Engineering Economy: Chapter 9: Replacement Analysis

Engineering Economy
Chapter 9: Replacement Analysis
Copyright ©2012 by Pearson Education, Inc.

Engineering Economy, Fifteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
The objective of Chapter 9 is to
address the question of whether a
currently owned asset should be
kept in service or immediately
replaced.

If you need a new machine and
don’t buy it, you pay for it
without ever getting the machine.
-Henry Ford (1922)

What to do with an existing asset?
• Keep it
• Abandon it (do not replace)
• Replace it, but keep it for backup purposes
• Augment the capacity of the asset
• Dispose of it, and replace it with another

Three reasons to consider a
change.
• Physical impairment (deterioration)
• Altered requirements
• New and improved technology is now
available.
The second and third reasons are sometimes
referred to as different categories of obsolescence.
Some important terms for
replacement analysis
• Economic life: the period of time (years) that
yields the minimum equivalent uniform annual
cost (EUAC) of owning and operating as asset.
• Ownership life: the period between acquisition and
disposal by a specific owner.
• Physical life: period between original acquisition
and final disposal over the entire life of an asset.
• Useful life: the time period an asset is kept in
productive service (primary or backup).
Replacement: past estimation errors
• Any study today is about the future—past

estimation “errors” related to the defender
are irrelevant.
• The only exception to the above is if there
are income tax implications forthcoming
that were not foreseen.

Replacement: watch out for the
sunk-cost trap
• Only present and future cash flows are
considered in replacement studies.
• Past decisions are relevant only to the extent
that they resulted in the current situation.
• Sunk costs—used here as the difference
between an asset’s BV and MV at a particular
point in time—have no relevance except to the
extent they affect income taxes.

Replacement: the outsider viewpoint
• The outsider viewpoint is the perspective taken by
an impartial third party to establish the fair MV of
the defender. Also called the opportunity cost
approach.
• The opportunity cost is the opportunity foregone
by deciding to keep an asset.
• If an upgrade of the defender is required to have a
competitive service level with the challenger, this
should be added to the present realizable MV.

Pause and Solve
You own an old “water skiing” motor boat that is a real gas
guzzler. It is 10-years old and can be sold now for $3,000 cash.
Assume its market value (MV) in 2 years will be $500. The
annual maintenance expenses are expected to be $400 into the
foreseeable future, and the boat averages only 2 miles per gallon
of fuel. Gasoline costs $5.00 per gallon, and the boat will be
used for about 200 miles per year
If you sell the old boat, you can buy a newer model boat for
$10,000. It will be under a maintenance warranty for 2 years, so
this expense is negligible. The newer boat will average 10 miles
per gallon of fuel and will have an MV of $7,000 in 2 years. Use
a 2-year study period to determine whether to replace or not?

Replacement: economic lives of the
challenger and defender
• The economic life of the challenger minimizes the
EUAC.
• The economic life of the defender is often one
year, so a proper analysis may be between
different-lived alternatives.
• The defender may be kept longer than it’s
apparent economic life as long as it’s marginal
cost is less than the minimum EUAC of the
challenger over it’s economic life.
Given below is the summary of several values of
defender and challenger. Evaluate on the basis of
EUAC, whether replacement should be made or not?

Solution

Replacement: income taxes
• Replacement often results in gains or losses

from the sale of depreciable property.
• Studies must be made on an after-tax basis
for an accurate economic analysis since this
can have a considerable effect on the
resulting decision.

Before-tax PW example
Acme owns a CNC machine that it is considering
replacing. Its current market value is $25,000, but it can
be productively used for four more years at which time
its market value will be zero. Operating and maintenance
expenses are $50,000 per year
Acme can purchase a new CNC machine, with the same
functionality as the current machine, for $90,000. In four
years the market value of the new machine is estimated
to be $45,000. Annual operating and maintenance costs
will be $35,000 per year.
Should the old CNC machine be replaced using a before-
tax MARR of 15% and a study period of four years?
Example solution
Defender
Challenger
PW of the challenger is greater than PW of the defender

(but it is close).
Proper analysis requires knowing the
economic life (minimum EUAC) of the
alternatives.
• The EUAC of a new asset can be computed
if the capital investment, annual expenses,
and year-by-year market values are known
or can be estimated.
• The difficulties in estimating these values
are encountered in most engineering
economy studies, and can be overcome in
most cases.
Finding the EUAC of the challenger
requires finding the total marginal cost
of the challenger, for each year. The
minimum such value identifies the
economic life.
This equation represents the present worth, through year k,
of total costs. (Although the sign is positive, it is a cost.
Eq. 9-1.)

Total marginal cost formula
The total marginal cost is the equivalent worth, at the
end of year k, of the increase in PW of total cost from
year k-1 to year k.
This can be simplified to (eq. 9-2)

Finding the economic life of the new
CNC machine.
Year 1 Year 2 Year 3 Year 4
O&M costs $35,000 $35,000 $35,000 $35,000
Market value $75,000 $60,000 $50,000 $45,000
Marginal costs:
O&M $35,000 $35,000 $35,000 $35,000
Depreciation $15,000 $15,000 $10,000 $5,000
Int. on capital $13,500 $11,250 $9,000 $7,500
TC $63,500 $61,250 $54,000 $47,500
Pause and solve
In a replacement analysis for an industrial saw, the
following data are known about the challenger. Initial
investment is $18,000. Annual maintenance costs begin at
the end of year three, with a cost at that time of $1,000, with
$1,000 at the end of year four, increasing by $8,600 each
year thereafter. The salvage value is $0 at all times. Using
a MARR of 10% per year, what is the economic life of the
challenger?

Cost of
Year BV Maintenance cost Depreciation MC EUAC
capital
0 18000 ----- ---- ---- ---- ----
1 0 0 18000 1800 19800 19800
2 0 0 0 0 0 10372
3 0 1000 0 0 1000 7540
4 0 1000 0 0 1000 6132 EC
5 0 8600 0 0 8600 6535
6 0 8600 0 0 8600 6802

The economic life of the defender
• If a major overhaul is needed, the life
yielding the minimum EUAC is likely the
time to the next major overhaul.
• If the MV is zero (and will be so later), and
operating expenses are expected to increase,
the economic life will the one year.
• The defender should be kept as long as its
marginal cost is less than the minimum
EUAC of the best challenger.
The defender in this case is two years old, originally cost $19,500, and
has a present realizable MV of $7,500. If kept, its MVs and annual
expenses are expected to be as follows:

Solution

Finding the economic life of the defender
CNC machine.
O&M costs $50,000 $50,000 $50,000 $50,000
Market value $15,000 $10,000 $5,000 $0

O&M $50,000 $50,000 $50,000 $50,000
Depreciation $10,000 $5,000 $5,000 $5,000
Int. on capital $3,750 $2,250 $1,500 $750
TC $63,750 $57,250 $56,500 $55,750
Replacement cautions.
• In general, if a defender is kept beyond where the TC
exceeds the minimum EUAC for the challenger, the
replacement becomes more urgent.
• Rapidly changing technology, bringing about significant
improvement in performance, can lead to postponing
replacement decisions.
• When the defender and challenger have different useful
lives, often the analysis is really to determine if now is the
time to replace the defender.
• Repeatability or cotermination can be used where
appropriate.

Abandonment is retirement without
replacement.
• For projects having positive net cash flows
(following an initial investment) and a finite
period of required service.
• Should the project be undertaken? If so, and
given market (abandonment) values for each year,
what is the best year to abandon the project?
What is its economic life?
• These are similar to determining the economic life
of an asset, but where benefits instead of costs
dominate.
• Abandon the year PW is a maximum.
Abandonment example
A machine lathe has a current market value of
$60,000 and can be kept in service for 4 more
years. With an MARR of 12%/year, when
should it be abandoned? The following data are
projected for future years.

Net receipts $50,000 $40,000 $15,000 $10,000
Market value $35,000 $20,000 $15,000 $5,000

Abandonment solution
Keep for one year
Keep for two years
Keep for three years (BEST!) Keep for four years

Active Learning 2
In a replacement analysis for a vacuum sell on a spacecraft,
the following data are known about the challenger; the initial
investment is $12,000; there is no annual maintenance cost for
the first three years, however, it will be $2,000 in each of
years four and five, and then $4,500 in the sixth year and
increasing by $2,500 each year thereafter. The salvage value
is $0 at all times, and MARR is 10% per year. What is the
economic life of this challenger?

Solution
In order to find the best time to replace the vacuum seal, we need to find out the
Equivalent Uniform Annual Cost (EUAC) for given years.
Year Initial O&M EUAC - Calculation EUAC

Investment Cost
0 $12,000
1 $0 $12,000 (A/P, 10%, 1) $13,200

2 $0 $12,000 (A/P, 10%, 2) $6,914
3 $0 $12,000 (A/P, 10%, 3) $4,825

4 $2000 $12,000 (A/P, 10%, 4) + $2000 (A/F, 10%,4) $4,217
5 $2000 $12,000(A/P, 10%,5) + $2000 (A/F, 10%,5) + $3854
$2000 (P/F, 10%, 4)*(A/P, 10%, 5)
6 $4500 $12,000 (A/P, 10%, 6) + $4500 (A/F, 10%, 6) $3937
+ $2000 (P/F, 10%, 4) * (A/P, 10%, 6) +
$2000 (P/F, 10%, 5) * (A/P, 10%, 6)

Active Learning 3
A steam generated system at a biomass-fueled power plant uses an
electrostatic precipitator (ESP) to clean its gaseous effluents. The
power plant has consistently made use of the same type of ESP
over the past several years. The installed cost of a new ESP has
been relatively constant at $80,000. Records of operation and
maintenance expenses indicate the following average expenses per
year as a function of the age of the ESP. The MVs of the ESP are
also reasonably well known as a function of age. Determine the
best time to replace the ESP if the MARR is 15% per year.
Year 1 2 3 4 5
O&M Expenses $30,000 $30,000 $35,000 $40,000 $45,000
Market Value $60,000 $50,000 $40,000 $25,000 $12,500

Solution
In order to find the best time to replace the ESP, we need to find out the Equivalent
Uniform Annual Cost (EUAC) for given years. Select the time which has lease EUAC
among the study period.
Year EUAC Calculation EUAC

1 $80,000(A/P,15%,1) – $60,000(A/F, 15%, 1) + $62,000
$30,000(A/F, 15%,1)
2 $80,000(A/P,15%,2) - $50,000(A/F,15%,2) + $55,950
$30,000
3 $54,961
4 $56,170
5 $56,920

Self Study: Example 9-5 (Text book page 400-
401)

The economic life of the defender
• If a major overhaul is needed, the life
yielding the minimum EUAC is likely the
time to the next major overhaul.
• If the MV is zero (and will be so later), and
operating expenses are expected to increase,
the economic life will be the one year.
• The defender should be kept as long as its
marginal cost is less than the minimum
EUAC of the best challenger.
Active Learning 4
 A forklift truck is two years old, originally costed
$19,500, and has a present realizable MV of $7,500. If
kept, its MVs and annual expenses are expected to be
follows. Determine the most economical period to keep
the defender before replacing it (if at all) with the present
challenger of Example (9-4 of Text book). The before tax
cost of capital (MARR) is 10% per year.
Year MV, End of year K Annual Expenses, Ek
1 $6,000 $8,250
2 $4,500 $9,900
3 $3,000 $11,700
4 $1,500 $13,200

Engineering Economy: Chapter 9: Replacement Analysis

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Engineering Economy

Chapter 9: Replacement Analysis

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

• Any study today is about the future—past

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

• Replacement often results in gains or losses

Copyright ©2012 by Pearson Education, Inc.

PW of the challenger is greater than PW of the defender

Copyright ©2012 by Pearson Education, Inc.

This can be simplified to (eq. 9-2)

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

0 18000 ----- ---- ---- ---- ----

1 0 0 18000 1800 19800 19800

3 0 1000 0 0 1000 7540

4 0 1000 0 0 1000 6132 EC

5 0 8600 0 0 8600 6535

6 0 8600 0 0 8600 6802

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Year 1 Year 2 Year 3 Year 4

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Year 1 Year 2 Year 3 Year 4

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Keep for two years

Keep for three years (BEST!) Keep for four years

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Year Initial O&M EUAC - Calculation EUAC

1 $0 $12,000 (A/P, 10%, 1) $13,200

3 $0 $12,000 (A/P, 10%, 3) $4,825

Copyright ©2012 by Pearson Education, Inc.

Market Value $60,000 $50,000 $40,000 $25,000 $12,500

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Year EUAC Calculation EUAC

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Copyright ©2012 by Pearson Education, Inc.

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