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    Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

    Authored by Don Smith, Texas A&M University 2004

    CHAPTER 11

    Replacement and RetentionDecisions

    McGrawHill

    ENGINEERING ECONOMYSixthEdition

    Blank and

    Tarquin

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    Authored by Don Smith, Texas A&M University 2004

    Chapter 11 Learning Objectives

    1. Basics of Replacement Study;2. Economic Service Life;

    3. Performing a Replacement Study;

    4. Additional Considerations in aReplacement Study;

    5. Replacement Study over aSpecified Study Period;

    6. Chapter Summary

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    CHAPTER 11

    Section 11.1 Basics ofReplacement Study

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    Authored by Don Smith, Texas A&M University 2004

    11.1 Why Replace Assets

    Reduced Performance: Wear and Tear;

    Decreasing reliability and Productivity;

    Increasing operating and maintenance costs.

    Altered Requirements: New production needs, accuracy, speed, etc.

    Obsolescence:

    Current assets may be less productive;

    Not state of the art meet competition.

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    Authored by Don Smith, Texas A&M University 2004

    11.1 Terminology

    Defender Asset:

    Current installed asset;

    Challenger Asset:

    The potential replacement or challenging asset;

    Under consideration to replace the defender asset.

    Together, the Defender and Challenger:

    Constitute mutually exclusive alternatives;

    Select one and reject the other.

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    11.1 Annual Worth Values

    Analysis Approach forReplacement:

    Annual Worth Approach;

    EUAC since costs tend todominate the study (-) cash

    flows;

    Salvage values if any are alsopart of the analysis (+) value.

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    11.1 Economic Service Life

    Economic Service Life (ESL) Number of years for an alternative for

    which the AW or EUAC is Minimum;

    Implies that a period by period analysis

    is performed;

    Computing the AW for 1 year; then 2

    years; until a minimum cost time

    period is found; Performed manually or by spreadsheet.

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    Authored by Don Smith, Texas A&M University 2004

    11.1 Investment Concerns-Defender

    For a replacement analysis twoinvestment costs are critical:

    1. The proper investment cost to

    apply to keeping the defenderin service;

    2. The proper investment cost to

    apply to any challenger asset

    that might replace the current

    defender asset.

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    11.1 Investment Concerns-Defender

    While it may seem strange tocharge an investment cost for

    keeping ones own asset (the

    defender) this is what must occur.

    Keeping the defender is not free!

    Why? Because the firm is giving up the

    opportunity to receive a possible cashflow from selling the current defender!

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    11.1 Investment Concerns

    One must assign an investmentcost to KEEPING the defender

    asset!

    The appropriate investment costto assign to the defender asset is:

    The current fair market value of

    the defender at the time the

    replacement decision is being

    examined.

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    11.1 Defender First Cost

    Defender First Cost: Initial investment in the defender asset

    back in time;

    This investment (cost) is considered

    sunk for analysis purposes;

    A past cost that cannot be changed or

    altered;

    The issue of the relevance of theinvestment cost in the analysis will be

    addressed soon.

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    11.1 Challenger First Cost

    This is the total investment (Pchallenger )required in a new (challenger) asset

    that will possibly replace the current

    defender.

    In a replacement study this investment

    is know with a fair amount of certainty.

    What IF a trade in value is offered for

    the defender to apply to thechallenger?

    C i ht Th M G Hill C i I P i i i d f d ti di l

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    11.1 Trade In Concerns

    Often a trade in value is offered bya vendor to take in the defender

    with a credit on the purchase

    towards the challenger.

    Be careful how this is handled!

    Points to focus upon.

    C i ht Th M G Hill C i I P i i i d f d ti di l

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    11.1 Basic Principles

    The past investment in the defender issunk and not totally relevant to the

    analysis.

    Only the Fair Market Value (FMV) of the

    defender is relevant. FMV of the defender is the net economic

    worth of the current defender;

    Sale or disposal price less any costs

    associated with removing the defender.

    C i ht Th M G Hill C i I P i i i d f d ti di l

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    11.1 Basic Principles ImportantQuestion

    At times, a high trade-in valuemay be offered for the defender

    compared to its current fair market

    value.

    If this is the case: What should be the investment cost in

    the challenger for a replacement study

    analysis if a trade-in value is offered?

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    Authored by Don Smith, Texas A&M University 2004

    11.1 Trade-In Issues

    For a Trade-In, the correct investment cost to assign

    to the challenger is:

    Investment in the Challenger:

    PC (TIV MVD)

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    11.1 Trade-In Issues

    Investment in the challenger

    PC (TIV MVD)

    Cash Price for the challenger less:

    (Trade-in Value Market Value of the Defender)

    This represents the true investment in thechallenger to the firm!

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    11.1 Trade-In Issues

    Investment in the challenger

    PC (TIV MVD)

    The Cash pricefor

    The challengerwith

    No trade-in

    The Opportunity CostGiven up by not

    Selling theDefender outright!

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    11.1 Trade-In Issues - Example

    Bought a system 3 years ago for$120,000. (Defender);

    A fair market value of the current

    defender is $70,000 right now;A challenger can be purchased for

    cash for $100,000 now!

    T