Contemporary Engineering Economics, 4 th edition, © 2007 Replacement Analysis Fundamentals Lecture No. 56 Chapter 14 Contemporary Engineering Economics Copyright © 2006

Contemporary Engineering Economics, 4 th edition, © 2007 Chapter Opening Story – Options for Replacing Alaskan Viaduct Issue: The Washington State Department of Transportation has to decide whether the state should replace the damaged viaduct with a tunnel or to rebuild the viaduct in its current existing structure Option 1: Build a Tunnel  Cost: $3.6B to $4.1B Option 2: Rebuild the Viaduct  Cost: $2.7-$3.1B

Contemporary Engineering Economics, 4 th edition, © 2007 Sunk cost: any past cost unaffected by any future decisions Trade-in allowance: value offered by the vendor to reduce the price of a new equipment Defender: an old machine Challenger: a new machine Current market value: selling price of the defender in the market place Replacement Terminology

Contemporary Engineering Economics, 4 th edition, © 2007 Sunk Cost associated with an Asset’s Disposal $0 $5000 $10,000 $15,000 $20,000 $25,000 $30,000 Original investment $10,000$5000 Market value $10,000 Lost investment (economic depreciation) Repair cost $20,000 Sunk costs = $15,000

Contemporary Engineering Economics, 4 th edition, © 2007 Replacement Decisions Cash Flow Approach  Treat the proceeds from sale of the old machine as down payment toward purchasing the new machine.  This approach is meaningful when both the defender and challenger have the same service life. Opportunity Cost Approach  Treat the proceeds from sale of the old machine as the investment required to keep the old machine.  This approach is more commonly practiced in replacement analysis.

Contemporary Engineering Economics, 4 th edition, © 2007 Example 14.2 Defender  Market price: $10,000  Remaining useful life: 3 years  Salvage value: $2,500  O&M cost: $8,000 Challenger  Cost: $15,000  Useful life: 3 years  Salvage value: $5,500  O&M cost: $6,000

Contemporary Engineering Economics, 4 th edition, © $8000 $2500 $15,000 $6000 $5500 (a) Defender(b) Challenger $10,000 Sales proceeds from defender Replacement Analysis – Cash Flow Approach

Contemporary Engineering Economics, 4 th edition, © 2007 Defender: PW(12%) D = $8,000 (P/A, 12%, 3) -$2,500 (P/F, 12%, 3) = $17, AEC(12%) D = PW(12%) D (A/P, 12%, 3) = $7, Challenger: PW(12%) C = $5,000 + $6,000 (P/A, 12%, 3) - $5,500 (P/F, 12%, 3) = $15, AEC(12%) C = PW(12%) C (A/P, 12%, 3) = $6, Replace the defender now! Annual Equivalent Cost - Cash Flow Approach

Contemporary Engineering Economics, 4 th edition, © 2007 Comparison of Defender and Challenger Based on Opportunity Cost Approach

Contemporary Engineering Economics, 4 th edition, © 2007 Defender: PW(12%) D = -$10,000 - $8,000(P/A, 12%, 3) + $2,500(P/F, 12%, 3) = -$27, AEC(12%) D = -PW(12%) D (A/P, 12%, 3) = $11, Challenger: PW(12%) C = -$15,000 - $6,000(P/A, 12%, 3) + $5,500(P/F, 12%, 3) = -$25, AEC(12%) C = -PW(12%) C (A/P, 12%, 3) = $10, Replace the defender now! Annual Equivalent Cost - Opportunity Cost Approach