Replacement studies

Type of Costs
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 Fixed Costs

 Variable Costs

 Increment Costs

 Marginal Costs

 Sunk Cost
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Reasons for Replacement:

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Reasons for Replacement:

 Decrease in Physical Efficiency

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Reasons for Replacement:

 Decrease in Physical Efficiency

 Obsolescence
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Instances of Replacement Analysis:

Replacement due to constantly increasing

maintenance cost
 Replacement due to declining efficiency
 Replacement due to inadequacy
 Replacement due to obsolescence
 Replacement due to a combination of causes
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Defender: it is the existing asset which is being

considered for replacement

Challenger: this is the asset which is proposed to

replace the existing asset
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Sunk
  Cost due to Unamortized Value
 Example 1
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 An existing factory must be enlarged or replaced to

accommodate new production machinery. The structure was
built at a cost of P2.6 million. Its present book value, based on
straight line depreciation is P700,000 but it has been appraised
at P800,000. If the stricture is altered, the cost will be P1.6
million and its service life will be extended 8 years with a
salvage value of P600,000. A new factory could be purchased or
built for P5 million. It would have a life of 20 years and a salvage
value of P700,000. Annual maintenance of the new building
would be P160,000 compared with P100,000 in the enlarged
structure. However, the improved layout in the new building
would reduce annual production cost by P240,000. All other
expenses for the new structure are estimated as being equal.
Using an investment rate of 8 percent, determine which is the
more attractive investment for this firm.
 Example 2
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 A car can be purchased for P600,000 when new. There follows

a schedule of annual operating expenses for each year and
trade-in values at the end of each year. Assume that these
amounts would be repeated for future replacements, and that
the car will not be kept more than 3 years. If interest on invested
capital is 15% before taxes, determine which year’s end the car
should be replaced so that cost will be minimized.
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   If P is the first cost, B the annual

operating cost for the first year which increases
by a uniform gradient amount G every year
thereafter, n the life in years of an asset, and
salvage value zero, then , the life of the asset
for minimum annual cost is:
 Example
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 A recapping plant is planning to acquire a new Diesel

generating set to replace its present unit which they run
during brownouts. The new set would cost P135,000
with a five year life and no estimated salvage value.
Variable cost would be P150,000 a year.
 The present generating set has a book value of P75,000
and a remaining life of 5 years. Its disposal value now is
P7,500 but it would be zero after 5 years. Variable
operating cost would be P187,500 a year. Money is
worth 10%.
 Which is profitable, to buy the new generator set or
retain the present set?
 Example
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 It is desired to determine the present economic

value of an old machine by considering of how it
compares with the best modern machine that could
replace it. The old machine is expected to require
out of pocket costs of P85,000 each year for 4 years
and then be scrapped for P5,000 residual value. The
new machine requires an investment of P40,000 and
would have out of pocket costs of P79,000 a year for
8 years and then zero salvage value. Invested
capital should earn a minimum return of 15% before
taxes. Determine the present value of the old
machine.
 Example
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 A company has a machine for which it spends P18,000 a
year for operation and maintenance. If sold now it can
bring P12,000. If it is continued in service it is expected to
last for 10 more years, at which time its salvage value will
be zero. Another plan is to overhaul the machine at a cost
of P8,000 which is expected to reduce annual
disbursements toP15,000. Its economic life is expected to
be also 10 years with a salvage value of P2,000.
Alternatively, a new machine can be purchased for
P45,000 which is expected to reduce annual operation and
maintenance to P10,000 for a life of 10 years, at which
time the salvage value is expected to be P10,000. If money
is worth 15% to the company, which alternative would you
recommend?
 Example
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 An existing highway bridge has been found inadequate

for present day heavier loads. Two alternatives are
available: strengthen the bridge at a cost of P120,000 or
replace it with a modern bridge of sufficient capacity at a
cost of P640,000. The present salvage value of the old
bridge is P75,000 and it is expected to last 5 years after
which it has to be replaced. At the end of that time, the
old bridge will have a salvage value of P45,000. To
maintain the safety of the old bridge P2,500 is needed
each year. The new bridge is expected to last 25 years
and will have a salvage value of P60,000. Depreciation
is on the straight line basis with the average interest at
8%. Which alternative is more economical?
 Example
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Average
   interest with salvage value: