CHAPTER SEVEN

DEPRECIATION &
EQUIPMENT
REPLACEMENT
 Depreciation
• Discusses the different issues related to the gradual change or
reduction in the value of an asset.
• A decline in the value of an asset are due to
 General wear and tear
 Deterioration
 Obsolescence
 Reduced in need
 Methods of Calculating Depreciation
• To calculate depreciation by any depreciation method, close
estimates of the following items must be known:
 Purchase price or initial cost of the asset (P),
 Economic life or recovery period allowed for the asset (N),
 The salvage value of the asset (S).

The following three methods are most commonly used for

the calculation of depreciation,
1. Straight-Line method
2. Sum-Of-the-Years method
3. Decline-Balance method
 1. The Straight-Line(SL) Method
•• Easiest
  and most widely used
• The annual amount of depreciation Dn, for any year n, is a
constant value and thus the book value BVn decreases at a
uniform rate over the useful life of the asset.
 Example [1]

•• A
  piece of equipment is available for the purchase for 12,000
birr, has an estimated useful life of 5 years, and has an
estimated salvage value of 2,000 birr. Determine the
depreciation and the book value for each of the 5 years using
the SL method.

 Solution
 Solution

Year Dn Book Value(BVn)

0 0 12,000
1 2000 10,000
2 2000 8,000
3 2000 6,000
4 2000 4,000
5 2000 2,000
 2. Sum-Of-the-Years(SOY) Method

•• Depreciation for each year is calculated using a number called

 Sum-Of-the-Years.

Where , RL is the remaining life at any year, at the beginning of

the year
 Example [2]

•• Solve
  example 1 using SOY method

 Solution
 Solution

Year RL Dn BVn
0 - - 0 12,000
0
1 5- -
5/15 0
3,333 12,000
8,667
2
1 4
5 4/15
5/15 2,667
3,333 6,000
8,667
3
2 3
4 3/15
4/15 2,000
2,667 4,000
6,000
4
3 2
3 2/15
3/15 1,333
2,000 2,667
4,000
5 1 1/15 667 2,000
4 2 2/15 1,333 2,667
5 1 1/15 667 2,000
 3. Double-Declining-Balance(DDB) Method

•• In this method, the salvage value is estimated but is not

 considered in the calculation
• Depreciation calculation is done until the end of the
estimated life or the year for which the book value is less than
or equal to the estimated resale value, whichever comes first
)
 Example [3]

• Solve example 1 also using DDB Method

Year Dn BVn

0
0 -- 0
0 12,000
12,000
1
1 0
0 7,200
7,200
2
2 0+4800=4800
0+4800=4800 4,320
4,320
3
3 4800+2880=7680
4800+2880=7680 2,592
2,592
4
4 7680+1728=9408
7680+1728=9408 2,000
2,000
5
5 9408+1037=10445
9408+1037=10445 0
0 2,000
2,000
Allowable depreciation curves for the three methods of depreciation
calculation.

14000

12000 P=12000

10000
Book Value

8000
SL
6000
SOY
4000 DDB

2000 S=2000

0
0 1 2 3 4 5
Year
 Equipment Replacement
• Engineers replace the existing equipment due to:
 Obsolescence – technological change
 Depletion – loss of market value
 Deterioration – wear that is overly expensive to repair
 Physical or mechanical impairment
 Uneconomic or increasing maintenance and/or operating
cost
 Inadequacy – the required function can no longer be
carried out economically
 Replacement Analysis
• Replacement analysis always involve comparison of an
existing asset with a new one.
• Defender - the existing equipment previously implemented.
• Challenger - the proposed replacement currently under
consideration
• The defender would have been purchased some years ago at
some cost say Po. Today if it is traded in or sold because of a
consideration to buy a challenger, the value obtained will be
lower say P
• The term (Po – P) is called the sunk cost. The sunk cost is
never taken into account in engineering economic analysis.
 Example [4]

• An equipment which was purchased at a cost of 22,000birr

four years ago is considered for replacement against a
challenger whose cost is 18,000birr. The existing equipment
can be traded in today at 6,000birr and if kept on for another
6 years, will have a salvage value of 2,000birr. The annual
maintenance cost of the existing asset is 7,000birr per year.
The challenger has an annual operating cost of 3,500birr and
its salvage value 3,000birr at end of year 6, i = 15%.
 Solution
• Po = 22,000birr, P = 6,000birr and S = 6,000birr
• AEC(Defender) = 6000(A/P, 15%,6) + 7000 - 2000(A/F,15%,6)
= 8356.8birr

• AEC(Challenger) = 18,000(A/P,15%,6) + 3500 - 3000(A/F,15%,6)

= 7913birr
 Please note that the sunk cost (Po – P) = 22000birr – 6000birr =
16000birr is not used anywhere in the analysis.
• Since the equivalent annual cost of challenger is less than the
defender, it would be economical to replace the existing
equipment with the new equipment. This shows that
replacement is desirable.
 Example [5]

• Two years ago, an equipment was purchased at a cost of

200,000birr to be useful for 8 years. Its salvage value at the
end of its life is 25,000birr. The annual maintenance cost is
25,000birr. The market value of existing equipment is
120,000birr. Now a new equipment is available at 150,000birr
to be useful for six years. Its annual maintenance cost is
14,000birr. The salvage value of the new equipment is
20,000birr. If the interest rate is 12% find if it is worth
replacing the existing equipment with the new equipment.
 Solution

• CFD for Defender

25,000
-2 -1 0 1 2 3 4 5 6

25,000
200,000

EAC = 120,000(A/P,12%,6)+25,000-25,000(A/F,12%,6)
= 120,000*0.2432+25,000-25,000*0.1232 = 51,104 Birr
 Solution
• CFD for Challenger
20,000

0 1 2 3 4 5 6

14,000
150,000
• EAC = 150,000(A/P,12%,6) + 14,000 – 20,000(A/F,12%,6)
= 48,016 Birr
Hence replace the existing equipment with the challenger.