Chapter Six

Replacement and Retention Decisions

The replacement study procedure is:

New replacement study:
1. On the basis of the better AWC or AWD value, select the challenger C or defender D.
When the challenger is selected, replace the defender now, and expect to keep the challenger
for nC years. This replacement study is complete. If the defender is selected, plan to retain it
for up to nD more years. (This is the leftmost branch of Figure 6–1 .) Next year, perform the
following steps.
One-year-later analysis:
2. Determine if all estimates are still current for both alternatives, especially first cost,
market value, and AOC. If not, proceed to step 3. If yes and this is year nD , replace the
defender. If this is not year nD , retain the defender for another year and repeat this same
step. This step may be repeated several times.
3. Whenever the estimates have changed, update them and determine new AW C and AWD
values. Initiate a new replacement study (step 1).
The need for a replacement study can develop from several sources:

Reduced performance:

Physical deterioration, reduced reliability or productivity. This usually results in increased

costs of operation, higher scrap and rework costs, lost sales, reduced quality, diminished
(reduce) safety, and larger maintenance expenses (costs).
Altered requirements

New requirements of accuracy, speed, or other specifications cannot be met by the existing
equipment or system (complete replacement, retrofitting or augmentation).

Obsolescence

International competition and rapidly changing technology make currently used systems
and assets perform acceptably but less productively than equipment coming available. The
decreased development cycle time to bring new products to market is often the reason for
premature (early) replacement studies, that is, studies performed before the estimated useful
or economic life is reached

Definitions

1. Defender and challenger: are the names for two mutually exclusive alternatives. The
defender is the currently installed asset and the challenger is the potential replacement. A
replacement study compares these two alternatives.
2.AW values: are used as the primary economic measure of comparison between the
defender and challenger.
• The term EUAC (equivalent uniform annual cost) may be used instead of AW, often
only costs are included in the evaluation; revenues generated by the defender or
challenger are assumed to be equal. Since the equivalence calculations for EUAC are
exactly the same as for AW, we use the term AW.
• Therefore, all values will be negative when only costs are involved. Salvage value is an
exception; it is a cash inflow and carries a plus sign.

3. Defender first cost: is the initial investment amount (P) used for the defender.
• The current market value (MV) is the correct estimate to use for P for the defender in a
replacement study. The fair market value may be obtained from professional appraisers,
resellers, or liquidators who know the value of used assets.
• The estimated salvage value at the end of 1 year becomes the market value at the
beginning of the next year, provided the estimates remain correct as the years pass. It is
incorrect to use trade-in value that does not represent a FMV, or the depreciated book
value taken from accounting records as MV for the defender first cost.
• If the defender must be upgraded or augmented to make it equivalent to the challenger
(in speed, capacity, etc.), this cost is added to the MV to obtain the estimate of defender
first cost.
• In the case of asset augmentation for the defender alternative, this separate asset and its
estimates are included along with the installed asset estimates to form the complete
defender alternative. This alternative is then compared with the challenger via a
replacement study.
4. Challenger first cost: is the amount of capital that must be recovered (amortized) when
replacing a defender with a challenger. This amount is almost always equal to P, the first
cost of the challenger.
• On occasion, an unrealistically high trade-in value may be offered for the defender
compared to its fair market value. In this event, the net cash flow required for the
challenger is reduced, and this fact should be considered in the analysis.
• The correct amount to recover and use in the economic analysis for the challenger is its
first cost minus the difference between the trade-in value (TIV) and market value (MV)
of the defender. In equation form, this is P- (TIV - MV).
• This amount represents the actual cost to the company because it includes both the
opportunity cost (market value of the defender) and the out-of-pocket cost (first cost
minus trade-in) to acquire the challenger. Of course, when the trade-in and market values
are the same, the challenger P value is used in all computations.
5. Marginal costs (MC) are year-by-year estimates of the costs to own and operate an asset
for that year. Three components are added to determine the marginal cost:
1. Cost of ownership (loss in market value is the best estimate of this cost)
2. Forgone interest on the market value at the beginning of the year
3. AOC for each year
Example 6-1:
A mechanical engineer who designs and sells equipment that automates manual labor
processes is offering a machine/robot combination that will significantly reduce labor
costs associated with manufacturing garage-door opener transmitters. The equipment
has a first cost of L.D 170,000, an estimated annual operating cost of L.D 54,000, a
maximum useful life of 5 years, and a L.D 20,000 salvage value anytime it is replaced.
The existing equipment was purchased 12 years ago for L.D 65,000 and has an annual
operating cost of L.D78,000. At most, the currently owned equipment can be used 2
more years, at which time it will be auctioned off for an expected amount of L.D 6000,
less 33% paid to the company handling the auction. The same scenario will occur if the
currently owned equipment is replaced now. Determine the defender and challenger
estimates of P, n, S, and AOC in conducting a replacement analysis today at an interest
rate of 20% per year.
Solution:

Defender: Challenger:
P = market value = 6000(1 – 0.33) = L.D 4000 P = L.D 170,000
AOC = L.D 78,000 per year AOC = L.D 54,000 per year
n = 2 years n = 5 years
S = 6000(1 – 0.33) = L.D 4000 S = L.D 20,000

(Note: P and AOC will carry – signs in an evaluation)

Example 6-2:
Equipment that was purchased by Newport Corporation for making pneumatic vibration
isolators cost L.D 90,000 two years ago. It has a market value that can be described by the
relation L.D 90,000 − 8000k, where k is the years from time of purchase. The operating
cost for the first 5 years is L.D 65,000 per year, after which it increases by L.D 6300 per
year. The asset’s salvage value was originally estimated to be L.D 7000 after a predicted
10-year useful life. Determine the values of P, S, and AOC if (a) a replacement study is
done now and it is assumed that the equipment will be kept a maximum of only 1 more
year, and (b) a replacement study is done 1 year from now and it is assumed that the
equipment will be kept a maximum of only 1 more year after that.

Solution:
(a)
P = 90,000 – 8000(2) = L.D 74,000
S = 90,000 – 8000(3) = L.D 66,000
AOC = L.D 65,000
(b)
P = 90,000 – 8000(3) = L.D 66,000
S = 90,000 – 8000(4) = L.D 58,000
AOC = L.D 65,000
6.1 Economic Service Life

The economic service life (ESL) is the number of years n at which the equivalent uniform
annual worth (AW) of costs is the minimum, considering the most current cost estimates
over Economic service life all possible years that the asset may provide a needed service.
Total AW of costs is the sum of capital recovery (CR), which is the A W of the initial
investment and any salvage value, and the AW of the estimated annual operating cost
(AOC), that is,
Total AW = capital recovery - AW of annual operating costs
= CR - AW of AOC 6-1

The ESL is the n value for the smallest total AW of costs . (Remember: These AW
values are cost estimates, so the AW values are negative numbers. Therefore, L.D –
200 is a lower cost than L.D -500.) Figure 6–1 shows the characteristic shape of a
total AW of cost curve. The CR component of total AW decreases, while the AOC
component increases, thus forming the concave shape. The two AW components are
calculated as follows:
1. Decreasing cost of capital recovery. The capital recovery is the AW of investment; it
decreases with each year of ownership. The salvage value S , which usually decreases with
time, is the estimated market value (MV) in that year.
Capital recovery = CR = -P ( A/P , i, n ) + S ( A/F , i ,n ) 6-2
2. Increasing cost of AW of AOC. Since the AOC (or M&O) estimates usually increase
over the years, the AW of AOC increases. To calculate the AW of the AOC series for 1, 2,
3, . . . years, determine the present worth of each AOC value with the P/F factor, then
redistribute this P value over the years of ownership, using the A/P factor.

The complete equation for total AW of costs over k years (k = 1, 2, 3, . . . ) is:

k 
TotalAW k   P ( A / P; i; k )  S k ( A / F ; i; k )   AOC j ( P / F ; i; k ) ( A / P; i; k ) 6-3
 j 1 
where P = initial investment or current market value
Sk = salvage value or market value after k years
AOCj = annual operating cost for year j ( j = 1 to k )
Example 6-3:
A 3-year-old heavy-duty transport vehicle is being considered for early replacement. Its
current market value is L.D 20,000. Estimated future market values and annual operating
costs for the next 5 years are given in the following table columns 2 and 3. What is the
economic service life of this defender if the interest rate is 10% per year?
Year MA L.D AOC L.D
(1) (2) (3)
1 10000 -5000
2 8000 -6500
3 6000 -8000
4 2000 -9500
5 0 -12500

Solution:

The capital recovery ( CR ) for the L.D -20000 current market value ( j = 0 ) plus
10% return. Equation [5.3] is used to calculate total AW k for k = 1, 2, . . . , 5. Table 5 –
1, column 4, shows CR. Column 5 gives the equivalent AW of AOC for k years. As an
illustration, the computation of total AW. Column 6 total AW k.
For k = 1:
CR1 = -20000( 1.1) + 10000(1.0) = -12000 L.D
AW of AOC = -5000
Total AW1 = -12000 – 5000 = -17000 L.D
For k = 2
CR2 = −P(A∕P,i,2) + MV2(A∕F,i,2) = -20000( o.5762) + 8000(0.4762) = -7714.4L.D
AW2 of AOC = - [ 5000(P/F, 10, 1 ) + 6500(P/F,10,2)](A/P,10,2)
= - [ 5000( 0.9091) + 6500(0.8265)](0.5762) = - 5714.6 L.D
For k = 3 Applying equation 5-3
Total AW3 = −P(A∕P,i,3) + MV3(A∕F,i,3) − [PW of AOC1,AOC2, and AOC3](A∕P,i,3)
= −20,000(A∕P,10%,3) + 6000(A∕F,10%,3) − [5000(P∕F,10%,1) +
6500(P∕F,10%,2) + 8000(P∕F,10%,3)](A∕P,10%,3)
= −6230 − 6405 = L.D −12,635
Year MA L.D AOC CR AW of Total
(1) (2) L.D (4) AOC AWk
(3) (5) 4+5=6
1 10000 -5000 -12000 -5000 -17000
2 8000 -6500 -7714 -5715 -13429
3 6000 -8000 -6230 -6405 -12635
4 2000 -9500 -5878 -7072 -12950
5 0 -12500 -5276 -7961 -13237
Example 6.4:
A piece of equipment has a first cost of L.D 150,000, a maximum useful life of 7 years,
and a market (salvage) value described by the relation S = 120,000 – 20,000k, where k is
the number of years since it was purchased. The salvage value cannot go below zero. The
AOC series is estimated using AOC = 60,000 + 10,000k. The interest rate is 15% per
year. Determine the economic service life.
Solution:

Year Salvage Value L.D AOC L.D per year

k S = 120000 – AOC = 60000 +
20000k 10000k
1 100000 70000
2 80000 80000
3 60000 90000
4 40000 100000
5 20000 110000
6 0 120000
7 0 130000
 100
80

60
40
20

0 1 2 3 4 5 6 7

70
80
90
100
110
120
130
150

AW1 = -150,000(A/P,15%,1) – 70,000 + 100,000(A/F,15%,1) = L.D -142,500

AW2 = -150,000(A/P,15%,2) – [70,000 + 10,000(A/G,15%,2)] + 80,000(A/F,15%,2)

= L.D -129,709

AW3 = -150,000(A/P,15%,3) – [70,000 + 10,000(A/G,15%,3)] + 60,000(A/F,15%,3)

= L.D -127,491
 Year Salvage Value AOC L.D per AWk
k L.D year L.D per year
S = 120000 – AOC = 60000
20000k + 10000k
1 100000 70000 -129,709
2 80000 80000 -129,709
3 60000 90000 -127,491
4 40000 100000 -127,792
5 20000 110000 -129,009
6 0 120000 -130,608
7 0 130000 -130,552

ESL = 3 years with AW3 = L.D -127,491

Example 6-5
From the data shown, determine the ESL of the asset. (Note: Values in the table are AW
values, not individual year-end values.)

Years AW of AW of AW of
Retained First Cost, L.D Operating Salvage Value,
(1) Cost, L.D L.D
(2) (3)
1 −165,000 −36,000 99,000
2 −86,429 −36,000 38,095
3 −60,317 −42,000 18,127
4 −47,321 −43,000 6,464
5 −39,570 −48,000 3,276
Solution:

Years AW of AW of AW of Total AW
Retained First Cost, Operating Salvage 1+2+3=4
L.D Cost, L.D Value, L.D L.D
(1) (2) (3)
1 −165,000 −36,000 99,000 -102,000
2 −86,429 −36,000 38,095 -84,334
3 −60,317 −42,000 18,127 -84,190
4 −47,321 −43,000 6,464 -83,857
5 −39,570 −48,000 3,276 -84,294

Economic service life is n = 4 years.

6.2 Evaluating replacement Alternatives

When replacement decisions are being considered, two courses of action are available:
1. Retain the asset presently owned for additional period,
2. Remove the existing asset and replace it by another.
As with other economic alternatives, the economic future of the present asset can be
represented by a cash flow of estimated receipts and disbursements.

6.2.1 Replacement Analysis for Equal Lives

Example 6-6:

Two methods can be for producing expansion anchors. Method A costs L.D. 80000
initially and will have a L.D. 15000 salvage after 4 years. The operating cost with this
method be L.D. 30000 per year. Method B will have a first cost is L.D. 120000, an
operating cost of L.D. 8000 per year, and salvage value after its 4 years life is 10000.
At interest rate of 12 % per year, whish method should be used on the basis of :
1. Present worth analysis ?
2. Future worth analysis ?
3. Annual worth analysis?
 Solution:
For method A 15000

0 1 2 3 4

30000

80000

1. In case of present worth:

PWA = - 80000 – 30000( P/A, 12 , 4 ) + 15000 ( P/F, 12 ,4 )

PWA = - 80000 – 30000 ( 3.0374 ) + 15000 ( 0.6355 ) = - 161590

2. In case of Future worth:

FWA = - 80000( F/P, 12 ,4 ) – 30000( F/A, 12 , 4 ) + 15000

FWA = - 80000 ( 1.5740 ) – 30000 ( 4.7790 ) + 15000 = - 254290

3. In case of equal Annual worth:

AWA = - 30000 – 80000 ( A/P , 12 , 4 ) + 15000 ( A/F 12, 4 )

AWA = - 30000 – 80000 ( 0.3292 ) + 15000 ( 0.1574 ) = - 53975
 10000
For method B

0 1 2 3 4

8000

120000

1. In case of present worth:

PWB = - 120000 – 8000( P/A, 12 , 4 ) + 10000 ( P/F, 12 ,4 )
PWB = - 120000 – 8000 ( 3.0374 ) + 10000 ( 0.6355 ) = - 137944
2. In case of Future worth:
FWB = - 120000( F/P, 12 ,4 ) – 8000( F/A, 12 , 4 ) + 10000
FWB = - 120000 ( 1.5740 ) – 8000 ( 4.7790 ) + 10000 = - 217112
3. In case of equal Annual worth:
AWB = - 8000 – 120000 ( A/P , 12 , 4 ) + 10000 ( A/F 12, 4 )
AWB = - 8000 – 120000 ( 0.3292 ) + 10000 ( 0.1574 ) = - 45930
PWA > PWB ; FWA > FWB ; and AWA > AWB
Then keep method A
 5.2.2 Replacement Analysis for Unequal Lives

Example 6-7:

Two methods are under consideration for producing the case for a portable hazardous
material photoionization monitor. A plastic case will required an initial investment of L.D.
75000 and have an annual operating cost of L.D. 27000 with no salvage value after 2
years. An aluminum case will require an investment of L.D. 125000 and will have annual
costs of L.D. 12000. Some of the equipment can be sold for L.D. 30000 after its 3 years
life. At an interest rate of 10 % per year, which case should be used on the basis of PW,
FW, and AW analysis ?
Solution:
For Plastic Case:
P = 75000, A = 27000 , n1 = 2, and S = 0 , n2 = 3 ; i = 0.1

27000

75000 75000 75000

1. In case of present worth:

PWP = - 75000 – 27000( P/A, 10 , 6 ) - 75000( P/F, 10 , 2 ) - 75000( P/F, 10 , 4 )

PWP = - 75000 – 2700 ( 4.3553 ) - 75000( 0.8265 ) - 75000( 0.6830 )
= - 305806
2. In case of Future worth:

FWP = - 75000( F/P, 10 ,6 ) – 27000( F/A, 10 , 6 ) - 75000( F/P, 10 ,4 )

- 75000( F/P, 10 ,2 )
FWP = - 75000 ( 1.7720 ) – 27000 ( 7.7160 ) - 75000( 1.4640 )
- 75000( 1.2100 ) = - 541782
3. In case of equal Annual worth:

27000 27000

P = 75000

AWP = - 27000 – 75000 ( A/P , 10 , 3 )

= -27000 – 75000 ( 0.4021 ) = - 57158
For Aluminum Case:

P = 1200, A = 12000 , n1 = 2, and S = 30000 , n2 = 3 ; i = 0.1

30000 30000

12000

125000 125000

1. In case of present worth:

PWA = - 125000 - 12000( P/A, 10 , 6 ) + [- 125000 + 30000 ]( P/F, 10 , 3 )
+ 30000( P/F, 10 , 6 )
PWA = -125000 - 12000( 4.3553 ) – [125000 – 30000 ]( 0.7513 )
+ 30000( 0.5645 ) = - 231702

2. In case of Future worth:

FWA = - 125000( F/P, 10 ,6 ) – 12000( F/A, 10 , 6 ) – [125000 – 30000 ]( F/P, 10 ,3 )
+ 30000
FWA = - 125000( 1.7720 ) – 12000( 7.7160 ) – [125000 – 30000 ]( 1.331 )
+ 30000 = - 410537
3. In case of equal Annual worth:

30000

12000 12000 12000

P = 125000
Cash flow for Aluminum Case

AWA = - 12000 – 125000 ( A/P , 10 , 3 ) + 30000 ( A/F 10 , 3 )

= -12000 – 125000 ( 0.4021 ) + 30000 ( 0.3021 ) = - 53200

Select Method A.