Replacement Analysis

Replacement Study Basics

Reasons for replacement study
1. Reduced performance
2. Altered requirements
3. Obsolescence

Terminology
Defender – Currently installed asset
Challenger – Potential replacement for defender
Market value (MV) – Value of defender if sold in open market
Economic service life – No. of years at which lowest AW of cost occurs
Defender first cost – MV of defender; used as its first cost (P) in analysis
Challenger first cost – Capital to recover for challenger (usually its P value)
Sunk cost – Prior expenditure not recoverable from challenger cost
Nonowner’s viewpoint – Outsider’s (consultant’s) viewpoint for objectivity
 Example: Replacement Basics
An asset purchased 2 years ago for $40,000 is harder to maintain than
expected. It can be sold now for $12,000 or kept for a maximum of 2
more years, in which case its operating cost will be $20,000 each year,
with a salvage value of $9,000 two years from now. A suitable
challenger will have a first cost of $60,000 with an annual operating
cost of $4,100 per year and a salvage value of $15,000 after 5 years.
Determine the values of
P, A, n, and S for the defender and challenger for an AW analysis.
Solution:
Defender: P = $-12,000; A = $-20,000; n = 2; S = $9,000

Challenger: P = $-60,000; A = $-4,100; n = 5; S = $15,000

 Overview of a Replacement Study
 Replacement studies are applications of the AW
method
 Study periods (planning horizons) are either specified or
unlimited
 Assumptions for unlimited study period:
1. Services provided for indefinite future
2. Challenger is best available now and for future, and will be
repeated in future life cycles
3. Cost estimates for each life cycle for defender and challenger
remain the same
 If study period is specified, assumptions do not hold
 Replacement study procedures differ for the two cases
 Economic Service Life
Economic service life (ESL) refers to the asset
retention time (n) that yields its lowest equivalent
AW
Determined by calculating AW for 1, 2, 3,…n years

General equation is:

Total AW = capital recovery – AW of annual operating costs
= CR – AW of AOC
 Example: Economic Service Life
Determine the ESL of an asset which has the costs shown below. Let i = 10%
Year Cost,$/year Salvage value,$
0 - 20,000 -
1 -5,000 10,000
2 -6,500 8,000
3 - 9,000 5,000
4 -11,000 5,000
Solution: 5 -15,000 3,000
AW1 = - 20,000(A/P,10%,1) – 5000(P/F,10%,1)(A/P,10%,1) + 10,000(A/F,10%,1) = $ -
17,000

AW2 = - 20,000(A/P,10%,2) – [5000(P/F,10%,1) + 6500(P/F,10%,2)](A/P,10%,2)

+ 8000(A/F,10%,2)
= $ -13,429
Similarly, AW3 = $ -13,239 AW4 = $ -12,864 AW5 = $ -13,623
Economic service life is 4 years
Performing a Replacement Study
 Performing a Replacement Study --
Unlimited Study Period
1. Calculate AWD and AWC based on their ESL; select lower AW
2. If AWC was selected in step (1), keep for nC years (i.e., economic
service life of challenger); if AWD was selected, keep defender
one more year and then repeat analysis (i.e., one-year-later
analysis)
3. As long as all estimates remain current in succeeding years, keep
defender until nD is reached, and then replace defender with
best challenger
4. If any estimates change before nD is reached, repeat steps (1)
through (4)

Note: If study period is specified, perform steps (1) through

(4) only through end of study period
 Example: Replacement Analysis
An asset purchased 2 years ago for $40,000 is harder to maintain than
expected. It can be sold now for $12,000 or kept for a maximum of 2 more
years, in which case its operating cost will be $20,000 each year, with a
salvage value of $10,000 after 1 year or $9000 after two years. A suitable
challenger will have an annual worth of $-24,000 per year. At an interest rate
of 10% per year, should the defender be replaced now, one year from now,
or two years from now?
Solution: First, determine ESL for defender
AWD1 = -12,000(A/P,10%,1) – 20,000 + 10,000(A/F,10%,1) = $-23,200

AWD2 = -12,000(A/P,10%,2) – 20,000 + 9,000(A/F,10%,2) = $-22,629

ESL is n = 2 years; AWD = $-22,629
AWC = $-24,000
Lower AW = $-22,629 Replace defender in 2 years
Note: conduct one-year-later analysis next year
 Additional Considerations
Opportunity cost approach is the procedure that was previously
presented for obtaining P for the defender. The opportunity cost is the
money foregone by keeping the defender (i.e., not selling it). This
approach is always correct

Cash flow approach subtracts income received from sale of

defender from first cost of challenger.
Potential problems with cash flow approach:
Provides falsely low value for capital recovery of challenger
Can’t be used if remaining life of defender is not same as that
of challenger
 Replacement Analysis Over Specified Study
Period
Same procedure as before, except calculate AW values over
study period instead of over ESL years of nD and nC

It is necessary to develop all viable defender-challenger

combinations and calculate AW or PW for each one over
study period

Select option with lowest cost or highest income

 Example: Replacement Analysis; Specified
Period
An asset purchased 2 years ago for $40,000 is harder to maintain than
expected. It can be sold now for $12,000 or kept for a maximum of 2 more
years, in which case its operating cost will be $20,000 each year, with a
salvage value of $10,000 after 1 year or $9000 after two. A suitable
challenger will have an annual worth of $-24,000 per year. At an interest rate
of 10% per year and over a study period of exactly 2 years, determine when
the defender should be replaced.
Solution: From previous analysis, AWD for 1 and 2 years, and AWC
are: AW = $-23,200 AWD2 = $-22,629
D1 AWC = $-24,000

Option Year 1, $ Year 2, $ Year 3, $ AW, $

1 (C, C, C) -24,000 -24,000 -24,000 -24,000 Decision: Option
2 (D, C, C) -23,200 -24,000 -24,000 -23,708 3; Keep D for 2
3 (D, D, C) -22,629 -22,629 -24,000 -23,042 years, then
replace
 Replacement Value
Replacement value (RV) is market/trade-in value of
defender that renders AWD and AWC equal to each other

Set up equation AWD = AWC except use RV in place of P for

the defender; then solve for RV

If defender can be sold for amount > RV, challenger is

the better option, because it will have a lower AW value
 Example: Replacement Value
An asset purchased 2 years ago for $40,000 is harder to maintain than
expected. It can be sold now for $12,000 or kept for a maximum of 2
more years, in which case its operating cost will be $20,000 each year,
with a salvage value of $10,000 at the end of year two. A suitable
challenger will have an initial cost of $65,000, an annual cost of
$15,000, and a salvage value of $18,000 after its 5 year life. Determine
the RV of the defender that will render its AW equal to that of the
challenger, using an interest rate of 10% per year. Recommend a course
of action.
Solution: Set AWD = AWC
- RV(A/P,10%,2) - 20,000 + 10,000(A/F,10%,2) = - 65,000(A/P,10%,5) -
15,000 +18,000(A/F,10%,5)
RV = $24,228

Thus, if market value of defender > $24,228, select challenger