1. CHAPTER 9
Replacement Analysis

2. Objectives
To discuss the considerations involved in replacement analysis
To address the key question of whether an asset should be kept one or more years or immediately replaced it with the best available alternative

3. Reasons for replacement analysis
Physical Impairment (Deterioration)
Altered Requirements
Technology
Financing

4. Physical Impairment (Deterioration)
Efficiency loss resulting from continued use
aging
Increased routine and corrective maintenance costs
Greater energy requirements

5. Altered Requirements
Significant change in demand for related products or services
Significant change in the composition or design of associated products or services

6. Technology and Financing
Technological changes typically reduce cost per unit and improve quality of output
Results in earlier replacement of existing assets with improved assets
FINANCING
May involve income tax considerations (depreciation and after-tax analysis) EG: rental of assets may become more attractive than ownership

7. Terminology Challenger Asset
Defender Asset
Currently installed asset
Challenger Asset
The potential replacement or “challenging” asset
Under consideration to replace the defender asset
Together Constitute mutually exclusive alternatives
Select one and reject the other., the Defender and Challenger

8. Investment Concerns Defender
While it may seem strange to charge an investment cost for keeping one’s 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 cash flow from selling the current defender!
The appropriate investment cost to assign to the defender asset is:
The current fair market value of the defender at the time the replacement decision is being examined

9. The Sunk Cost Trap
The past investment in the defender is “sunk” and not totally relevant to the analysis.
A “sunk” cost is any cost that has occurred in the past and cannot be changed or altered by a current decision
Only present and future cash flows should be considered in replacement studies
Sunk costs are irrelevant to replacement decisions, except to extent they affect income taxes
When tax considerations are involved, sunk costs must be included in study

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

11. Investment Concerns-Challenger
The total investment (Pchallenger) required in a new (challenger) asset that will possibly replace the current defender
Known with a fair amount of certainty
Often a trade-in value is offered by a vendor to take in the defender with a credit on the purchase towards the challenger

12. Economic Service Life
Economic life of an asset minimizes equivalent uniform annual cost of owning and operating an asset
Economic life is often shorter than useful or physical life
Number of years for an alternative for which the AW or EUAC is Minimum;
AW or EUAC is an analysis approach for replacement
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.
Termed “The minimum cost life”
Estimate the ESL for the challenger and defender.

13. ESL – General Format AW(i%)t = Capital Recovery AW of operating costs
Compute:
AW(i%)t =
Capital Recovery
AW of operating costs
Salvage values may be incorporated into the capital recovery term.
Do this for n = 1, then n = 2, then n = … and observe the min. cost “n” value.
The minimum cost life is that value of “n” that yields the lowest annual cost over the range of “n” values applied.

14. Min. Total AW of costs life
Typical ESL Plot
Min. Total AW of costs life

15. Example
Defender Asset: 3 years old now, Market value now $13,000, 5-year study period assumed, Requires estimates of the future salvage values and annual operating costs for the 5-year period.
Estimated Future Market Values and AOC’s: (Assume the interest rate is 10% per year)
MktVt AOCt
t = 1: $9,000 $-2,500
t = 2: $8, ,700
t = 3: $6, ,000
t = 4: $2, ,500
t = 5: $0 -4,500

16. Example: Find the ESL Period-by-period analysis
AW(10%)1 = (-$13,000)(A/P,10%,1) + $9,000(A/F,10%,1) –2,500= -$7,800
AW(10%)2 = (-13,000)(A/P,10%,2) + 8,000(A/F,10%,2) -[2,500(P/F,10%,1) + 2,700(P/F,10%,2)](A/P,10%,2) = -$6,276/yr
AW(10%)3 = (-13,000)(A/P,10%,3) +6,000(A/F,10%,3) -[2500(P/F,10%,1) + 2,700(P/F,10%,2) + 3,000(P/F,10%,3](A/P,10%,3) = -$6,132/yr
AW(10%)4 = -$6,556/yr
AW(10%)5= -$6,579/yr

17. Marginal Cost Approach
Marginal Costs are year-by-year estimates of the costs to own the asset, and operate the asset for the current year in question
Three Components of Marginal Costs:
1. Cost of ownership (loss in Mkt. Value/yr);
2. Foregone interest of Mkt. Value at beginning of the year;
3. AOC for each year

18. Marginal Cost Analysis
Compute the marginal costs per year
Find their equivalent annual worth
AW of marginal costs = total AW of costs
Can perform either a ESL analysis or a Marginal Cost analysis when yearly Mkt. Values are estimated
Same result!
The “n” value and the associated AWn are then used in the replacement analysis

19. Marginal Cost Format: Example
Min. Cost Life

20. Setting Up for a Replacement Analysis
Conduct the ESL for the defender and the challenger(s);
Form the following alternatives:
Challenger Alternative (C): AWC for nC yrs;
Defender Alternative: (D): AWD for nD yrs.
“n” Not Known
For “n” of a defender or challenger that is not known or assumed:
Compute the ESL for a range of “n” values where n = {1, then 2, …, then K};
From this period-by-period analysis, determine the min. cost life and the associated AW for that life

21. Replacement: After-Tax
To properly evaluate a replacement- type problem, one should always use an after-tax approach.
Elements that can alter the ATCF vs. a BTCF analysis for replacement
Depreciation and the tax savings
Disposal implications of the defender
Recaptured Depreciation, or
Loss on Disposal
Half-year convention for disposal during the life of the defender if it is not fully recovered

22. Example Existing pump A (defender) Replacement pump B (challenger)
Capital investment when purchased 5 years ago -$17,000
Class life (SL half-year convention rule) years
Annual expenses : O&M and Taxes and insurance -$5,340
Present market value $ 750
Estimated market value at the end of 9 additional years $ 200
Replacement pump B (challenger)
Capital investment $16,000
Class life years
MACRS (GDS) property class 5 years
Estimated market value at the end of 9 years $3,200
Annual expenses: O&M and Taxes and insurance $3,320
Effective income tax rate = 40%, MARR (before taxes) = 10%, MARR (after taxes)= 6%
Use (a) a before-tax analysis, and then (b) an after-tax replacement analysis

23. Solution Before-tax analysis
AWA (10%) = -$5,340 – 750 (A/P, 10%, 9) (A/F, 10%, 9) = -$5,455
AWB (10%)= -$3,320 – 16,000 (A/P, 10%, 9) (A/F, 10%, 9) = -$5,862
Decision: the defender should be kept at least one more year

24. Solution After-tax Analysis for defender
EOY BTCF Dep. TI Taxes ATCF
,750*
*Gain or Loss on disposal (if sold now) =MV now – BV now (if sold now)
BV now (if sold now) = 17,000 – [945+4(1889)]=8500
Loss on disposal (if sold now) = =-7,750
Since we are keeping the defender, we have the reverse effect on taxable income, an increase of 7750 due to opportunity foregone

25. After-tax Analysis for Challenger
EOY BTCF Dep. TI Taxes ATCF
0 -16,000 none -$16,000
1 -3,
AW (6%) of pump A = -3,332
AW (6%) of pump B = -3,375
Pump... is economically preferable

26. Another Example Defender: Other Parameters: Challenger:
Purchased 3 years ago for $600,000
Now outdated due to advancing technology
Assume classical straight line has been applied. (In reality, MACRS would be applied.) with a 8-year recovery life
AOC: $100,000/year and worth $400,000 now!
Challenger:
First Cost: $1,000,000
Assume straight-line depreciation with a 5- year life
Annual Operating costs: $15,000/year
Assume a “0” salvage value at the end of 5 years
Other Parameters:
BT discount rate: 10%, AT discount rate: 7%, and effective tax rate: 34%

27. Economic Service Life Analysis
Assume further that a ESL analysis has been conducted and the following information is available:
For the Defender: ESL from now is 5 more years.
For the Challenger: ESL is 5 years.
Assume a “0” salvage value for both alternatives applies

28. Example Summary If the defender is retained:
BTCF annual cost: $205,520/year
ATCF annual cost: $138,056/year
If the challenger is purchased:
BTCF annual cost: $278,800/year
ATCF annual cost: $187,864/year
Typically, MACRS would be used;
For the defender, only a ½ year of recovery would be permitted
Thus, all ATCF values would be different than what has been shown