IE 343 Engineering Economics

Lecture 34: Chapter 9 – Replacement

Analysis
Instructor: Tian Ni
Nov.18, 2011

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 Foreign Exchange Rates and
Purchasing Power Concepts

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Foreign Exchange Rates & Purchasing Power
We have already known that the inflation/deflation
will affect your purchasing power.
When doing international trading between
countries, changes in exchange rates will also affect
your purchasing power.

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Foreign Exchange Rates - Simple Example
If one dollar goes from being worth 1.0 euros to 0.8
euros (in this situation the dollar is weakening),
1,000 euros worth of goods from a European
company that previously cost a U.S. purchaser
$1,000 must now be bought for 1,000 euros / 0.8 =
$1,250.
The purchasing power of the U.S. purchaser is
reduced due to the weaken of U.S. to euros
exchange rate.(from 1 dollar:1.0 euros to 1
dollar:0.8 euros)

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 Foreign Exchange Rates VS Inflation
Changes in the exchange rate between two
currencies over time are analogous to changes in the
general inflation rate because the relative
purchasing power between the two currencies is
changing similar to the relative purchasing power
between actual dollar amounts and real dollar
amounts.

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 Foreign Exchange Rates – Terminology
ius = rate of return in terms of a market interest rate
relative to US dollars
ifm = rate of return in terms of a market interest rate
relative to the currency of a foreign country
fe = annual devaluation rate between foreign
currency and US dollar
 If fe positive, foreign currency devalued relative to US
dollar
 If fe negative, US dollar devalued relative to foreign
currency

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 Foreign Exchange Rates VS Inflation
In inflation/deflation we have the relationship for ir,
im and f
1 + im
1 + im = (1 + f )(1 + ir ) => 1 + ir =
1+ f

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 Foreign Exchange Rates VS Inflation
In foreign exchange rates, we have a similar
relationship between ius, ifm and fe
1 + i fm
1 + i fm = (1 + ius )(1 + f e ) => 1 + ius =
1 + fe
or i fm = ius + f e + f e (ius )
i fm − f e
or ius =
1 + fe

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 Example 8.5 – Textbook 8-11
The monetary (currency) unit of another country, A,
has a present exchange rate of 10.7 units per U.S.
dollar.
(a) If the average devaluation of currency A in the
international market is estimated to be 4.2% per
year (for the next five years) relative to the U.S.
dollar, what would be the exchange rate three years
from now?

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 Example 8.5 – Textbook 8-11
(a) If the average devaluation of currency A in the
international market is estimated to be 4.2% per
year (for the next five years) relative to the U.S.
dollar, what would be the exchange rate three years
from now?
Solution:
(a) Currency A is devaluing 4.2% per year.
So one US dollar should be exchanged for 4.2%
more of the Currency A. So after three years the
exchange rate = 10.7(1.042)3 = 12.106 units of
Currency A per U.S. dollar.
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 Example 8.5 – Textbook 8-11
(b) If the average devaluation of the U.S. dollar (for
the next five years) is estimated to be 3% per year
relative to currency A, what would be the exchange
rate three years from now?
Solution:
(b) fe = 3% per year, but now U.S. dollar is
devaluing 3% per year. So one U.S. dollar should be
exchanged for less Currency A per year.
So after three years the exchange rate = 10.7/(1.03)3
= 9.792 units of A per U.S. dollar.

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 Example 8.6 – Textbook 8-10
The CMOS Electronics Company is considering a
capital investment of 50M pesos in an assembly
plant located in a foreign country. Currency is
expressed in pesos, and the exchange rate is now
100 pesos per US dollar.
The country has followed a policy of devaluing its
currency against the dollar by 10% per year to build
up its export business to the United States. ATCF
are expected in the following table, states in pesos:

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 Example 8.6 – Textbook 8-10

End of Year 0 1 2 3 4 5
ATCF (Millions
of Pesos) -50 20 20 20 30 30

If CMOS Electronics requires a 15% IRR per year,

after taxes, in US dollars (ius) on its foreign
investments, should this assembly plant be
approved? Assume there’s no other risks on this
foreign investment.

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 Example 8.6 – Textbook 8-10
We know that the Pesos is devaluing fe = 10% per
year, so the Exchange Rates becomes 100(1.1) =
110 Pesos per one US dollar in year one, 100(1.21)
= 121 Pesos per one US dollar in year two, and so
on.

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 Example 8.6 – Textbook 8-10
We can justify this investment by US dollar or
Pesos
We know that After-tax MARR(in US dollar) =
15%
If we want to justify our investment by Pesos, we
need to calculate After-tax MARR(in Pesos)
 i fm = ius + f e + f e (ius )
So After-tax MARR(in Pesos) = 15% + 10% +
15%(10%) = 26.5%

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 Example 8.6 – Textbook 8-10
End of Year ATCF(Pesos) Exchange Rate ATCF(Dollars)
0 -50,000,000 100.0 Pesos per $1 -500,000
1 20,000,000 110.0 Pesos per $1 181,818
2 20,000,000 121.0 Pesos per $1 165,289
3 20,000,000 133.1 Pesos per $1 150,263
4 30,000,000 146.4 Pesos per $1 204,904
5 30,000,000 161.1 Pesos per $1 186,276
IRR in Pesos = 34.6% IRR in Dollar = 22.4%
PW(26.5%) in PW(15%) in
Pesos = 9,165,236.5 Dollar = 91,652.4

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 Example 8.6 – Textbook 8-10
This investment is justified in terms of US dollar
and After-tax MARR(in US dollar), because IRR(in
US Dollar) = 22.4% > 15%
We can also justify this investment by Pesos,
because IRR(in Pesos) = 34.6% > After-tax
MARR(in Pesos) = 26.5%
Recall the relationship between IRRus and IRRfm
IRR fm (in Pesos) − f e 0.346 − 0.1
IRRus (in dollar) = =
1 + fe 1 + 0.1
= 22.4%

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 Chapter 9 – Replacement
Analysis

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 Replacement Analysis – Key Questions?
Should a currently owned asset be
 Kept in service?
 Replaced immediately?
 Abandoned?

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 Replacement Analysis – Key Questions?
How long should we keep an asset/machine?
(economic life)
At the end of the ‘economic life’ what would it cost
us to keep the machine running for additional
amounts of time?
How do taxes influence decision making?

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 Replacement Analysis – Focus
The focus of Replacement Analysis is on answering
the question
Alternative 1: Keep the old asset –
The Defender
or
Alternative 2: Replace with a new asset(s) –
The Challenger

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 Reasons for Replacing an Asset

Why replace an asset?

Physical Impairment: deterioration of asset
Altered Requirements: New requirements for
accuracy
Technological changes: Keep track of new
technology
The replacement of assets often represents
economic opportunity for the firm.

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 Factors to consider in Replacement
Sunk Costs(ignore):
 Any past costs unaffected by future decisions
 Only considered for tax purposes
Existing Asset Value:
 Use the present realizable market value, not the book
value or formerly estimated salvage value
Economic Lives of the challenger
Remaining Life of the defender
Income Tax Considerations

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 Terminology

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 Terminologies in Replacement Studies
Defender:
 is the old asset that is being considered for replacement.
Challenger:
 is the new asset that is considered for replacing the
defender.

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 Terminologies in Replacement Studies
AW values:
 are used for both the defender and challenger.
BV:
 Book value of an asset.
MV:
 Market value of an asset.

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 Terminologies in Replacement Studies
Life Terminologies:
Useful Life*:
 the length of time that we anticipate using the asset
Ownership Life:
 Period between date of acquisition and date of disposal
by a specific owner.
Physical Life:
 Period between original acquisition and final disposal

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 Terminologies in Replacement Studies
Tax Life:
 the length of time that we can depreciate the asset.
Economic Life*:
 the length of time during which keeping the asset is
economically justifiable.
 The ESL establish the life n for the challenger and
defender.

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 Terminologies in Replacement Studies
EUAC*:
 EUAC(Equivalent Uniform Annual Cost) is frequently
used instead of AW values since often only the cost are
used in the evaluation.

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 Terminologies in Replacement Studies
Outsider viewpoint:
 We use the so-called outsider viewpoint for
approximating the investment worth of an exiting
asset(defender).
 Outsider viewpoint is the perspective that would be taken
by an impartial third party to establish the fair MV of a
used(secondhand) asset.
Present Realizable MV:
 Is the correct capital investment amount to be assigned to
an existing asset in replacement studies
 Good way to reason is to use the opportunity cost or
opportunity forgone principle
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 Before-Tax Replacement
Analysis

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Example 9.1-Before Tax Replacement Analysis
A firm owns a pressure vessel that it is
contemplating replacing. The old pressure vessel
has annual operating and maintenance expenses of
$60,000 per year and it can be kept for five more
years, at which time it will have zero market value.
It is believed that $30,000 could be obtained for the
old pressure vessel if it were sold now.
(Defender)

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Example 9.1-Before Tax Replacement Analysis
A new pressure vessel can be purchased for
$120,000. The new pressure vessel will have a
market value of $50,000 in five years and will have
annual operating and maintenance expenses of
$30,000 per year. Using a (before-tax) MARR of
20% per year, determine whether or not the old
pressure vessel should be replaced. A study period
of five years is appropriate.
(Challenger)

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 Example 9.1
From outsider viewpoint:
Invest the old pressure vessel(Defender) VS Invest
the new pressure vessel(Challenger)
Before-Tax MARR = 20.00%
Study Period = 5

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 Example 9.1
From outsider viewpoint:
Invest the old pressure vessel(Defender) VS Invest
the new pressure vessel(Challenger)
EOY, k Defender Challenger
0 -30000 -120000
1 -60000 -30000
2 -60000 -30000
3 -60000 -30000
4 -60000 -30000
5 -60000 -30000
5(MV) 0 50000

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 Example 9.1 – Solution(PW)
Solution 1: (PW)
Defender:
PW(20%) = -$30,000 - $60,000(P/A, 20%, 5) =
-$209,436
Challenger:
PW(20%) = -$120,000 - $30,000(P/A, 20%, 5) +
$50,000(P/F, 20%, 5) = -$189,624
Select the Challenger – Replace the old pressure
vessel with the new one.

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 Example 9.1 – Solution(EUAC)
Solution 2: (EUAC)
In Example 9.1 only cost is considered, EUAC is
equivalent to the negation of AW
Defender:
EUAC(20%) = $30,000(A/P, 20%, 5) + $60,000=
$70,031
Challenger:
EUAC(20%) = $120,000(A/P, 20%, 5) + $30,000 -
$50,000(A/F, 20%, 5) = $63,407
Select the Challenger.
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 Next Time …
Continue Chapter 9: Replacement Studies

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