Engineering Economy (17HS6ICEEM)

MODULE 5
REPLACEMENT ANALYSIS: Introduction, reasons for replacement, Individual Replacement
of machinery or equipment with/without value of money, Group Replacement Policies,
Problems.

7.1 Introduction
Replacement analysis is concerned with the question, when is it time to replace existing
equipment with a new one? When the old one wears out.'' It is possible, after all, to keep a 1957
Chevy running up to the present day, if you're prepared to spend enough time and money on it.
Conversely, it may be worth replacing an IBM XT with a Pentium well before the former breaks
down. The figure 7.1 clearly explains about replacement of an equipment.

Time

Figure 7.1 Replacement of equipment

7.2 Reasons for Replacement

1. Technological development

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 Engineering Economy (17HS6ICEEM)

2. Poor performance over years

3. Unable to meet the required demands
Capital equipment that deteriorates with time: It is concerned with the equipment an machinery
that deteriorates with time.Many people feel that equipment should not be replaced until it is
physically worn off. But, it is not correct, preferable equipment must be constantly renewed and
updated otherwise it will be in the risk of failure or it may become obsolete.
Reasons for replacement
1. Deterioration
2. Obsolescence
3. Technological development
4. Inadequacy

Deterioration is the decline in the performance of the equipment as compared to the new
equipment. It may occur due to wear and tear. Due to this
a) Increase in the maintenance cost.
b) Reduces the product quality
c) Decreases the rate of production
d) Increases the labor cost
e) Reduces the efficiency of the equipment

7 .3Models:

Model 1:
“Replacement of items whose maintenance Cost increases with time and the value of the money
remains constant during the period”
Model 2: “replacement of items whose maintenance cost increases with time and value of money
also changes with time”.

Model 3: “Group Replacement policy”

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 Engineering Economy (17HS6ICEEM)

Model1: Notation and symbols

C- Purchase cost of the machinery or equipment

S- Salvage value or resale value or scrap value of the machinery or equipment

Tc- total cost increased on the item or equipment during the period y
Tc = C + m(Y) – S
Where M(Y) is the cumulative maintenance cost in that period.

G(Y) Average cost incurred on the equipment or item during the period. G(Y)
= Tc / y
Problem 1:
The cost of the machine is Rs 6100/- and its scrap value is Rs 100 at the end of every year. The
maintnance cost found from experience are as follows:
Year 1 2 3 4 5 6 7 8
M.C 100 250 400 600 900 1200 1600 2000

When should the machine be replaced?

Solution:
Given: C=Rs 6100
S=Rs 100
Year (Y) Maintenance Cumulative Total Cost Average
Maintenance C-S + m(y) Cost g(y)
cost m(y)
1 100 100 6100 6100
2 250 350 6350 3175
3 400 750 6750 2250
4 600 1350 7350 1837.5
5 900 2250 8250 1650
6 1200 3450 9450 1575
7 1600 5050 11050 1578.5
8 2000 7050 13050 1631.25

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 Engineering Economy (17HS6ICEEM)

It’s clear from the above analysis that the machine has to replaced at the end of 6th year or at the
beginning of 7th year because the maintenance cost of 7th year is more than the average cost of
the machine i.e 1578.5 > 1575.5

Problem 2:
Machine A costs Rs 9000/- annual operating cost is Rs 200/- for the first year and then increases
by Rs 2000/- every year. Determine the best age at which the machine should be replaced and
what would be the average cost of owning is operating cost of the machine? Machine B costs Rs
10000/- annual operating cost is Rs 400/- for the first year and then increased by Rs. 800/- every
year you now have a machine A which is one year old. Should you replace it with B? If so
when? Assume machines have no resale value and that the future costs are not discounted.
Solution:
Machine A:
Cost price C = Rs 9000 S = Rs 0
Year (Y) Maintenance Cumulative Total cost (Tc ) Average Cost
Cost Maintenance C-S + m(y) g(y)
cost m(y)
1 200 200 9200 9200
2 2200 2400 11400 5700
3 4200 6600 15600 5200
4 6200 12800 21800 5450
5 8200 21000 30000 6000

Machine B:
Cost price C =Rs 10,000 S =0
Year (Y) Maintenance Cumulative Total cost (Tc ) Average Cost
Cost Maintenance C-S + m(y) g(y)
cost m(y)
1 400 400 10400 10400
2 1200 1600 11600 5800
3 2000 3600 13600 4533.33
4 2800 6400 16400 4100
5 3600 10000 20000 4000
6 4400 14400 24400 4066.67

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 Engineering Economy (17HS6ICEEM)

Machine A should be replaced at the end of the 3rd year and the average cost is 5200/- . machine
B should be replaced at the end of 5th year and the average cost is Rs 4000/-. The I year
maintenance cost of machine A which is a year old is Rs2200/- < which is less than the average
cost of machine B i.e. 4000. The II year maintenance cost of machine A ( 1 year old) is 4200 >
avg cost of machine B (i.e. 4000/-) The III year maintenance cost of machine A is 6200/- which
is greater than the average cost of machine B. i.e. 4000/-. It is clear from above analysis that
machine A that is one year old can be used one more year from now and then replaced with
machine B.
Model 2
“Replacement of items whose maintenance cost increases with time and the value of money also
changes with time” The maintenance cost varies with time and we want to find out the optimum
time period at which the items will be replaced value of money decreases with a constant rate
which is known as depreciation ratio or discounted factor which is given by V= 1/ (1+i)^n-1
for the value of 1 rupee
where i rate of interest,
n- no. of years

Problem 5:
A company buys a machine for Rs 6000/-. The maintenance cost are expected to be Rs 300/- in
each year for the first 2 years and go up annually as follows 700, 1000, 1500, 2000, and 2500.
Assume the money is worth of 20% per year. When the machine should be replaced.
Solution
C = 6000/-
I = 20%
Assumption: - in this to solve the problem we assume that the maintenance cost is
spent on the machine at the beginning of each year as 1.

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 Engineering Economy (17HS6ICEEM)

Year Maintenance Present Present Cumulative Total cost Cumulative Weighted

cost value value of Present Tc = Present value Average
of 1 Re Maintenance value C-S + m(y) of 1 Re cost
P/F, cost Maintenance (TC/Cum
present Value)
20% cost m (y)
1 300 1 300 300 6300 1 6300
2 300 0.833 249.9 549.9 6549.9 1.833 3573.32
3 700 0.694 486.1 1036 7036 2.527 2784.32
4 1000 0.578 578 1614 7614 3.105 2452.17
5 1500 0.482 723 2337 8337 3.587 2324.22
6 2000 0.401 802 3139 9139 3.988 2291.62
7 2500 0.334 835 3974 9974 4.322 2307.72
rd
Specimen calculations for 3 year by
n-1
V= 1/ (1+i)
2
1/ (1.2)

=0.694

=0.694*700 = 486.1
th th
The machine should be replaced at the end of 6 year or at the beginning of 7 year
th
because the maintenance cost in the 7 year is more than the average cost of the machine
2500 > 2291.62

Problem 6:
A machine cost Rs 10000/- the operating cost is Rs 500/- for the first 5 years and then increased
by Rs 100/- every year subsequently from the 6th year onwards.Assuming the money is worth of
10% per year. Find the optimal length of time to hold the machine before replacement.
Solution:
C=10,000, i = 10%
S=0
Assumption:

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 Engineering Economy (17HS6ICEEM)

To solve the problem, we assume that maintenance cost spent on the equipment is at the
beginning of each year.
Specimen Calculations for 3rd year
V= 1/ (1+i)^n-1
= 1/ (1.1)3
=0.826
= 0.826 x 500
= 413

Year Maintenance Present Present Cumulative Total cost Cumulativ Weighted

cost value of value of Present value Tc =C-S + m(y) e Present Average
1 Re Maintenance Maintenance value of 1 cost
cost cost m (y) Re
1 500 1 500 500 10500 1 10500
2 500 0.909 454.5 954.5 10954.5 1.909 5738.34
3 500 0.826 413 1367.5 11367.5 2.735 4156.31
4 500 0.751 375.5 1743 11743 3.486 3368.62
5 500 0.683 341.5 2084.5 12084.5 4.169 2898.66
6 600 0.621 372.6 2457.1 12457.1 4.79 2600.65
7 700 0.564 394.8 2851.9 12851.9 5.354 2400.43
8 800 0.513 410.4 3262.3 13262.3 5.867 2260.49
9 900 0.466 419.4 3681.7 13681.7 6.333 2160.38
10 1000 0.424 424 4105.7 14105.7 6.757 2087.57
11 1100 0.385 423.5 4529.2 14529.2 7.142 2034.33
12 1200 0.350 420 4949.2 14949.2 7.492 1995.36
13 1300 0.318 413.4 5362.6 15362.6 7.81 1967.04
14 1400 0.289 404.6 5767.2 15767.2 8.099 1946.81
15 1500 0.263 394.5 6161.7 16161.7 8.362 1932.76
16 1600 0.239 382.4 6544.1 16544.1 8.601 1923.51
17 1700 0.217 368.9 6913 16913 8.818 1918.01
18 1800 0.198 356.4 7269.4 17269.4 9.016 1915.42
19 1900 0.180 342 7611.4 17611.4 9.196 1915.11
20 2000 0.163 326 7937.4 17937.4 9.359 1916.59

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 Engineering Economy (17HS6ICEEM)

Conclusion: The machine should be replaced at the end of 19th year or at the beginning of 20
year because the maintenance cost in the 20th year is more than the average cost of 19th year i.e.
1916.59 > 1915.11

It is better to replace at the end of 10th year Rs 18000.40/-

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EXAMPLE A firm is considering replacement of an equipment,
whose first cost is Rs. 4,000 and the scrap value is negligible at the end of
any year. Based on experience, it was found that the maintenance cost is
zero during the first year and it increases by Rs. 200 every year thereafter.
(a) When should the equipment be replaced if i = 0%?
(b) When should the equipment be replaced if i = 12%?

(a) When i = 0%. In this problem,

(i) First cost = Rs. 4,000
(ii) Maintenance cost is Rs. 0 during the first year and it increases
by Rs. 200 every year thereafter.
This is summarized in column B of Table 8.1.

Table 8.1 Calculations to Determine Economic Life (First cost = Rs. 4,000, Interest = 0 %)

End of Maintenance Summation of Average cost of Average first Average total

year cost at end maintenance maintenance cost if replaced cost through
of year costs through year at year end year given
(n) given given
SB C/A 4,000/A D+E
A B (Rs.) C (Rs.) D (Rs.) E (Rs.) F (Rs.)
1 0 0 0 4,000.00 4,000.00
2 200 200 100 2,000.00 2,100.00
3 400 600 200 1,333.33 1,533.33
4 600 1,200 300 1,000.00 1,300.00
5 800 2,000 400 800.00 1,200.00
6 1,000 3,000 500 666.67 1,166.67*
7 1,200 4,200 600 571.43 1,171.43
*Economic life of the machine = 6 years

Column C summarizes the summation of maintenance costs for each

replacement period. The value corresponding to any end of year in this column
represents the total maintenance cost of using the equipment till the end of that
particular year.
 First cost (FC) + Summation of maintenance cost
Average total cost =
Replacement period
FC Column C
= +
n n
Average first cost for + Average maintenance cost
= the given period for the given period

Column F = Column E + Column D

The value corresponding to any end of year (n) in Column F represents the
average total cost of using the equipment till the end of that particular year.
For this problem, the average total cost decreases till the end of year 6 and
then it increases. Therefore, the optimal replacement period is six years, i.e.
economic life of the equipment is six years.

(b) When interest rate, i = 12%. When the interest rate is more than 0%,
the steps to be taken for getting the economic life are summarized with
reference to Table 8.2.

Table 8.2 Calculations to Determine Economic Life (First cost = Rs. 4,000,
Interest = 12%)

End of Maintenance P/F, 12%, Present worth Summation of Present worth A/P, 12%, Annual
year cost at end n as of beginning present worth of cumulative n equivalent
of year of year 1 of of maintenance maintenance total
(n) maintenance costs through cost & first cost through
costs year given cost year given
(B ´ C) SD E + Rs. 4,000 F´G
A B (Rs) C D (Rs.) E (Rs.) F (Rs.) G H (Rs.)
1 0 0.8929 0.00 0.00 4,000.00 1.1200 4,480.00
2 200 0.7972 159.44 159.44 4,159.44 0.5917 2,461.14
3 400 0.7118 284.72 444.16 4,444.16 0.4163 1,850.10
4 600 0.6355 381.30 825.46 4,825.46 0.3292 1,588.54
5 800 0.5674 453.92 1,279.38 5,279.38 0.2774 1,464.50
6 1,000 0.5066 506.60 1,785.98 5,785.98 0.2432 1,407.15
7 1,200 0.4524 542.88 2,328.86 6,328.86 0.2191 1,386.65*
8 1,400 0.4039 565.46 2,894.32 6,894.32 0.2013 1,387.83
9 1,600 0.3606 576.96 3,471.28 7,471.28 0.1877 1,402.36
10 1,800 0.3220 579.60 4,050.88 8,050.88 0.1770 1,425.00
*Economic life of the machine = 7 years

The steps are summarized now:

1. Discount the maintenance costs to the beginning of year 1.
1
Column D = Column B ´
(1 + i)n
= Column B ´ (P/F, i, n) = Column B ´ Column C.
2. Find the summation of present worth of maintenance costs through the
year given (Column E = S Column D).
 3. Find Column F by adding the first cost of Rs. 4,000 to Column E.
4. Find the annual equivalent total cost through the years given.

i (1 + i )n
Column H = Column F ´
(1 + i )n − 1
= Column F ´ (A/P, 12%, n) = Column F ´ Column G

5. Identify the end of year for which the annual equivalent total cost is
minimum.
For this problem, the annual equivalent total cost is minimum at the end of
year 7. Therefore, the economic life of the equipment is seven years.

EXAMPLE The following table gives the operation cost, maintenance

cost and salvage value at the end of every year of a machine whose
purchase value is Rs. 20,000.
Find the economic life of the machine assuming interest rate, i = 15%.

End of year Operation cost Maintenance Salvage value

(n) at the end of cost at the at the end of
year (Rs.) end of year (Rs.) year (Rs.)
1 3,000 300 9,000
2 4,000 400 8,000
3 5,000 500 7,000
4 6,000 600 6,000
5 7,000 700 5,000
6 8,000 800 4,000
7 9,000 900 3,000
8 10,000 1,000 2,000
9 11,000 1,100 1,000
10 12,000 1,200 0

Solution
First cost = Rs. 20,000
Interest rate = 15%
The other details are summarized in Table 8.3 along with regular
calculations for determining the economic life.
 Table 8.3 Calculations to Determine Economic Life

(First Cost = Rs. 20,000, Interest Rate = 15%)

End of Operation Maintenance Sum of operation Present worth Cumulative Salvage Present Total A/P, 15%, Annual
year cost at cost at the and maintenance as of beginning sum of value at worth present n equlant.
the end end of year costs at the end P/F, 15%, of year 1 of sum column F the end as of worth total
(n) of year of year n of operation & through year of year beginning cost
maintenance cost designated of year 1 through
of salvage year
value given
B+C D´E SF H´E G + 20,000 – I J´K
A B (Rs.) C (Rs.) D (Rs.) E F (Rs.) G (Rs.) H (Rs.) I (Rs.) J (Rs.) K L (Rs.)
1 3,000 300 3,300 0.8696 2,869.68 2,869.68 9,000 7,826.40 15,043.28 1.1500 17,299.77
2 4,000 400 4,400 0.7562 3,326.84 6,196.52 8,000 6,048.80 20,147.72 0.6151 12,392.86
3 5,000 500 5,500 0.6575 3,616.25 9,812.77 7,000 4,602.50 25,210.27 0.4380 11,042.01
4 6,000 600 6,600 0.5718 3,773.88 13,586.65 6,000 3,430.80 30,155.85 0.3503 10,563.59
5 7,000 700 7,700 0.4972 3,828.44 17,415.09 5,000 2,486.00 34,929.09 0.2983 10,419.35 *
6 8,000 800 8,800 0.4323 3,804.24 21,219.33 4,000 1,729.20 39,490.13 0.2642 10,433.29
7 9,000 900 9,900 0.3759 3,721.41 24,940.74 3,000 1,127.70 43,813.04 0.2404 10,532.66
*Economic Life = 5 years
Total annual equivalent cost
Ë Cumulative sum of
Present worth Û
Ì present worth as of Ü
Ì =
beginning of year 1 + First  as of beginning Ü – (A /P, 15%, n)
Ì of operation and cost of year 1 of Ü
ÌÍ maintenance costs salvage value ÜÝ

i.e. Column L = (Column G + 20,000 – Column I) ´ Column K

= Column J ´ Column K
In Column L, the annual equivalent total cost is minimum for n = 5. Therefore,
the economic life of the machine is five years.

EXAMPLE 8.3 A company has already identified machine A and determined

the economic life as four years by assuming 15% interest rate. The annual
equivalent total cost corresponding to the economic life is Rs. 2,780.
Now, the manufacturer of machine B has approached the company.
Machine B, which has the same capacity as that of machine A, is priced at
Rs. 6,000. The maintenance cost of machine B is estimated at Rs. 1,500 for the
first year and an equal yearly increment of Rs. 300 thereafter.
If the money is worth 15% per year, which machine should be purchased?
(Assume that the scrap value of each of the machines is negligible at any year.)

Determination of economic life and corresponding annual equivalent total cost

of machine B. The details of machine B are summarized in Table 8.4 along
with the usual calculations to determine the economic life.

Table 8.4 Calculations to Determine Economic Life (First Cost = Rs. 6,000, Interest = 15%)

End of Maintenance P/F, 15%, Present worth Summation of Column E A/P, 15%, Annual
year cost for end n as of beginning present worth + n equivalent total
(n) of year of year 1 of of maintenance Rs. 6000 cost through
maintenance costs through year given
costs year given
B´C SD F´G
A B (Rs) C D (Rs.) E (Rs.) F (Rs.) G H (Rs.)
1 1,500 0.8696 1,304.40 1,304.40 7,304.40 1.1500 8,400.06

2 1,800 0.7561 1,360.98 2,665.38 8,665.38 0.6151 5,330.08

3 2,100 0.6575 1,380.75 4,046.13 10,046.13 0.4380 4,400.21

4 2,400 0.5718 1,372.32 5,418.45 11,418.45 0.3503 3,999.88

5 2,700 0.4972 1,342.44 6,760.89 12,760.89 0.2983 3,806.57

6 3,000 0.4323 1,296.90 8,057.79 14,057.79 0.2642 3,714.07

7 3,300 0.3759 1,240.47 9,298.26 15,298.26 0.2404 3,677.70

8 3,600 0.3269 1,176.84 10,475.10 16,475.10 0.2229 3,672.30 *

9 3,900 0.2843 1,108.77 11,583.87 17,583.87 0.2096 3,685.58

10 4,200 0.2472 1,038.24 12,622.11 18,622.11 0.1993 3,711.39

*Economic life of the machine = 8 years
 Column B of Table 8.4 summarizes the yearly maintenance costs of
machine B. The first cost of machine B is equal to Rs. 6,000.
Annual equivalent total cost

ËSummation of present worth First Û

= Ìof maintenance cost through + cost Ü ´ (A/P, 15%, n)
ÍÌ year ÜÝ

= (Column E + Rs. 6,000) ´ Column G

= Column F ´ Column G

In Column H, the minimum annual equivalent total cost occurs when n

is equal to 8. Hence the economic life of machine B is 8 years and the
corresponding annual equivalent total cost is Rs. 3,672.30.

RESULT
Minimum annual equivalent total cost for machine A = Rs. 2,780
Minimum annual equivalent total cost for machine B = Rs. 3,672.30
Since the minimum annual equivalent total cost of machine A is less than
that of machine B, machine A is selected as the best machine which has the
economic life of four years. (Note: Selection of the best machine is based on the
minimum annual equivalent total cost. The comparison is made over the
minimum common multiple of the lives of machine A and machine B, i.e.
4 ´ 2 = 8 years).

8.5 REPLACEMENT OF EXISTING ASSET WITH A

NEW ASSET

In this section, the concept of comparison of replacement of an existing asset

with a new asset is presented. In this analysis, the annual equivalent cost of each
alternative should be computed first. Then the alternative which has the least
cost should be selected as the best alternative. Before discussing details, some
preliminary concepts which are essential for this type of replacement analysis
are presented.

8.5.1 Capital Recovery with Return

Consider the following data of a machine. Let
P = purchase price of the machine,
F = salvage value of the machine at the end of machine life,
n = life of the machine in years, and
i = interest rate, compounded annually
The corresponding cash flow diagram is shown in Fig. 8.3.
 S
F
i%
0 1 2 3 n
. .

P
Fig. 8.3 Cash flow diagram of machine.

The equation for the annual equivalent amount for the above cash flow
diagram is
AE(i) = (P – F) ´ ( A/P, i, n) + F ´ i + A
This equation represents the capital recovery with return.

8.5.2 Concept of Challenger and Defender

If an existing equipment is considered for replacement with a new equipment,
then the existing equipment is known as the defender and the new equipment is
known as challenger.
Assume that an equipment has been purchased about three years back for
Rs. 5,00,000 and it is considered for replacement with a new equipment. The
supplier of the new equipment will take the old one for some money, say,
Rs. 3,00,000. This should be treated as the present value of the existing
equipment and it should be considered for all further economic analysis. The
purchase value of the existing equipment before three years is now known as
sunk cost, and it should not be considered for further analysis.

EXAMPLE 8.4 Two years ago, a machine was purchased at a cost of

Rs. 2,00,000 to be useful for eight years. Its salvage value at the end of its life
is Rs. 25,000. The annual maintenance cost is Rs. 25,000. The market value of
the present machine is Rs. 1,20,000. Now, a new machine to cater to the need
of the present machine is available at Rs. 1,50,000 to be useful for six years. Its
annual maintenance cost is Rs. 14,000. The salvage value of the new machine
is Rs. 20,000. Using an interest rate of 12%, find whether it is worth replacing
the present machine with the new machine.

Solution Alternative 1—Present machine

Purchase price = Rs. 2,00,000
Present value (P) = Rs. 1,20,000
Salvage value (F) = Rs. 25,000
Annual maintenance cost (A) = Rs. 25,000
Remaining life = 6 years
Interest rate = 12%
The cash flow diagram of the present machine is illustrated in Fig. 8.4. The
 25,000

–2 –1 0 1 2 3 4 5 6

25,000 25,000 25,000 25,000 25,000 25,000

1,20,000
2,00,000
2,20,000
Fig. 8.4 Cash flow diagram for alternative 1.

annual maintenance cost for the preceding periods are not shown in this figure.
The annual equivalent cost is computed as
AE(12%) = (P – F)(A/P, 12%, 6) + F ´ i + A
= (1,20,000 – 25,000)(0.2432) + 25,000 ´ 0.12 + 25,000
= Rs. 51,104
Alternative 2 — New machine
Purchase price (P) = Rs. 1,50,000
Salvage value (F) = Rs. 20,000
Annual maintenance cost (A) = Rs. 14,000
Life = 6 years
Interest rate = 12%
The cash flow diagram of the new machine is depicted in Fig. 8.5.

20,000

0 1 2 3 4 5 6

14,000 14,000 14,000 14,000 14,000 14,000

1,50,000
Fig. 8.5 Cash flow diagram for alternative 2.

The formula for the annual equivalent cost is

AE(12%) = (P – F)(A/P, 12%, 6) + F ´ i + A
= (1,50,000 – 20,000)(0.2432) + 20,000 ´ 0.12 + 14,000
= Rs. 48,016
Since the annual equivalent cost of the new machine is less than that of the
present machine, it is suggested that the present machine be replaced with the
new machine.
EXAMPLE 8.5 A diesel engine was installed 10 years ago at a cost of
Rs. 50,000. It has a present realizable market value of Rs. 15,000. If kept, it can
be expected to last five years more, with operating and maintenance cost of
Rs. 14,000 per year and to have a salvage value of Rs. 8,000 at the end of the
fifth year. This engine can be replaced with an improved version costing
Rs. 65,000 which has an expected life of 20 years. This improved version will
have an estimated annual operating and maintenance cost of Rs. 9,000 and
ultimate salvage value of Rs. 13,000. Using an interest rate of 15%, make an
annual equivalent cost analysis to determine whether to keep or replace the old
engine.

Solution Alternative 1— Old diesel engine

Purchase price = Rs. 50,000
Present value (P) = Rs. 15,000
Salvage value (F) = Rs. 8,000
Annual operating and maintenance cost (A) = Rs. 14,000
Remaining life (n) = 5 years
Interest rate = 15%
The cash flow diagram of the old diesel engine is shown in Fig. 8.6.

8,000

–10 . –1 0 1 2 3 4 5

14,000 14,000 14,000 14,000 14,000

15,000
50,000
Fig. 8.6 Cash flow diagram for alternative 1.

The formula for the annual equivalent cost is

AE(15%) = (P – F)(A/P, 15%, 5) + F ´ i + A
= (15,000 – 8,000)(0.2983) + 8,000 ´ 0.15 + 14,000
= Rs. 17,288.10
Alternative 2 — New diesel engine
Present value (P) = Rs. 65,000
Salvage value (F) = Rs. 13,000
Annual operating and maintenance cost (A) = Rs. 9,000
Life (n) = 20 years
Interest rate = 15%
The cash flow diagram of the new diesel engine is shown in Fig. 8.7.
 13,000

0 1 2 3 . 20

9,000 9,000 9,000 9,000

65,000
Fig. 8.7 Cash flow diagram for alternative 2.

The formula for the annual equivalent cost is

AE(15%) = (P – F)(A/P, 15%, 20) + F ´ i + A
= (65,000 – 13,000)(0.1598) + 13,000 ´ 0.15 + 9,000
= Rs. 19,259.60
For comparing the engines based on equal lives (20 years), the annual
equivalent figures are given in Fig. 8.8. Equal lives are nothing but the least
common multiple of the lives of the alternatives.

0 0
17,288.10 1 19,259.60 1
17,288.10 2 19,259.60 2
17,288.10 3 19,259.60 3
17,288.10 4 19,259.60 4
17,288.10 5 19,259.60 5
17,288.10 6 19,259.60 6
17,288.10 7 19,259.60 7
17,288.10 8 19,259.60 8
17,288.10 9 19,259.60 9
17,288.10 10 19,259.60 10
17,288.10 11 19,259.60 11
17,288.10 12 19,259.60 12
17,288.10 13 19,259.60 13
17,288.10 14 19,259.60 14
17,288.10 15 19,259.60 15
17,288.10 16 19,259.60 16
17,288.10 17 19,259.60 17
17,288.10 18 19,259.60 18
17,288.10 19 19,259.60 19
17,288.10 20 19,259.60 20
Old engine New engine
Fig. 8.8 Cash flow diagram of alternatives based on common lives.

Since the annual equivalent cost of the old diesel engine is less than that of the
new diesel engine, it is suggested to keep the old diesel engine. Here, an
important assumption is that the old engine will be replaced four times during
the 20 years period of comparison.
EXAMPLE 8.6 A steel highway bridge must either be reinforced or replaced.
Reinforcement would cost Rs. 6,60,000 and would make the bridge fit for an
additional five years of service. If it is reinforced, it is estimated that its net
salvage value would be Rs. 4,00,000 at the time it is retired from service. The
new prestressed concrete bridge would cost Rs. 15,00,000 and would meet the
foreseeable requirements of the next 40 years. Such a bridge would have no
salvage value. It is estimated that the annual maintenance cost of the reinforced
bridge would exceed that of the concrete bridge by Rs. 96,000. If the bridge is
replaced by a new prestressed concrete bridge, the scrap value of the steel would
exceed the demolition cost by Rs. 4,20,000. Assume that the money costs the
state 10%. What would you recommend?

Solution There are two alternatives:

1. Reinforce the existing bridge.
2. Replace the existing bridge by a new prestressed concrete bridge.
Alternative 1— Reinforce the existing bridge
Cost of reinforcement (P) = Rs. 6,60,000
Salvage value after 5 years (F) = Rs. 4,00,000
The excess annual maintenance cost over prestressed concrete bridge (A)
= Rs. 96,000
Life (n) = 5 years
Interest rate (i) = 10%
The cash flow diagram of alternative 1 is illustrated in Fig. 8.9.
4,00,000

0 1 2 3 4 5

96,000 96,000 96,000 96,000 96,000

6,60,000
Fig. 8.9 Cash flow diagram for alternative 1.

The annual equivalent cost of the alternative 1 is computed as

AE(10%) = (P – F)(A/P, 10%, 5) + F ´ i + A
= (6,60,000 – 4,00,000)(0.2638) + 4,00,000 ´ 0.10 + 96,000
= Rs. 2,04,588

Alternative 2—Replace the existing bridge by a new prestressed concrete

bridge
Cost of prestressed concrete bridge (P) = Rs. 15,00,000
Excess scrap value of steel over the demolition cost of the current bridge
(X) = Rs. 4,20,000
 Life (n) = 40 years
Interest rate (i) = 10%
Note that the excess maintenance cost of the reinforced bridge over the
prestressed concrete bridge is included in alternative 1.
The cash flow diagram for alternative 2 is shown in Fig. 8.10.
4,20,000

0 1 2 . . 40

15,00,000
Fig. 8.10 Cash flow diagram for alternative 2.

The annual equivalent cost of alternative 2 is calculated as

AE(10%) = (P – X) (A/P, 10%, 40)
= (15,00,000 – 4,20,000) ´ 0.1023
= Rs. 1,10,484
The annual equivalent cost of alternative 2 is less than that of alternative 1.
Based on equal lives comparison over 40 years, alternative 2 is selected as the
best alternative.
Thus, it is suggested to go in for prestressed concrete bridge.

EXAMPLE 8.7 Three years back, a municipality purchased a 10 hp motor for

pumping drinking water. Its useful life was estimated to be 10 years. Due to the
fast development of that locality, the municipality is unable to meet the current
demand for water with the existing motor. The municipality can cope with the
situation either by augmenting an additional 5 hp motor or replacing the existing
10 hp motor with a new 15 hp motor. The details of these motors are now
tabulated.

Old 10 hp New 5 hp New 15 hp

motor motor motor
Purchase cost (P) Rs. 25,000 10,000 35,000
Life in years (n) 10 7 7
Salvage value at the end of
machine life (Rs.) 1,500 800 4,000
Annual operating & maintenance
cost (Rs.) 1,600 1,000 500

The current market value of the 10 hp motor is Rs. 10,000. Using an interest
rate of 15%, find the best alternative.
Solution There are two alternatives to cope with the situation:
1. Augmenting the present 10 hp motor with an additional 5 hp motor.
2. Replacing the present 10 hp motor with a new 15 hp motor.
Alternative 1—Augmenting the present 10 hp motor with an additional
5 hp motor
Total annual equivalent cost = Annual equivalent cost of 10 hp motor +
Annual equivalent cost of 5 hp motor
Calculation of annual equivalent cost of 10 hp Motor
Present market value of the 10 hp motor (P) = Rs. 10,000
Remaining life (n) = 7 years
Salvage value at the end of motor life (F) = Rs. 1,500
Annual operation and maintenance cost (A) = Rs. 1,600
Interest rate, i = 15 %
The cash flow diagram of this alternative is shown in Fig. 8.11.

1,500

–3 –1 0 1 2 7

1,600 1,600 1,600 1,600 1,600

10,000
25,000
Fig. 8.11 Cash flow diagram for 10 hp motor.

The annual equivalent cost of the 10 hp motor is calculated as

AE(15%) = (P – F)(A/P, 15%, 7) + F ´ i + A

= (10,000 – 1,500)(0.2404) + 1,500 ´ 0.15 + 1,600
= Rs. 3,868.40

Calculation of annual equivalent cost of 5 hp motor

Purchase value of the 5 hp motor (P) = Rs. 10,000
Life (n) = 7 years
Salvage value at the end of motor life (F) = Rs. 800
Annual operation and maintenance cost (A) = Rs. 1,000
Interest rate, i = 15%

The cash flow diagram of the 5 hp motor is illustrated in Fig. 8.12.

 800
800

0 1 2 . . 7

1,000 1,000 1,000 1,000 1,000

10,000
Fig. 8.12 Cash flow diagram for 5 hp motor.

The annual equivalent cost of the 5 hp motor is computed as

AE(15%) = (P – F)(A/P, 15%, 7) + F ´ i + A
= (10,000 – 800)(0.2404) + 800 ´ 0.15 + 1,000
= Rs. 3,331.68
Total annual equivalent cost of the alternative 1 = Rs. 3,868.40
+ Rs. 3,331.68
= Rs. 7,200.08
Alternative 2—Replacing the present 10 hp motor with a new 15 hp motor
Purchase value of the 15 hp motor (P) = Rs. 35,000
Life (n) = 7 years
Salvage value at the end of motor life (F) = Rs. 4,000
Annual operation and maintenance cost (A) = Rs. 500
Interest rate, i = 15%
The cash flow diagram of this alternative is shown in Fig. 8.13.
4,000

0 1 2 . . 7

500 500 500 500 500

35,000
Fig. 8.13 Cash flow diagram for alternative 2.

The annual equivalent cost of alternative 2 is

AE(15%) = (P – F) (A/P, 15%, 7) + F ´ i + A
= (35,000 – 4,000)(0.2404) + 4,000 ´ 0.15 + 500
= Rs. 8,552.40
The total annual equivalent cost of alternative 1 is less than that of alternative
2. Therefore, it is suggested that the present 10 hp motor be augmented with a
new 5 hp motor.
EXAMPLE 8.8 A machine was purchased two years ago for Rs. 10,000. Its
annual maintenance cost is Rs. 750. Its life is six years and its salvage value at
the end of its life is Rs. 1,000. Now, a company is offering a new machine at
a cost of Rs. 10,000. Its life is four years and its salvage value at the end of its
life is Rs. 4,000. The annual maintenance cost of the new machine is Rs. 500.
The company which is supplying the new machine is willing to take the old
machine for Rs. 8,000 if it is replaced by the new machine. Assume an interest
rate of 12%, compounded annually.
(a) Find the comparative use value of the old machine.
(b) Is it advisable to replace the old machine?

Solution Old machine Let the comparative use value of the old machine be X.
Remaining life (n) = 4 years.
Salvage value of the old machine (F) = Rs. 1,000
Annual maintenance cost (A) = Rs. 750
Interest rate, i = 12%
The cash flow diagram of the old machine is depicted in Fig. 8.14.

1,000

–2 –1 0 1 2 3 4

750 750 750 750

500
X
10,000
Fig. 8.14 Cash flow diagram for old machine.

The annual equivalent cost of the old machine is computed as

AE(12%) = (X – F)(A/P, 12%, 4) + F ´ i + A
= (X – 1,000)(0.3292) + 1,000 ´ 0.12 + 750

New machine
Cost of the new Machine (P) = Rs. 10,000
Life (n) = 4 years.
Salvage value of the new machine (F) = Rs. 4,000
Annual Maintenance cost (A) = Rs. 500
Interest rate, i = 12%
The cash flow diagram of the new machine is illustrated in Fig. 8.15.
 4,000

0 1 2 3 4

500 500 500 500

10,000
Fig. 8.15 Cash flow diagram for new machine.

The annual equivalent cost of the new machine is illustrated as

AE(12%) = (P – F) (A/P, 12%, 4) + F ´ i + A
= (10,000 – 4,000)(0.3292) + 4,000 ´ 0.12 + 500
= Rs. 2,955.20
Now, equate the annual equivalent costs of the two alternatives and solve
for X.
(X – 1,000)(0.3292) + 1,000 ´ 0.12 + 750 = 2,955.20
X = Rs. 7,334.14
The comparative use value of the old machine is Rs. 7,334.14, which is less
than the price (Rs. 8,000) offered by the company which is supplying the new
machine in the event of replacing the old machine by the new machine.
Therefore, it is advisable to replace the old machine with the new one.
 QUESTIONS
1. List and explain the different types of maintenance.
2. Discuss the reasons for replacement.
3. Define ‘economic life’ of an equipment.
4. Distinguish between breakdown maintenance and preventive maintenance.
5. A firm is considering replacement of an equipment, whose first cost is
Rs. 1,750 and the scrap value is negligible at any year. Based on experience,
it was found that the maintenance cost is zero during the first year and it
increases by Rs. 100 every year thereafter.
(a) When should the equipment be replaced if i = 0%?
(b) When should the equipment be replaced if i = 12%?
6. The following table gives the operation cost, maintenance cost and salvage
value at the end of every year of a machine whose purchase value is
Rs. 20,000.
(a) Find the economic life of the machine assuming interest rate (i) of 0%
(b) Find the economic life of the machine assuming interest rate of 15%.

End of year (n) Operation cost Maintenance cost Salvage value

1 2,000 200 10,000
2 3,000 300 9,000
3 4,000 400 8,000
4 5,000 500 7,000
5 6,000 600 6,000
6 7,000 700 5,000
7 8,000 800 4,000
8 9,000 900 3,000
9 10,000 1,000 2,000
10 11,000 1,100 1,000
 7. A manufacturer is offered two machines A and B. A is priced at Rs. 8,000
and maintenance costs are estimated at Rs. 500 for the first year and an
equal increment of Rs. 100 from year 2 to year 5, and Rs. 1,500 for the
sixth year and an equal increment of Rs. 500 from year 7 onwards.
Machine B which has the same capacity is priced at Rs. 6,000. The
maintenance costs of the machine B are estimated at Rs. 1,000 for the first
year and an equal yearly increment of Rs. 200 thereafter.
If the money is worth 15% per year, which machine should be
purchased? (Assume that the scrap value of each of the machines is
negligible at any year.)
8. Three years back, a machine was purchased at a cost of Rs. 3,00,000 to be
useful for 10 years. Its salvage value at the end of its estimated life is Rs.
50,000. Its annual maintenance cost is Rs. 40,000. The market value of the
present machine is Rs. 2,00,000. A new machine to cater to the need of the
present machine is available at Rs. 2,50,000 to be useful for 7 years. Its
annual maintenance cost is Rs. 14,000. The salvage value of the new
machine is Rs. 20,000. Using an interest rate of 15%, find whether it is
worth replacing the present machine with the new one.
9. A steel highway bridge must either be reinforced or replaced.
Reinforcement would cost Rs. 8,60,000 and would make the bridge
adequate for an additional seven years of service. If it is reinforced, it is
estimated that its net salvage value would be Rs. 5,00,000 at the time it is
retired from service. The new prestressed concrete bridge would cost
Rs. 18,00,000 and would meet the foreseeable requirements of the next
35 years. Such a bridge would have no salvage value. It is estimated that
the annual maintenance cost of the reinforced bridge would exceed that
of the concrete bridge by Rs. 1,00,000. If the bridge is replaced by a new
prestressed concrete bridge, the scrap value of the steel would exceed the
demolition cost by Rs. 5,20,000. Assume that the money costs the state
12%. What would you recommend?
10. Three years back, a municipality purchased a 10 hp motor for pumping
drinking water. Its useful life was estimated to be 10 years. Its annual
operation and maintenance cost is Rs. 1,500. Due to rapid development of
that locality, the municipality is unable to meet the current demand for
water with the existing motor. The municipality can cope with the situation
either by augmenting an additional 5 hp motor or replacing the existing
10 hp motor with a new 15 hp motor. The details of these motors are given
in the following table.

Old 10 hp New 5 hp New 15 hp

motor motor motor
Purchase cost (P) Rs. 20,000 8,000 30,000
Life in years (n) 10 7 7
Salvage value at the
end of machine life (Rs.) 1,200 800 3,500
Annual operating &
maintenance cost (Rs.) 1,500 900 450
 The current market value of the 10 hp motor is Rs. 10,000. Using an
interest rate of 18% find the best alternative.