1. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-1 Developed By: Dr. Don Smith, P.E. Department of Industrial Engineering Texas A&M University College Station, Texas Executive Summary Version Chapter 11 Replacement and Retention Decisions

2. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-2 LEARNING OBJECTIVES 1.Basics 2.Economic service life 3.Replacement study 4.Additional considerations 5.Study period

3. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-3 Sct 11.1 Basics of Replacement Study  Reduced Performance:  Wear and tear  Decreasing reliability and productivity  Increasing operating and maintenance costs  Altered Requirements:  New production needs, accuracy, speed, etc.  Obsolescence:  Current assets may be less productive  Not state of the art – need to meet competition

4. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-4 Terminology  Defender Asset:  Currently installed asset;  Challenger Asset:  The potential replacement or “challenging” asset;  Under consideration to replace the defender asset.  Together, Defender (D) and Challenger (C)  Constitute mutually exclusive alternatives;  Select one and reject the other.

5. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-5 Terminology - continued  AW values are typically calculated  EUAC –Equivalent Uniform Annual Cost  Includes mostly costs estimates  Economic Service Life (ESL)  For a given alternative is:  Number of years at which the lowest AW-of-cost occurs  Defender First Cost  Initial investment in the defender – P  Current Market value now – correct estimate to assign to keeping a defender

6. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-6 Terminology - continued  Challenger first cost  Amount of capital that must be recovered when replacing a defender with a challenger  Sunk cost  Cost that has occurred in the past and cannot be altered  Sunk costs are generally of no use in a before-tax replacement analysis  Consultant’s viewpoint  The analyst assumes that he/she is an outsider (a consultant)  Thus, the analyst owns neither asset and must assign reasonable value to the defender and challenger

7. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-7 The Proper Viewpoint  For a replacement analysis two investment costs are critical: 1. The proper investment cost to apply to keeping the defender in service; 2. The proper investment cost to apply to any challenger asset that might replace the current defender asset. 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.

8. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-8 Investment Concerns  One must assign an investment cost to KEEPING the defender asset  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.  Challenger Investment  This is the total investment (P challenger ) required for a new (challenger) asset that will possibly replace the current defender.

9. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-9 Sct 11.2 Economic Service Life (ESL)  ESL is:  Number of years n at which the equivalent annual worth (AW) of costs is minimized considering the most current cost estimates over all possible years that the asset may provide a needed service  ESL is the n where total AW is a minimum for tabulation at i% over a selected range of years.  Plot n versus  Total AW = – CR – AW of annual operating costs  Seek the time period that minimizes the Total AW for the range of lives selected

10. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-10 Typical Annual Worth Plot Seek the n value resulting in minimum Total AW Represents the n for Economic Service Life

11. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-11 Tabulating the Total AW of Costs Note the following  Capital recovery costs decline as time increases  AW of costs increase over time  Total AW = - CR - AW costs  See Figure 11-1 and Equation 11.3  Study Example 11.2

12. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-12 Important Points  Marginal costs (MC) are year-by-year estimates of the costs to own and operate an asset for one year  AW of marginal costs = total AW of costs  The analysis is best performed via a spreadsheet model  Refer to Example 11.3

13. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-13 Sct 11.3 Performing a Replacement Study Two approaches: 1.Without a study period 2.With a study period  See Figure 11-4

14. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-14 New Replacement Study  Given: (C) and (D) estimates, select one  Apply:  AW D vs. AW C  Select the better alternative  Stay with the Defender for n D years or,  Go with the challenger for n C years.

15. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-15 One-Year Later Analysis  Validate all cost and market value estimates;  If estimates are still good, is the current year n D ?  If “YES”, replace (D) with (C);  If “NO”, retain defender for one more year and re- evaluate then.  If cost estimates have changed then:  Update all estimates  Calculate AW C and AW D  Initiate a new replacement study.  See Example 11.4

16. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-16 Market Value of Defender  What minimum market value of the defender will make the current challenger economically attractive?  If a high enough market value (trade-in) is possible for the defender asset, one should take it and go with the challenger immediately!  Break-even or replacement value (RV) If the actual market value (trade-in) exceed the breakeven replacement value, the challenger is the better alternative. If this is the case, replace now with the challenger!

17. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-17 Sct 11.4 Additional Considerations in a Replacement Study Several additional aspects of a replacement study 1.Future-year replacement decisions; 2.Opportunity cost vs. Cash flow approaches; 3.Anticipation of improved future challengers. The analyst must understand trends, advances, changes in technology, and competitive pressures that often impact the remaining life of a defender and the challenger

18. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-18 Future Replacement Decisions 1. Future-year replacement decisions:  Replace now? One year from now? Two years from now? etc.  The procedure just presented does assist with answering this question provided: The cost estimates for (C) and (D) do not change!

19. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-19 Future Replacement Decisions 1. Future-year replacement decisions: If cost estimates change for either (D) or (C) then the analysis should be initiated again within a reasonable time frame. With changing estimates the decision to replace may be altered

20. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-20 2. Opportunity Cost vs. Cash Flow Opportunity cost approach  The method just presented applies the opportunity cost approach: Investment in D now is the fair market value of D now; Represents the opportunity cost foregone by not disposing of D now; Investment in C now is the first cost of C  This is a correct approach for a replacement analysis.

21. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-21 Cash Flow Approach  Assumes that when the challenger is selected and the defender trade-in is a cash inflow, then:  The investment in the challenger is immediately reduced by the trade-in amount.  Discourage this approach;  Works only if the lives of C and D are equal!

22. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-22 Anticipation of Future Challengers 3. Assumption: At some time in the future a worthy challenger will appear and replace the defender.  Always study future trends of challengers;  May be best to augment the defender until such time that a more worthy challenger becomes available.  Tax considerations should be considered (see Chapter 17)

23. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-23 Sct 11.5 Specified Study Period  At times, a fixed study period will apply to both the challenger and defender.  Such a study may not be based upon the ESL approach for one or both alternatives.  If a fixed study period then approach is……

24. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-24 Specified Study Period  Determine AW for both C and D over the prescribed study period;  No need to perform an ESL analysis;  Assumption is that the services of C and D are not needed beyond the study period.  Use the AW relations over the study period to select C or D

25. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-25 Defender’s Remaining Life  If the defender’s remaining life is shorter than the study period … Focus on upgrading the defender and obtain cost estimates in order to extend the defender out to the study period. These costs become part of retaining the defender out to the prescribed study period and are used in the replacement study

26. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-26 Chapter Summary  Compare the best challenger to the current defender;  “Best” is defined as the option with the lowest AW of costs over the specified period of time;  Apply the ESL method to find the economic life of the defender and challenger;  For ESL, need estimates of future market values and annual operating costs for both C and D.  AW is the best method, especially if alternative lives are unequal.

27. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-27 Summary - continued  For a fixed study period, apply the traditional AW method for both D and C.  Always focus on the estimates of future costs and market values using sound principles of estimation.  Avoid the trap of incorporating sunk costs into a replacement analysis

28. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6 th Edition, 2005 © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 11-28 Chapter 11 End of Set