REPLACEMENT ANALYSIS

Prof. Mercedes S. Ferrer-Alameda

DEFINITIONS

�Defender: Actual Equipment been evaluated

�Challenger: New equipment Challenger: New equipment meant to be the replacement of the defender

DEFINITIONS

� Marginal Cost: The cost of keeping the defender for one more year. This cost includes:

� Operation & Maintenance (O & M)

� Insurance

� Capital Recovery Cost (cost of opportunity)� Capital Recovery Cost (cost of opportunity)

� Includes: loss in market value + lost interests

DEFINITIONS

� Minimum Cost Life (Economic Life): Number of years at which the EUAC is minimized. The minimum cost life is usually shorter that the useful life due to increasing O & M costs

EXAMPLE #1

� An in-used equipment has a current market value of $5000. For the next 3 years, the market value will be $3000, $1000 and $500 respectively.

� A challenger can be purchased for $7500 with no salvage value at the end of three years. Operating and maintenance costs for the defender are $1700, $2000 and $2500 for the next three years. For the challenger, the O & M costs are $500, $ 1100 the defender are $1700, $2000 and $2500 for the next three years. For the challenger, the O & M costs are $500, $ 1100 and $1300. Use MARR = 10% � Determine Marginal Cost of the defender� Costo marginal año 1:

� 2000 + 2000*(.10) + 1700� Costo marginal año 2

� 2000 + 2000*(.10) + 2000� Costo marginal año 3

� 500 + 500*(.10) + 2500

EXAMPLE #2: CALCULATING ECONOMIC

LIFE

� The purchase price of a challenger is $15,000. Determine the economic life at 10%. The schedule of future operating costs and salvage values is:

Year 1 2 3 4 5 6

O & M 4500 4800 5700 6900 8400 10200

S 9000 6900 5100 3900 3300 2700

Year O&M Costs

Annualized

O&M Costs SV

Annualized

SV

Annualized Capital

Investment ($15,000) EUAC

1 $4,500.00 4500 9000 ($9,000.00) $16,500.00 $12,000.00

2 $4,800.00 $4,642.86 6900 ($3,285.71) $8,642.86 $10,000.00

3 $5,700.00 $4,962.24 5100 ($1,540.79) $6,031.72 $9,453.17

4 $6,900.00 $5,379.77 3900 ($840.34) $4,732.06 $9,271.49

5 $8,400.00 $5,874.47 3300 ($540.53) $3,956.96 $9,290.90

6 $10,200.00 $6,435.09 2700 ($349.94) $3,444.11 $9,529.266 $10,200.00 $6,435.09 2700 ($349.94) $3,444.11 $9,529.26

OPPORTUNITY COST APPROACH

� Salvage value is considered as an opportunity cost for keeping the defender. Is a foregone opportunity…

� It only answer the question on whether or not it is justifiable to replace the defender NOWjustifiable to replace the defender NOW

� Steps:

� Identify the planning horizon: Usually taken as the remaining useful life for the defender

� If the planning horizon is finite, identify cash-flow for both: defender and challenger. Remember to consider salvage value for the defender as an initial investment

� Perform incremental PW analysis

EXAMPLE #3

� Evaluate Example 1 assuming three years planning horizon

Year

Cash Flow

Defender

Cash Flow

Challenger Incremental

0 -$5,000.00 -$7,500.00 -$2,500.000 -$5,000.00 -$7,500.00 -$2,500.00

1 -$1,700.00 -$500.00 $1,200.00

2 -$2,000.00 -$1,100.00 $900.00

3 -$2,500.00 -$1,300.00 $1,200.00

Incremental

PW(12%) $143.04

Incremental analysis results in a

positive PW, the defender should

be replaced NOW

REPLACEMENT STRATEGIES UNDER THE INFINITE

PLANNING HORIZON

� Answer the question about WHEN should the defender be replaced

� Steps:

� Compute and compare the cost at economic lives for both: the defender (AECD* ) and the challenger (AECc* )

� If AECD* < AECC* , the defender should be kept, at least until the economic is reached. Otherwise, the defender should be replaced now

� If the defender should be kept, determine when should it be replaced, after the economic live is finished. � Calculate the marginal cost and compare to the AECC*

� If MC< AECC*, keep the defender for one more year

� Repeat procedure until MC > AECC*

EXAMPLE #4

� A grinder was purchased 3 years ago for $40,000. It has provided adequate service but an improved version is now available for $35,000 which will reduce operating costs and cut inspection expenses. Costs and salvage values for the two machines are Costs and salvage values for the two machines are shown below. Should the replacement be made at a MARR = 15%?

� If the service will be needed for only 4 more years, will your decision change?

Year Defender Challenger

O&M S O&M S

0 12000 35000

1 3400 7000 200 30000

2 3900 4000 1000 27000

3 4600 2500 1200 24000

4 6500 1000 1500 20000

5 2000 19000

6 2000 18000

Year O&M Costs

Annualized

O&M Costs SV Annualized SV

Annualized

Opportunity Cost

($12,000) EUAC

1 $3,400.00 $3,400.00 7000 ($7,000.00) $13,800.00 $10,200.00

2 $3,900.00 $3,883.87 4000 ($1,860.47) $7,381.40 $9,404.80

3 $4,600.00 $4,279.08 2500 ($719.94) $5,255.72 $8,814.86

4 $6,500.00 $4,977.16 1000 ($200.27) $4,203.18 $8,980.08

Economic Life Analysis for the Defender

4 $6,500.00 $4,977.16 1000 ($200.27) $4,203.18 $8,980.08

5

6

Year O&M Costs

Annualized

O&M Costs SV Annualized SV

Annualized Capital

Investment

($35,000) EUAC

1 $200.00 200 30000 ($30,000.00) $40,250.00 $10,450.00

2 $1,000.00 $572.09 27000 ($12,558.14) $21,529.07 $9,543.02

3 $1,200.00 $752.92 24000 ($6,911.45) $15,329.19 $9,170.66

4 $1,500.00 $902.53 20000 ($4,005.31) $12,259.29 $9,156.51

Economic Life Analysis for the Challenger

4 $1,500.00 $902.53 20000 ($4,005.31) $12,259.29 $9,156.51

5 $2,000.00 $1,065.30 19000 ($2,818.00) $10,441.04 $8,688.35

6 $2,000.00 $1,172.08 18000 ($2,056.26) $9,248.29 $8,364.11

EUAC at Economic Life for the Challenger is lower than EUAC at Economic Life for the Defender. The Defender should be replaced NOW

EXAMPLE #5

� Assume defender in example #1 can be replaced with challenger in example #2. Should the in-used equipment be replaced now?

� Steps:� Steps:

� Planning horizon? – No planning horizon

� Calculate cost at Economic Life for the defender

Year O&M Costs

Annualized

O&M Costs SV

Annualized

SV

Annualized

Opportunity

Cost ($5,000) EUAC

1 $1,700.00 $1,700.00 3000 $3,000.00 $5,500.00 $10,200.00

2 $2,000.00 $1,842.86 1000 $476.19 $2,880.95 $5,200.00

3 $2,500.00 $2,041.39 500 $151.06 $2,010.57 $4,203.02

Economic Life Analysis for the Defender

Economic Life Analysis for the Challenger

Year O&M Costs

Annualized

O&M Costs SV

Annualized

SV

Annualized Capital

Investment ($15,000) EUAC

1 $4,500.00 4500 9000 ($9,000.00) $16,500.00 $12,000.00

2 $4,800.00 $4,642.86 6900 ($3,285.71) $8,642.86 $10,000.00

3 $5,700.00 $4,962.24 5100 ($1,540.79) $6,031.72 $9,453.17

4 $6,900.00 $5,379.77 3900 ($840.34) $4,732.06 $9,271.49

5 $8,400.00 $5,874.47 3300 ($540.53) $3,956.96 $9,290.90

6 $10,200.00 $6,435.09 2700 ($349.94) $3,444.11 $9,529.26

Economic Life Analysis for the Challenger

OTHER CONSIDERATIONS: TRADE IN

� A second challenger competes with the defender in example 1. This challenger has a purchase price of $12000, but $6000 is offered for the defender as trade-in and the seller guarantees that operating costs will be no more than $800/year, for the first 5 years. be no more than $800/year, for the first 5 years.

� Should the offer be accepted when the required rate of return is 10% and a salvage value of $2000 at the end of the challenger’s 5-years economic life?

� Use a No-Planning Horizon approach

OTHER CONSIDERATIONS: TRADE IN

� The initial investment for the challenger must be reduced on $1000, that represents the real trade-in advantage

� EUAC (challenger) = (12,000-1000) (A/P, 10%,5) - $2000 (A/F, 10%, 5) + $800- $2000 (A/F, 10%, 5) + $800

Challenger should be selected

EUAC(Challenger) = $3,374.18

PRACTICE

� Current in-use equipment can be sold in the market for $5,000, however to keep it in service it will require an immediate overhaul for $1,200. Operating costs are estimated in $2,000 for the next year, expected to increase in $2,500 per year thereafter. Future market values are expected to decline in $1000 per yearexpected to decline in $1000 per year

� New machine cost $10,000 and will have operating costs of 1,800 on the first year, increasing by $800/year thereafter. The expected salvage value is $6000 for the first year, and will decline 15% each year

� Using an MARR = 15%, determine when the defender should be replaced

OTHER CONSIDERATIONS: TAXES

� To perform a Replacement-After Tax Analysis, several considerations are important:

� For the defender:

� Current opportunity cost will be affected (positively or negatively) by the gains or losses at the selling transaction

If the in-used machine is sold by a value under the current � If the in-used machine is sold by a value under the current book-value, a loss may be claim, resulting in tax savings (a benefit). This will have the effect of reducing the Opportunity Cost

� If the in-used machine is sold by a value over the current book-value, a loss may be claim, resulting in additional tax expense. This will have the effect of increasing the Opportunity Cost

� Perform an After-Tax cash flow including the above considerations:

EXAMPLE #6

� Machintosh Printing, Inc., purchased a $20,000 printing machine two years ago. The company expected this machine to have five-year useful life and salvage value of $5000. The company spent $5000 last year on repairs, and current operating costs are running at a rate of $8000/yr. Furthermore, the anticipated salvage value has been Furthermore, the anticipated salvage value has been reduced to $2500 at the end of the remaining useful life. In addition, the company has found that the current machine has a market value of $10,000 today.

� Suppose that initial $20,000 in capital expenditure was setup to be depreciated using seven-years MACRS. If the company’s marginal income tax rate is 40%, determine the after-tax cash flow, assumig you keep the defender

� Calculate Opportunity Cost: Benefit losses if the defender in kept

� Current selling price + Tax impact

� Current market value: $10,000

� Tax savings or tax expenses on disposal � Tax savings or tax expenses on disposal

� Determine taxable income or loss from disposal

� Selling price – Book Value

� Book value: Initial investment – up to date depreciation

� $20,000 – ($2858 + 4898/2) = $14,693

� Depreciation for second year was divided by two because MACRS requires the assumption that ALL TRANSACTIONS occur at the mid of the year