CHAPTER 9CHAPTER 9

REPLACEMENT REPLACEMENT ANALYSISANALYSIS

REPLACEMENT ANALYSISREPLACEMENT ANALYSISThe evaluation of changes in The evaluation of changes in economics of assets associated with economics of assets associated with their use in an operating environment.their use in an operating environment.

Considers assetConsiders asset• replacementreplacement• retirementretirement• augmentationaugmentation

REASONS FOR REASONS FOR REPLACEMENT ANALYSISREPLACEMENT ANALYSIS• Physical Impairment (Deterioration)Physical Impairment (Deterioration)

• Altered RequirementsAltered Requirements

• TechnologyTechnology

• FinancingFinancing

PHYSICAL IMPAIRMENT PHYSICAL IMPAIRMENT (DETERIORATION)(DETERIORATION)

• Efficiency loss resulting from continued Efficiency loss resulting from continued use -- aginguse -- aging

• Increased routine and corrective Increased routine and corrective maintenance costsmaintenance costs

• Greater energy requirementsGreater energy requirements

• Increased need for operator interventionIncreased need for operator intervention

• Unanticipated problems leading to Unanticipated problems leading to equipment deteriorationequipment deterioration

ALTERED REQUIREMENTSALTERED REQUIREMENTS

• Significant change in demand for Significant change in demand for related products or servicesrelated products or services

• Significant change in the Significant change in the composition or design of associated composition or design of associated products or services products or services

• May be considered a form of May be considered a form of obsolescenceobsolescence

TECHNOLOGYTECHNOLOGY• Impact of technological change varies Impact of technological change varies

with associated industrywith associated industry

• Technological changes typically reduce Technological changes typically reduce cost per unit and improve quality of cost per unit and improve quality of outputoutput

• Results in earlier replacement of existing Results in earlier replacement of existing assets with improved assetsassets with improved assets

• May be considered a form of May be considered a form of obsolescenceobsolescence

FINANCINGFINANCING• Considers economic opportunity Considers economic opportunity

changes external to the physical changes external to the physical operation or use of the asset(s)operation or use of the asset(s)

• May involve income tax May involve income tax considerations (depreciation and considerations (depreciation and after-tax analysis)after-tax analysis)– EG: rental of assets may become more EG: rental of assets may become more

attractive than ownershipattractive than ownership

• May be considered a form of May be considered a form of obsolescenceobsolescence

ECONOMIC LIFEECONOMIC LIFE• The period of time (years) that results in the The period of time (years) that results in the

minimum minimum Equivalent Uniform Annual CostEquivalent Uniform Annual Cost (EUAC) of owning and operating an asset(EUAC) of owning and operating an asset

• EUAC is a term sometimes used to identify the EUAC is a term sometimes used to identify the annual worth of a primarily cost cash flow pattern annual worth of a primarily cost cash flow pattern

• Assuming good asset management, economic Assuming good asset management, economic life should coincide with time from date of life should coincide with time from date of acquisition to date of abandonment, demotion in acquisition to date of abandonment, demotion in use, or replacement from primary intended use, or replacement from primary intended serviceservice

ECONOMIC LIFEECONOMIC LIFE

• Sometimes called minimum-cost life Sometimes called minimum-cost life or optimum replacement intervalor optimum replacement interval

• For a new asset, economic life can For a new asset, economic life can be computed if capital investment, be computed if capital investment, annual expenses, and year-by-year annual expenses, and year-by-year market values are known or can be market values are known or can be estimatedestimated

OWNERSHIP LIFEOWNERSHIP LIFE

• Period between date of acquisition Period between date of acquisition and date of disposal by a specific and date of disposal by a specific ownerowner

• A given asset may have different A given asset may have different categories of use during this periodcategories of use during this period

PHYSICAL LIFEPHYSICAL LIFE

• Period of time between Period of time between original acquisition and final original acquisition and final disposal of an asset over its disposal of an asset over its succession of ownerssuccession of owners

USEFUL LIFEUSEFUL LIFE

• The time period in years that an The time period in years that an asset is kept in productive service asset is kept in productive service either in primary or backup modeeither in primary or backup mode

• An estimate of how long an asset is An estimate of how long an asset is expected to be used in a trade or expected to be used in a trade or business to produce incomebusiness to produce income

REPLACEMENT STUDY REPLACEMENT STUDY CONSIDERATIONSCONSIDERATIONS

1.1. Recognition and acceptance of past errorsRecognition and acceptance of past errors

2. Sunk costs2. Sunk costs

3. Existing asset value and the 3. Existing asset value and the outsideroutsider viewpoint viewpoint

4. Income tax considerations4. Income tax considerations

5. Economic life of the proposed replacement 5. Economic life of the proposed replacement (Challenger)(Challenger)

6. Remaining (economic) life of the old asset 6. Remaining (economic) life of the old asset (defender)(defender)

PAST ESTIMATION ERRORSPAST ESTIMATION ERRORS

• Past estimation errors are Past estimation errors are irrelevantirrelevant unless there are income tax implicationsunless there are income tax implications

i.e., when BV > current MV, frequently i.e., when BV > current MV, frequently attributed to estimation error, while may attributed to estimation error, while may be due to inadequate capacity or higher be due to inadequate capacity or higher than expected maintenance costs than expected maintenance costs

• Must focus on valid estimation of future Must focus on valid estimation of future replacement, without consideration of replacement, without consideration of loss which may have occurred in pastloss which may have occurred in past

THE SUNK COST TRAPTHE SUNK COST TRAP• Only present and future cash flows should be Only present and future cash flows should be

considered in replacement studiesconsidered in replacement studies• Unamortized values of existing asset Unamortized values of existing asset

considered for replacement are the result of considered for replacement are the result of past decisions -- (Sunk costs = BV - MV)past decisions -- (Sunk costs = BV - MV)

• Sunk costs are irrelevant to replacement Sunk costs are irrelevant to replacement decisions, except to extent they affect income decisions, except to extent they affect income taxes taxes

• When tax considerations are involved, sunk When tax considerations are involved, sunk costs must be included in study costs must be included in study

EXISTING ASSET INVESTMENT EXISTING ASSET INVESTMENT VALUE -- AN OUSIDER VIEWPOINTVALUE -- AN OUSIDER VIEWPOINT

• Perspective of impartial third party in Perspective of impartial third party in establishing fair market value (MV) of establishing fair market value (MV) of your used assetyour used asset

• Present realizable MV modified by Present realizable MV modified by appropriate income tax effects defines appropriate income tax effects defines correct investment amount for asset in correct investment amount for asset in replacement studiesreplacement studies

• Consider the opportunity cost of Consider the opportunity cost of retaining the asset -- the defenderretaining the asset -- the defender

THE OUTSIDER VIEWPOINTTHE OUTSIDER VIEWPOINT

The total investment in the The total investment in the defender is the opportunity cost defender is the opportunity cost of not selling the existing asset of not selling the existing asset for its current MV, plus the cost for its current MV, plus the cost of upgrading to be competitive of upgrading to be competitive with best available challengerwith best available challenger

INCOME TAX CONSEQUENCESINCOME TAX CONSEQUENCES• Replacement of assets often result in Replacement of assets often result in

gains or losses from sale of land or gains or losses from sale of land or depreciable propertydepreciable property

• Studies must be made on an after-tax Studies must be made on an after-tax basisbasis

• Prospective gain from asset disposal Prospective gain from asset disposal can be reduced by as much as 40% or can be reduced by as much as 40% or 50% as a result of taxes50% as a result of taxes

ECONOMIC LIFE OF THE CHALLENGERECONOMIC LIFE OF THE CHALLENGER• Economic life of an asset minimizes equivalent Economic life of an asset minimizes equivalent

uniform annual cost of owning and operating uniform annual cost of owning and operating an assetan asset

• Economic life is often shorter than useful or Economic life is often shorter than useful or physical lifephysical life

• Economic data regarding challengers are Economic data regarding challengers are periodically (often annually) updatedperiodically (often annually) updated

• Replacement studies then repeated to ensure Replacement studies then repeated to ensure most up-to-date evaluation most up-to-date evaluation

ECONOMIC LIFE OF DEFENDERECONOMIC LIFE OF DEFENDER• Often one yearOften one year

• Because different lives are involved, care Because different lives are involved, care should be taken when comparing should be taken when comparing defender with challengerdefender with challenger

• Defender should be kept longer than Defender should be kept longer than apparent economic life as long as its apparent economic life as long as its marginal cost < minimum equivalent marginal cost < minimum equivalent uniform annual cost of challenger over uniform annual cost of challenger over its economic lifeits economic life

USEFUL LIFE(S) OF DEFENDER AND / USEFUL LIFE(S) OF DEFENDER AND / OR CHALLENGER INESTIMABLEOR CHALLENGER INESTIMABLE

When useful life of defender or When useful life of defender or challenger is unknown and can’t be challenger is unknown and can’t be reasonably estimated, must rely on:reasonably estimated, must rely on:

• economic lifeeconomic life

• minimum EUACminimum EUAC

• total year-by-year marginal coststotal year-by-year marginal costs

for defender and best alternative for defender and best alternative challengerchallenger

BEFORE-TAX ANALYSISBEFORE-TAX ANALYSIS

Determining Present worth of Determining Present worth of total coststotal costsPWPWkk ( i%) = I - MV ( i%) = I - MVkk (P / F, i%,k) + (P / F, i%,k) + kkEj (P / F, i%, j)Ej (P / F, i%, j)

j=1 j=1

Sum of Sum of • PW of initial capital investments occurring after PW of initial capital investments occurring after

time 0time 0• PW of MV at end of year kPW of MV at end of year k• PW of annual expenses through year kPW of annual expenses through year k

BEFORE-TAX ANALYSISBEFORE-TAX ANALYSIS

Determining Present Worth of Marginal Determining Present Worth of Marginal CostsCosts

• Marginal cost is the difference in present Marginal cost is the difference in present worth of total cost for year ‘k’ minus the worth of total cost for year ‘k’ minus the present worth of total cost for year ‘k - 1’present worth of total cost for year ‘k - 1’

• Total amount of this Total amount of this marginal costmarginal cost is is found by:found by:

TCTCkk(i%) = (PW(i%) = (PWkk - PW - PWk-1k-1) (F / P, i%,k)) (F / P, i%,k)

BEFORE-TAX ANALYSISBEFORE-TAX ANALYSISDetermining Present Worth of Marginal CostsDetermining Present Worth of Marginal Costs• Simplification of Total calculation of marginal Simplification of Total calculation of marginal

costcost

TCTCkk(i%) = MV(i%) = MVk-1k-1 - MV - MVkk + iMV + iMVk-1k-1 + E + Ekk

This is the sum of:This is the sum of:• the loss in MV during year of extended servicethe loss in MV during year of extended service• the opportunity cost of capital invested in the the opportunity cost of capital invested in the

asset at the beginning of year ‘k’asset at the beginning of year ‘k’• the annual expenses incurred in year ‘k’ the annual expenses incurred in year ‘k’

BEFORE-TAX ANALYSISBEFORE-TAX ANALYSIS

• The total marginal (Year-by-year) costs The total marginal (Year-by-year) costs are used to find the EAUC through are used to find the EAUC through each year ‘K’each year ‘K’

• The minimum EAUCThe minimum EAUCkk value during the value during the

useful life of the asset, determines its useful life of the asset, determines its before-tax economic lifebefore-tax economic life

• Before-tax economic life = Before-tax economic life = N*N*

AFTER-TAX ANALYSISAFTER-TAX ANALYSIS• Extending the Before-Tax Analysis equation to Extending the Before-Tax Analysis equation to

account for income tax effects:account for income tax effects:

PWPWkk(i%) = I + (i%) = I + kk[ ( 1 - t ) E[ ( 1 - t ) Ejj - td - tdjj ] ( P / F, i%, j ) - ] ( P / F, i%, j ) - j=1 j=1

[ ( 1 - t )MVk + t ( BVk ) ] ( P / F, i%, k)[ ( 1 - t )MVk + t ( BVk ) ] ( P / F, i%, k)Equation finds PW of ATCF through year k by:Equation finds PW of ATCF through year k by:• adding initial capital investment and sum of after-adding initial capital investment and sum of after-

tax PW of annual expenses through year k, tax PW of annual expenses through year k, including adjustments for annual depreciation including adjustments for annual depreciation amountsamounts

• adjusting the total after-tax PW of costs by the after-adjusting the total after-tax PW of costs by the after-tax consequences of gain or loss on disposal of tax consequences of gain or loss on disposal of asset at end of year kasset at end of year k

AFTER-TAX ANALYSISAFTER-TAX ANALYSISDetermining Present Worth of Marginal CostsDetermining Present Worth of Marginal Costs

Total amount of this after-tax marginal cost:Total amount of this after-tax marginal cost:

TCTCkk = ( PW = ( PWkk - PW - PWk-1k-1 ) ( F / P, i%, k ) ) ( F / P, i%, k )

SimplifyingSimplifyingTCTCkk (i%) = (1 - t)(MV (i%) = (1 - t)(MVk-1k-1 - MV - MVkk + iMV + iMVk-1k-1 + E + Ekk) + i (t)(BV) + i (t)(BVk-1k-1))

The economic life of the asset on an after-tax basis The economic life of the asset on an after-tax basis is is N*N*ATAT

DETERMINING THE ECONOMIC DETERMINING THE ECONOMIC

LIFE OF A DEFENDERLIFE OF A DEFENDER • When major outlay for alteration or overhaul is When major outlay for alteration or overhaul is

required, the life that will yield least EUAC is required, the life that will yield least EUAC is likely time to next alteration or overhaullikely time to next alteration or overhaul

• When defender MV is 0 and operating expenses When defender MV is 0 and operating expenses expected to increase annually, the remaining life expected to increase annually, the remaining life that will yield least EAUC will be 1 yearthat will yield least EAUC will be 1 year

• When MVs are greater than 0 and expected to When MVs are greater than 0 and expected to decline from year to year, calculate remaining decline from year to year, calculate remaining economic life in same manner as for before-tax economic life in same manner as for before-tax analysisanalysis

• By using outsider viewpoint, the present By using outsider viewpoint, the present realizable MV is considered its investment valuerealizable MV is considered its investment value

RETENTION OF THE RETENTION OF THE DEFENDERDEFENDER

The defender should be kept longer The defender should be kept longer than the apparent economic life of than the apparent economic life of the defender as long as its the defender as long as its marginalmarginal cost (total cost for an additional year cost (total cost for an additional year of service) is less than the minimum of service) is less than the minimum EUAC for the best alternative EUAC for the best alternative challengerchallenger

COMPARING DEFENDERS AND COMPARING DEFENDERS AND CHALLENGERS WITH DIFFERENT CHALLENGERS WITH DIFFERENT

USEFUL LIVESUSEFUL LIVES• Requires use of the repeatability or Requires use of the repeatability or

coterminated assumptionscoterminated assumptions• Normally, the second stipulation of the Normally, the second stipulation of the

repeatability assumption can not be met for repeatability assumption can not be met for the (older and used) defenderthe (older and used) defender

• Failure to meet this stipulation may be Failure to meet this stipulation may be circumvented if period of needed service is circumvented if period of needed service is indefinitely long and purpose of analysis is indefinitely long and purpose of analysis is simply to determine timing of defender simply to determine timing of defender replacementreplacement

PROJECT RETIREMENT WITHOUT PROJECT RETIREMENT WITHOUT REPLACEMENT -- ABANDONMENTREPLACEMENT -- ABANDONMENT

Two assumptions apply:Two assumptions apply:• Once capital investment made, firm desires to Once capital investment made, firm desires to

postpone project abandonment as long as its postpone project abandonment as long as its present equivalent value (PW) is not decreasingpresent equivalent value (PW) is not decreasing

• The project will be terminated at the best The project will be terminated at the best abandonment time and will not be replaced by abandonment time and will not be replaced by the firmthe firm