally, these two assumptions are:
1. The 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. Any challengers put into service
will also be replaced with the same currently available challenger.
2. The period of needed service of the asset is indefinitely long. Thus the challenger
asset, once put into service, will continuously replace itself in repeating cycles.
If these two assumptions are satisfied completely, then our calculations are exact.
Often, however, future challengers represent further improvements so that Assumption 1
 Replacement Analysis Technique 2 451

is not satisfied. While the calculations are no longer exact, the repeatability assumptions
allow us to make the best decision we can with the data we have.
If the defender’s marginal cost is increasing, once it rises above the challenger’s
minimum EUAC, it will continue to be greater. Under the repeatability assumptions, we
would never want to incur a defender’s marginal cost that was greater than the challenger’s
minimum EUAC. Thus, we use replacement analysis technique 1 when the defender’s
marginal costs are increasing.

REPLACEMENT ANALYSIS TECHNIQUE 2: DEFENDER MARGINAL COSTS CAN BE

COMPUTED AND ARE NOT INCREASING

If the defender’s marginal costs do not increase, we have no guarantee that replacement
analysis technique 1 will produce the alternative that is of the greatest economic advan-
tage. Consider the new asset in Example 13-2, which has marginal costs that begin at a
high of $17,750, then decrease over the next years to a low of $13,950, and then increase
thereafter to $16,950 in Year 7. If evaluated one year after implementation, the asset would
not have increasing marginal costs. Defenders in their early stages typically do not fit
the requirements of replacement analysis technique 1. In the situation graphed in Figure
13-3, such defender assets would be in the downward slope of a concave marginal cost
curve.
Example 13-5 details why replacement analysis technique 1 cannot be applied when
defenders do not have consistently increasing marginal cost curves. Instead we apply
replacement analysis technique 2. That is, we calculate the defender’s minimum EUAC
to see whether the replacement should occur immediately. If not, as shown in Example 13-
5, the replacement occurs after the defender’s minimum cost life when the marginal costs
are increasing. Then replacement analysis technique 1 applies again.

EXAMPLE 13–5
Let us look again at the defender and challenger assets in Example 13-4. This time let us arbitrarily
change the defender’s marginal costs for its 5-year useful life. Now when, if at all, should the
defender be replaced with the challenger?
Defender Total Marginal
Year, n Cost in Year n

1 $16,000
2 14,000
3 13,500
4 15,300
5 17,500

SOLUTION
In this case the defender’s total marginal costs are not consistently increasing from year to year.
However, if we ignore this fact and apply replacement analysis technique 1, the recommendation
would be to replace the defender now, because the defender’s marginal cost for the first year
452 CHAPTER 13: REPLACEMENT ANALYSIS

($16,000) is greater than the minimum EUAC of the challenger ($15,430). This would be the
wrong choice.
Since the defender’s marginal costs are below the challenger’s minimum EUAC in the second
through fourth years, we must calculate the EUAC of keeping the defender asset in each of its
remaining 5 years, at i = 15%.
Present Cost if Kept EUAC if
Year, n n Years (PCn ) Kept n Years

1 16,000(P/F, 15%, 1) × (A/ P, 15%, 1) = $16,000

2 PC1 + 14,000(P/F, 15%, 2) × (A/ P, 15%, 2) = 15,070
3 PC2 + 13,500(P/F, 15%, 3) × (A/ P, 15%, 3) = 14,618
4 PC3 + 15,300(P/F, 15%, 4) × (A/ P, 15%, 4) = 14,754
5 PC4 + 17,500(P/F, 15%, 5) × (A/ P, 15%, 5) = 15,162

The minimum EUAC of the defender for 3 years is $14,618, which is less than that
of the challenger’s minimum EUAC of $15,430. Thus, under the replacement repeatability
assumptions, we will keep the defender for at least 3 years. We must still decide how much
longer.
The defender’s EUAC begins to rise in Year 4, because the marginal costs are increas-
ing, and because they are above the defender’s minimum EUAC. Thus, we can use
replacement analysis technique 1 for Year 4 and later. The defender’s marginal cost in Year
4 is $15,300, which is $130 below the challenger’s minimum EUAC of $15,430. Since the
defender’s marginal cost of $17,500 is higher in Year 5, we replace it with the new chal-
lenger at the end of Year 4. Notice that we did not keep the defender for its minimum cost
life of 3 years, we kept it for 4 years.
If the challenger’s minimum EUAC were less than the defender’s minimum EUAC of
$14,618, then the defender would be immediately replaced.
Example 13-5 illustrates several potentially confusing points about replacement
analysis.
• If the defender’s marginal cost data is not increasing, the defender’s minimum EUAC
must be calculated.
• If the defender’s minimum EUAC exceeds the challenger’s minimum EUAC, then
replace immediately. If the defender’s minimum EUAC is lower than the challenger’s
minimum EUAC, then under the replacement repeatability assumptions the defender
will be kept at least the number of years for its minimum EUAC.
• After this number of years, then replace when the defender’s increasing marginal
cost exceeds the challenger’s minimum EUAC.
The problem statement for Example 13-6 illustrates a second approach to calculating
the defender’s marginal costs for its capital costs. The value at the year’s beginning is mul-
tiplied by (1 + i) and the salvage value at the year’s end is subtracted. Each year’s total
marginal cost also includes the operations and maintenance costs.
Then the solution to Example 13-6 details the calculation of the minimum EUAC when
the defender’s data is presented as costs and salvage values in each year rather than as
marginal costs. Notice that this is calculated the same way as the minimum cost life was
calculated for new assets—the challengers.
 Replacement Analysis Technique 2 453

EXAMPLE 13–6

A 5-year-old machine, whose current market value is $5000, is being analyzed to determine
its minimum EUAC at a 10% interest rate. Salvage value and maintenance estimates and the
corresponding marginal costs are given in the following table.
Data Calculating Marginal Costs

Salvage O&M Marginal

Year Value Cost St-1 (1 + i ) –St Cost

0 $5000
1 4000 $ 0 $5500 $–4000 $1500
2 3500 100 4400 –3500 1000
3 3000 200 3850 –3000 1050
4 2500 300 3300 –2500 1100
5 2000 400 2750 –2000 1150
6 2000 500 2200 –2000 700
7 2000 600 2200 –2000 800
8 2000 700 2200 –2000 900
9 2000 800 2200 –2000 1000
10 2000 900 2200 –2000 1100
11 2000 1000 2200 –2000 1200

SOLUTION
Because the marginal costs have a complex, nonincreasing pattern, we must calculate the
defender’s minimum EUAC.
If Retired at End of Year n
Salvage EUAC of
Value (S) Capital EUAC of
Years at End of Maintenance Recovery (P− S) × Maintenance Total
Kept, n Year n Cost for Year (A/P, 10%, n) + Si 100( A/G, 10%,n) EUAC

0 P = $5000
1 4000 $ 0 $1100 + 400 $ 0 $1500
2 3500 100 864 + 350 48 1262
3 3000 200 804 + 300 94 1198
4 2500 300 789 + 250 138 1177
5 2000 400 791 + 200 181 1172
6 2000 500 689 + 200 222 1111
7 2000 600 616 + 200 262 1078
8 2000 700 562 + 200 300 1062
9 2000 800 521 + 200 337 1058←
10 2000 900 488 + 200 372 1060
11 2000 1000 462 + 200 406 1068

A minimum EUAC of $1058 is computed at Year 9 for the existing machine. Notice that the EUAC
begins to increase with n when the marginal cost in Year 10 exceeds the EUAC for 9 years.
454 CHAPTER 13: REPLACEMENT ANALYSIS

Now to apply replacement analysis technique 2 to Example 13-6, we ask: Is the chal-
lenger’s minimum EUAC higher or lower than the defender’s minimum EUAC of $1058?
If the challenger’s minimum EUAC is lower, then we replace the defender now.
Under the repeatability assumptions, if the challenger’s minimum EUAC is higher, we
would keep the defender at least 9 years. Replacement would occur in Year 10 or later
when the defender’s marginal costs exceed the challenger’s minimum EUAC. Relaxing
the repeatability assumptions to allow for better challengers, we may replace the defender
whenever a new challenger has an EUAC that is lower than $1058.
Example 13-7 illustrates the common situation of a current defender that may be kept
if overhauled. This can also be analyzed as a potential new challenger.

EXAMPLE 13–7

We must decide whether existing (defender) equipment in an industrial plant should be

replaced. A $4000 overhaul must be done now if the equipment is to be retained in service.
Maintenance is $1800 in each of the next 2 years, after which it increases by $1000 each year.
The defender has no present or future salvage value. The equipment described in Example 13-1 is
the challenger (EUAC = $4589). Should the defender be kept or replaced if the interest rate is 8%?
FIGURE 13–4 Overhaul and maintenance costs for the
0 1 2 3 4 5
defender in Example 13-7.

1800 1800
2800
4000 3800
4800

SOLUTION
The first step is to determine the defender’s lowest EUAC. The pattern of overhaul and mainte-
nance costs (Figure 13-4) suggests that if the overhaul is done, the equipment should be kept for
several years. The computation is as follows:
If Retired at End of Year n

EUAC of Overhaul EUAC of Maintenance $1800 + $1000

Year, n $4000(A/P, 8%, n) Gradient from Year 3 on Total EUAC

1 $4320 $1800 $6120

2 2243 1800 4043
3 1552 1800 + 308* 3660←
4 1208 1800 + 683† 3691
5 1002 1800 + 1079 3881
∗ Forthe first 3 years, the maintenance is $1800, $1800, and $2800. Thus,
EUAC = 1800 + 1000(A/F, 8%, 3) = 1800 + 308.
†
EUAC = 1800+1000(P/G, 8%, 3)(P/F, 8%, 1)(A/ P, 8%, 4) = 1800+683.
 Replacement Analysis Technique 3 455

The lowest EUAC of the overhauled defender is $3660. In Example 13-1, the challenger’s
minimum cost life was 4 years with an EUAC of $4589. If we assume the equipment is needed
for at least 4 years, the overhauled defender’s EUAC ($3660) is less than the challenger’s EUAC
($4589). Overhaul the defender.
If the defender’s and challenger’s cost data do not change, we can use replacement analysis
technique 1 to determine when the overhauled defender should be replaced. We know from the
minimum EUAC calculation that the defender should be kept at least 3 years. Is this the best
life? The following table computes the marginal cost to answer this question.

Year, n Overhaul Cost Maintenance Cost Marginal Cost to Extend Service

0 $4000 $ 0
1 0 1800 $6120 = 4000(1.08) + 1800
2 0 1800 1800
3 0 2800 2800
4 0 3800 3800
5 0 4800 4800

Year 5 is the first year after Year 3, which has the overhauled defender’s lowest EUAC
(in which the $4800 marginal cost exceeds the challenger’s $4589 minimum EUAC). Thus,
the overhauled defender should be kept 4 more years if costs do not change. (Note that if the
defender can be overhauled again after 3 or 4 years, that might be an even better choice.)

REPLACEMENT ANALYSIS TECHNIQUE 3: WHEN DEFENDER MARGINAL COST

DATA ARE NOT AVAILABLE

In our third case, we simply compare the defender’s EUAC over its stated useful life, and
the challenger’s minimum EUAC. Pick the EUAC that is lower.
If the defender’s marginal cost data is not known and cannot be estimated, it is
impossible to apply replacement analysis techniques 1 or 2 to decide when the defender
should be replaced. Instead we must assume that the defender’s stated useful life is the only
one to consider. From a student problem-solving perspective, the defender in Example 13-7
might be described as follows.
The defender can be overhauled for $4800 to extend its life for 5 years. Maintenance
costs will average $3000 per year, and there will be no salvage value. In this case the only
possibility is to compare the defender’s EUAC for a 5-year life with the best challenger.
In the real world, the most likely scenario for this approach involves a facility-wide
overhaul every 3, 5, 10, etc. years. Pipelines and many process plants, such as refineries,
chemical plants, and steel mills, must shut down to do major maintenance. All equipment
is overhauled or replaced with a new challenger as needed, and the facility is expected to
operate until the next maintenance shutdown.
The defender’s EUAC over its remaining useful life is compared with the challenger’s
EUAC at its minimum cost life, and the lower cost is chosen. However, in making this
basic comparison an often complicating factor is deciding what first cost to assign to the
challenger and the defender.