1. Copyright Oxford University Press 2009 Chapter 13 Replacement Analysis

2. Copyright Oxford University Press 2009 Replacement Problem Replacement Analysis Decision Maps Minimum-Cost Life Marginal Cost of Keeping an Asset one more year Replacement Analysis Techniques Replacement Repeatability Assumptions After-tax Replacement Analysis Spreadsheet and Replacement Analysis Chapter Outline

3. Copyright Oxford University Press 2009 Recognize and develop replacement problems Use the decision map to select the appropriate replacement analysis technique to apply Calculate the minimum cost life of an asset Apply replacement analysis techniques correctly Perform replacement problems on an after-tax basis Use spreadsheet in solving replacement analysis problems Learning Objectives

4. Copyright Oxford University Press 2009 Should the existing equipment be retained or replaced? The Defender is the existing equipment. The Challenger is the best available replacement equipment. If the defender proves more economical, it will be retained. If the challenger proves more economical, it will be installed. Replacement Analysis

5. Copyright Oxford University Press 2009 Obsolescence occurs when an assets technology is surpassed by newer and/or different technologies (PC) Depletion is the gradual loss of market value of an asset as it is being consumed or exhausted (Oil well, Timber) Deterioration is the general loss in value of an asset due to aging process (Production machinery) The Replacement Problem

6. Copyright Oxford University Press 2009 Planned replacements can be scheduled to minimize the time and cost of disruptions. Variations of replacement problems, such as abandonment, retirement, improvements of defender or keeping defender as spare, can be considered as potential new challenger. Since replacement problems usually are considered with fixed output, only costs of defender and challengers are analyzed. Due to the lives of the defender and challengers are usually different, most calculations focus on annual marginal costs or on EUAC. The Replacement Problem

7. Copyright Oxford University Press 2009 Replacement Analysis Decision Map Identify Alternatives Best Challenger Defender Marginal Cost Data? Analysis Technique 3: Defenders EUAC over its remaining life Challengers EUAC at its min. cost life Analysis Technique 2: Defenders lowest EUAC Challengers EUAC at its minimum cost life Defender Marginal Cost Increasing? Available Find EUAC over given life Not Available Find lowest EUAC for Defender No Analysis Technique 1: Defenders next year marginal cost Challengers EUAC Yes

8. Copyright Oxford University Press 2009 The minimum cost life of any new asset is the number of years at which the EUAC of ownership is minimized. Because of increasing operating and maintenance costs, the minimum cost life is often shorter than the assets useful life. EUAC for each possible life, less than or equal to the useful life, is determined. The number of years at which the EUAC is minimum can then be identified. Minimum Cost Life of a New Asset

9. Copyright Oxford University Press 2009 Example 13-1 Minimum Cost Life of a New Asset EUAC(O&M)CREUAC(Total) $500$8,100$8,600 1,1254,2065,331 1,7332,9104,644 2,3252,2644,590* 2,9001,8784,779 3,4591,6225,082 4,0021,4415,442 4,5281,3055,833 5,0381,2016,239 5,5331,1186,650 6,0111,0517,062 6,4749957,470 6,9229497,871 7,3559108,265 7,7738768,649 YearMaint.OperatingO&M 1 $0 $500 2 900 1,800 3 1,3003,100 4 2,700 1,7004,400 5 3,600 2,1005,700 6 4,500 2,5007,000 7 5,400 2,9008,300 8 6,300 3,3009,600 9 7,200 3,70010,900 10 8,100 4,10012,200 11 9,000 4,50013,500 12 9,900 4,90014,800 13 10,800 5,30016,100 14 11,700 5,70017,400 15 12,600 6,10018,700

10. Copyright Oxford University Press 2009 Example 13-1 Minimum Cost Life of a New Asset Capital Recovery O&M Total EUAC

11. Copyright Oxford University Press 2009 Replacement Analysis Decision Map Identify Alternatives Best Challenger Defender Marginal Cost Data? Analysis Technique 3: Defenders EUAC over its remaining life Challengers EUAC at its min. cost life Analysis Technique 2: Defenders lowest EUAC Challengers EUAC at its minimum cost life Defender Marginal Cost Increasing? Available Find EUAC over given life Not Available Find lowest EUAC for Defender No Analysis Technique 1: Defenders next year marginal cost Challengers EUAC Yes

12. Copyright Oxford University Press 2009 Are the defender marginal cost data available? Are the defender marginal costs increasing? The total marginal cost for any year can include: Capital recovery cost (loss in market value and loss interest for the year) Yearly operating and maintenance costs Yearly taxes and insurance Any other expenses that occurs during that year The marginal cost is calculated as an equivalent end-of-year cash flow Defenders Marginal Cost Data

13. Copyright Oxford University Press 2009 Example 13-2 Marginal Cost Calculation Year Market Value Capital RecoveryO&M Cost of Breakdown Risk Total Marginal Cost 1 $18,000 $10,750$2,000$5,000$17,750 2 13,000 7,7002,5005,00015,200 3 9,000 5,9503,0005,00013,950 4 6,000 4,3503,5006,50014,350 5 4,000 2,9004,0008,00014,900 6 3,000 1,6004,5009,50015,600 7 2,500 9505,00011,00016,950 Capital Recovery Cost = MV N-1 (A/P, 15%, 1) – MV N (A/F, 15, 1) = MV N-1 (1+15%) – MV N (1) = (MV N-1 – MV N ) + MV N-1 (15%)

14. Copyright Oxford University Press 2009 Example 13-3 Marginal Cost Calculation Year Market Value Capital Recovery Operating Cost Total Marginal Cost 0 $15,000 1 14,000 $3,250$10,000$13,250 2 13,000 3,10011,50014,600 3 12,000 2,95013,00015,950 4 11,000 2,80014,50017,300 5 10,000 2,65016,00018,650 Capital Recovery Cost = MV N-1 (A/P, 15%, 1) – MV N (A/F, 15, 1) = MV N-1 (1+15%) – MV N (1) = (MV N-1 – MV N ) + MV N-1 (15%)

15. Copyright Oxford University Press 2009 Maintain the Defender as long as the marginal cost of ownership for one more year is less than the Challengers minimum EUAC. When the Defenders marginal cost becomes greater than the Challengers minimum EUAC, then replace the Defender with the Challenger. Replacement Analysis Technique 1: Defender Marginal Cost Increasing

16. Copyright Oxford University Press 2009 Example 13-4 Replacement Analysis Technique 1 Year Challenger Marginal Cost Challenger EUAC 1$17,750$17,750.00 215,20016,563.95 313,95015,811.20 414,35015,518.57 514,90015,426.83* 615,60015,446.61 716,95015,582.46 Year Defender Marginal Cost 1$13,250 214,600 315,950 417,300 518,650

17. Copyright Oxford University Press 2009 Currently available best Challenger will continue to be available in subsequent years and will be unchanged in its economic costs. When the Defender is ultimately replaced, it will be replaced with this Challenger. The period of needed services of the asset is indefinitely long. Replacement Repeatability Assumption

18. Copyright Oxford University Press 2009 Calculate the Defenders minimum EUAC. If the Defenders minimum EUAC exceeds the Challengers minimum EUAC, then replace immediately. If the Defenders minimum EUAC is lower than the Challengers minimum EUAC, then the Defender will be kept at least the minimum cost life. After the minimum cost life, then replace when the Defenders increasing marginal cost exceeds the Challengers minimum EUAC. Replacement Analysis Technique 2: Defender Marginal Cost Not Increasing

19. Copyright Oxford University Press 2009 Example 13-5 Replacement Analysis Technique 2 Year Challenger Marginal Cost Challenger EUAC 1$17,750$17,750.00 215,20016,563.95 313,95015,811.20 414,35015,518.57 514,90015,426.83* 615,60015,446.61 716,95015,582.46 Year Defender Marginal Cost Defender EUAC 1$16,000$16,000.00 214,000$15,069.77 313,500$14,617.71* 415,300$14,754.35 517,500$15,161.57

20. Copyright Oxford University Press 2009 Example 13-6 Finding Minimum Cost Life Year Market Value Capital RecoveryO&M Marginal CostEUAC 0 $5,000 1 4,000 $1,500 $0 $1500$1,500.00 2 3,500 900 100 10001,261.90 3 3,000 850 200 10501,197.89 4 2,500 800 300 11001,176.79 5 2,000 750 400 11501,172.41 6 2,000 200 500 7001,111.18 7 2,000 200 600 8001,078.38 8 2,000 200 700 9001,062.78 9 2,000 200 800 10001,058.16* 10 2,000 200 900 11001,060.78 11 2,000 200 1,000 12001,068.29

21. Copyright Oxford University Press 2009 Example 13-7 Replacement Analysis Technique 2 Year Challenger EUAC 1$8,600 25,331 34,644 44,590* 54,779 Year Defender Overhaul Cost Defender O&M Defender Marginal Cost Defender EUAC 0$4,000 1$1,800$6,120$6,120.00 21,800 4,043.08 32,800 3,660.17* 43,800 3,691.20 54,800 3,880.20

22. Copyright Oxford University Press 2009 Calculate the Defenders EUAC over its stated useful life. If the Defenders EUAC exceeds the Challengers minimum EUAC, then replace immediately. If the Defenders EUAC is lower than the Challengers minimum EUAC, then the Defender will be kept. Replacement Analysis Technique 3: Defender Marginal Cost Not Available

23. Copyright Oxford University Press 2009 Present market value, not the trade-in value, should be assigned as the first cost of the Defender. The first cost of the Challenger should include the purchase price, sales tax, installation cost, and other items that occur initially on a one-time basis if the Challenger is selected. The Defenders potential market (or salvage) value should not be subtracted from the Challengers first cost. Defining First Costs of Defender and Challenger

24. Copyright Oxford University Press 2009 Defender: SK-30, purchased 2 years ago for $1600, was depreciated with SL using 4-year life and 0 salvage. Challenger: EL-40, $1200 with a trade-in allowance of $350 for the SK-30; $1050 without a trade-in. Current price for new SK-30 is $995. Example 13-8 Defining Defender First Cost Defender: SK-30, Original cost: $1600 (Basis for SL depreciation) Present cost: $995 (Irrelevant) Book value: $800 (Useful in determining depreciation recapture or loss) Trade-in value: $350 (Irrelevant) Market value: $200 (First cost assigned to Defender)

25. Copyright Oxford University Press 2009 Circumstances where Repeatability Assumption may not apply: When there is a specific study period instead of an indefinite need for the asset When future Challengers are not assumed to be identical to the current best Challenger Repeatability Assumption Not Acceptable

26. Copyright Oxford University Press 2009 A Closer Look at Future Challengers It seems likely that future challengers will be better than the present Challenger The prospect of better future challengers may make it more desirable to retain the Defender and to reject the present Challenger Selecting the current best Challenger could be risky if 1) high cost and/or 2) long economic life Present Challenger Uniform Decline Rapid Improvements In Technology

27. Copyright Oxford University Press 2009 Ordinary taxes Gains and losses due to asset disposal After-Tax Replacement Analysis

28. Copyright Oxford University Press 2009 Example 13-9 Marginal Costs on After-Tax Basis Year Market Value Book Value Recaptured Depr. or LossTax After-Tax Market Value 0 $25,000 1 18,000 20,000-$2,000-$80018,800 2 13,000 15,000-2,000-80013,800 3 9,000 10,000-1,000-4009,400 4 6,000 5,0001,0004005,600 5 4,000 1,6002,400 6 3,000 1,2001,800 7 2,500 1,0001,500

29. Copyright Oxford University Press 2009 Example 13-9 Marginal Costs on After-Tax Basis Year After- Tax Market Value Capital Recovery O&M+ Ins. Taxable IncomeTax After-Tax Marginal Cost 0 $25,000 1 18,800 $8,700$7,000-$12,000-$4,800$10,900 2 13,800 6,8807,500-12,500-5,0009,380 3 9,400 5,7808,000-13,000-5,2008,580 4 5,600 4,74010,000-15,000-6,0008,740 5 2,400 3,76012,000-17,000-6,8008,960 6 1,800 84014,000-14,000-5,6009,240 7 1,500 48016,000-16,000-6,40010,080

30. Copyright Oxford University Press 2009 Example 13-10 After-Tax Minimum Cost Life Year Market Value MACRS Depr. Book Value Recaptured Depr. or LossTax After-Tax Market Value 0 $100,000 1 50,000 $14,29085,710-$35,710-$14,28464,284 2 45,000 24,49061,220-16,220-6,48851,488 3 40,000 17,49043,730-3,730-1,49241,492 4 35,000 12,49031,2403,7601,50433,496 5 30,000 8,93022,3107,6903,07626,924 6 25,000 8,92013,39011,6104,64420,356 7 20,000 8,9304,46015,5406,21613,784 8 15,000 4,460015,0006,0009,000 9 10,000 0 4,0006,000 10 5,000 0 2,0003,000

31. Copyright Oxford University Press 2009 Example 13-10 After-Tax Minimum Cost Life Yr. After-tax Market Value Capital RecoveryO&M Taxable IncomeTax After-Tax Marginal CostEUAC 0 $100,000 1 64,284 $41,716$10,000-$24,290-$9,716$42,000$42000 2 51,488 16,65314,000-38,490-15,39615,25729018 3 41,492 13,08518,000-35,490-14,19616,88925208 4 33,496 10,48622,000-34,490-13,79618,69023718 5 26,924 8,58226,000-34,930-13,97220,61023167 6 20,356 8,18330,000-38,920-15,56822,61523088* 7 13,784 7,79334,000-42,930-17,17224,62123270 8 9,000 5,61138,000-42,460-16,98426,62723610 9 6,000 3,54042,000-42,000-16,80028,74024056 10 3,000 3,36046,000-46,000-18,40030,96024580

32. Copyright Oxford University Press 2009 Example 13-11 Before-Tax Minimum Cost Life Yr. Market Value Capital RecoveryO&MEUAC(O&M) Total EUAC 0 $19,999 1 13,999 $8,281.62$50$50.00$8,331.62 2 11,199 6,174.985050.006,224.98 3 8,960 5,232.665050.005,282.66 4 7,168 4,623.71450138.774,762.48 5 6,092 4,113.17850260.004,373.17 6 5,179 3,740.771,250394.954,135.72 7 4,402 3,452.781,650535.613,988.39 8 3,742 3,221.472,050677.993,899.45 9 3,180 3,030.812,450819.893,850.69 10 2,703 2,870.702,850960.033,830.73 11 2,298 2,734.393,2501,097.603,831.99 12 1,953 2,617.103,6501,232.103,849.20

33. Copyright Oxford University Press 2009 Example 13-11 Before-Tax Minimum Cost Life