1. 1 Replacement Decision Models Lecture No. 28 Chapter 11 Fundamentals of Engineering Economics Copyright © 2008

2. 2 Required Assumptions and Decision Frameworks  Planning horizon (study period)  Technology  Relevant cash flow information  Decision Criterion

3. 3 Replacement Strategies under the Infinite Planning Horizon 1. Replace the defender now: The cash flows of the challenger will be used from today and will be repeated because an identical challenger will be used if replacement becomes necessary again in the future. This stream of cash flows is equivalent to a cash flow of AE C* each year for an infinite number of years. 2. Replace the defender, say, x years later: The cash flows of the defender will be used in the first x years. Starting in year x+1,the cash flows of the challenger will be used indefinitely.

4. 4 Implicit Assumption Made in AE Method when the Defender’s Remaining Life is Shorter than the Challenger’s Life

5. 5 Example 11.5 Replacement Analysis under the Infinite Planning Horizon Option 1: Retain the old honing machine. Option 2: Replace the old honing machine and buy new.

6. 6 Defender (Old Honing Machine):

7. 7 Cash Flow Transactions Associated with Keeping the Defender for 4 Years

8. 8 Economic Service Life Calculation for Defender (Example 11.5)

9. 9 Economic Service Life Calculation for Challenger (Example 11.5)

10. 10 Step 3: Replacement Decisions Should we replace the defender now? No, because AEC D < AEC C If not, when is the best time to replace the defender? Need to conduct a marginal analysis. N C* =5 years AEC C* =$6,312

11. 11 Marginal Analysis – When to Replace the Defender Question: What is the additional (incremental) cost for keeping the defender one more year from the end of its economic service life, from Year 1 to Year 2? Financial Data: Opportunity cost at the end of year 1: $3,000 (market value of the defender at the end year 1) Operating cost for the 2nd year: $4,500 Salvage value of the defender at the end of year 3: $2,250

12. 12 Marginal Analysis to Determine the Optimal Time for Replacing the Defender with the Challenger

13. 13 Replacement Analysis with Tax Consideration  Whenever possible, replacement decisions should be based on the cash flows after taxes.  When computing the net proceeds from sale of the old asset, any gains or losses must be identified to determine the correct amount of the opportunity cost.  All basic replacement decision rules including the way of computing economic service life remain unchanged.

14. 14 Example 11.6 Replacement Analysis under an Infinite Planning Horizon  Step 1: Economic service life calculation with tax consideration for Defender (Table 11.4)  Step 2: Economic service life calculation with tax consideration for Challenger (Table11.5)  Step 3: Replacement Decision under the Infinite Planning Horizon

15. 15 Economic Service Life Calculation for Defender with income Tax Consideration

16. 16 $0 $4000 $8000 $12,000 $16,000 $20,000 $8,000 $10,285 $20,000$12,000 $2,285 Cost basis Book value Total depreciation $1,715 Market value Loss tax credit Book loss Net proceeds from disposal ($8,914) Determining the Opportunity Cost of the Challenger at the end of Year 1

17. 17 Economics of Owning and Operating the Challenger for N More Years

18. 18 Annual Equivalent Cost ($) nDefenderChallenger 12345671234567 2,940 3,126 3,321 3,522 3,726 3,930 4,980 4,507 4,241 4,089 4,020 4,018 4,069 N* D = 1 yearN* C = 6 years Optimal Time to Replace the Defender

19. 19 Equivalent Annual Cash Flow Streams, when the Defender is Kept for n Years, followed by Infinitely Repeated Purchases of the Similar Challenger every Six Years

20. 20 Use the PW Criterion to Find the Optimal Time to Replace nPW(10%) Cost Sample Calculation at n = 3 012345012345 40,180 39,200 38,631 38,447 38,608 39,073

21. 21 Key Points In replacement analysis, the defender is an existing asset; the challenger is the best available replacement candidate. The current market value is the value to use in preparing a defender’s economic analysis. Sunk costs—past costs that cannot be changed by any future investment decision—should not be considered in a defender’s economic analysis.

22. 22 Two basic approaches to analyzing replacement problems are the cash flow approach and the opportunity cost approach.  The cash flow approach explicitly considers the actual cash flow consequences for each replacement alternative as they occur.  The opportunity cost approach views the net proceeds from sale of the defender as an opportunity cost of keeping the defender.

23. 23 Economic service life is the remaining useful life of a defender, or a challenger, that results in the minimum equivalent annual cost or maximum annual equivalent revenue of owning and operating the asset. We should use the respective economic service lives of the defender and the challenger when conducting a replacement analysis. Ultimately, in replacement analysis, the question is not whether to replace the defender, but when to do so. The AE method provides a marginal basis on which to make a year-by-year decision about the best time to replace the defender. As a general decision criterion, the PW method provides a more direct solution to a variety of replacement problems, with either an infinite or a finite planning horizon, or a technological change in a future challenger.