After completing chapter 4, students should be able to :

Identify principles and approach used in replacement analysis. Determine the economic life of an asset. Conduct a replacement analysis to select between existing asset (Defender) and its challenger. Conduct one year retention analysis.

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Why need replacement?

Performance of machine/equipment has deteriorated. Requirements has changed. Development of new technology.

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Approach used in analysis: Latest information Sunk cost New facility (Challenger) and existing facility (Defender)

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Annual worth of all costs Total capital recovery is the annual worth of the first investment and salvage value. Operation annual cost. Total annual worth = - (Total capital recovery) (annual worth of capital cost)
cost

Total annual worth

Annual operation cost Total capital recovery Economic life Years

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Example 4.1 i = 12%

Year (j) 0 1 2 3 4 5 Market value at year j (RM) 100,000 80,000 60,000 45,000 25,000 0 5,000 6,000 7,000 8,000 9,000 Operation cost at year j (RM)

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Solution: Cash flow diagram if asset is used for : b. 2 years only c. 3 years

a. 1 year only only

d. 4 years only

e. 5 years

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Year (j) 1 2 3 4 5

Capital recovery (RM) -100,000(A/P,0.12,1) + 80,000(A/F,0.12,1) = 32,000 -100,000(A/P,0.12,2) + 60,000(A/F,0.12,2) = 30868 -100,000(A/P,0.12,3) + 45,000(A/F,0.12,3) = 28,299.25 -100,000(A/P,0.12,4) + 25,000(A/F,0.12,4) = 28,299.25 -100,000(A/P,0.12,5) + 0 = 27,741

Annual operation cost (RM) 5,000 5,000 + 1,000(A/G,0.12,2) = 5,471.86 5,000 + 1,000(A/G,0.12,3) = 5,924.78 5,000 + 1,000(A/G,0.12,4) = 6,358.85 5,000 + 1,000(A/G,0.12,5) = 6,774.60

Total cost (RM) 37,000 38,339.90 34,224 *34,051.10 34,515.60

Economic life is 4 years

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Consultant approach Example 4.2 - Decision between selling existing vehicle and renting. - Existing vehicle was bought 5 years ago at the price of RM60,000. - Useful life is 10 more years only. - Salvage value is RM5,000 - Operation cost is RM15,000 per year. - If vehicle is sold now, market value is RM40,000 - Renting a vehicle will cost RM15,000 a year and the cost of petrol is RM9,000 a year Determine if the company should keep the existing vehicle or sell it and rent another vehicle if growth rate is 15% and the vehicle is required for 10 more years.

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Solution: a. Cash flow diagram if vehicle is retained.

Aretain = -40,000(A/P,0.15,10) 15,000 + 5,000(A/F,0.15,10) = -40,000(0.19925) 15,000 + 5,000(0.04925) = -22,723

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b. Cash flow diagram if rent.

Arent = -24,000 Aretain < Arent

Notes: Consultant approach latest data Market value is RM40,000. Machine value (price) RM60,000 is considered as sunk cost.

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Cash flow approach Example 4.3 Refer to example 4.2 Solution: a. Cash flow diagram if vehicle is retained

Aretain

= -15,000 + 5,000(A/F,0.15,10) = -15,000 + 5,000(0.04925) = -14,753

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b. Cash flow diagram if rent

Arent

= 40,000 (A/P,0.15,10) -24,000 = 40,000(0.19925) 24,000 = -16,030 Aretain < Arent

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Example 4.4
Defender Machine cost (RM) Operation cost (RM) Salvage value (RM) Life (Year) * 3,000 1,000 5 Challenger X 10,000 1,500 2,000 5 Challenger Y 20,000 1,000 1,000 5

* Challenger X trade-in value for defender is RM4,000 and Challenger Y trade-in value for defender is RM3,000 Determine the decision that should be made.

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Solution : Cash flow diagram for:

a. Defender S

b. Challenger X

c. Challenger Y

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Incremental Analysis:
Cash flow diagram for X-S

Reject X, accept S

Cash flow diagram for Y-S

Reject Y, accept S

It is more economical to keep existing machine S (defender)

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OR Cash flow diagram for Defender

AS = -3,000 + 1,000(A/F,0.25,5) = -3,000 + 1,000(0.12185) = -2878.15

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Cash flow diagram of Challenger X

AX = -6,000(A/P,0.25,5) 1,500 + 2,000(A/F,0.25,5) = -6,000(0.37185) 1,500 + 2,000(0.12185) = -3,487

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Cash flow diagram of Challenger Y

AY = -17,000(A/P,0.25,5) 1,000 + 1,000(A/F,0.25,5) = -17,000(0.37185) 1,000 + 1,000(0.12185) = -7,199 AY > AX > AS,
Select Defender

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When an asset near the end of its useful life. Example 4.5 a. Machine L - Bought 5 years ago and it is expected that it may be used for 3 more years. - Current market value is RM40,000 - If it is retained for 1 more year, operation cost is RM45,000 - Salvage value after 1 year is RM30,000 b. Machine P - Capable of replacing machine L - Useful life of machine P is 5 years with a first cost of RM90,000 and annual operation cost of RM40,000 - Salvage value is RM20,000 Should machine L be used for 1 more year if MARR is 25%.

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Solution a. If retain machine L for 1 more year

AL

= -40,000(A/P,0.25,1) 15,000(A/F,0.25,1) = -40,000(1.25) 15,000(1.00) = -65,000

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b. If buy machine P

AP

= -90,000(A/P, 0.25,5) 40,000 + 20,000(A/F,0.25,5) = -90,000(0.37185) 40,000 + 20,000(0.12185) = -71,029

AP > A L Retain machine L for 1 more year

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Analysis
One year retention -To decide if Defender should be retained for 1 more year. - A1=annual worth if Defender is used 1 more year and Achallenger= annual worth of challenger for its entire useful life. -If A1 < AChallenger, use Defender 1 more year. -If A1 > AChallenger, replace Defender with Challenger now.

Economic life -To determine estimated life where costs are at minimum. -Calculate A if use 1 year, 2 years and so on until (m+1) years where Am+1>Am<Am-1 -Economic life is m years.

Replacement -To determine if defender should be replaced with challenger. - If ADefender>Achallenger, retain Defender. -If ADefender<AChallenger , replace defender with challenger

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