Replacement Analysis

Fundamentals
Lecture No. 46
Chapter 14
Contemporary Engineering Economics
Copyright © 2016

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 Chapter Opening Story
A university medical center is
considering replacing an old
steam-driven chiller at $7.7
million.

 At issue:
o What basis do they make
the replacement decisions?
o How much savings in
energy cost would justify
the purchase of the new
absorption chiller?

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
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 Replacement Terminology

• Defender: an old • Sunk cost: any past cost

machine unaffected by any future
• Challenger: a new decisions
machine • Trade-in allowance: value
• Current market value: offered by the vendor to
selling price of the reduce the price of a new
defender in the market equipment
place

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
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Example 14.1: Sunk Cost associated with an
Asset’s Disposal

 Given:
o Original investment = $20,000
o Current market value = $10,000
o Repair cost made in the past = $5,000
 Find: (a) Sunk cost, (b) Relevant cost for
replacement analysis

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
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 Solution
 Relevant Cost for Replacement Analysis:
o Lost investment value, $10,000
o Repair cost made, $5,000
o Total sunk cost = $15,000
o Current market value = $10,000

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
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 Opportunity Cost Approach
• Basic Principle: Treat the proceeds from sale
of the old machine as the investment
required to keep the old machine.
• Compute the AEC for each alternative and
select the one with the minimum AEC.

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
Park All Rights Reserved
Example 14.2: Opportunity Cost Approach
Given:
o Defender
• Market price: $10,000
• Remaining useful life: 3 years
• Salvage value: $2,500
• O&M cost: $8,000

o Challenger
• Cost: $15,000
• Useful life: 3 years
• Salvage value: $5,500
• O&M cost: $6,000

Find: Replace the defender now?

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Solution: Replace the Defender

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
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 Economic Service Life
• Definition: Economic service life is the
remaining useful life of an asset that results
in the minimum annual equivalent cost.
• Annual Equivalent Cost (AEC)

AEC = Capital Cost + Operating Cost

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
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 Mathematical Relationship
• Capital Cost

• Operating Cost

• Total Cost

• Objective: Find n* that

minimizes AEC(i) n*

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
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Example 14.3: Economic Service Life for a Lift
Truck

 Given:
o I = $18,000
o i = 12%
o Salvage value = −20% over the previous year
o O&M = $3,000 during the first year, and 15%
increase over the previous year thereafter

 Find: Economic Service Life

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Cash flows if you kept n = 1 or n = 2

• n = 1: $11,400

0
1

$3,000
$18,000

• n = 2: $11,520

0 1
2

$3,000
$3,450

$18,000

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AEC Calculation If You Kept the Truck for 2
Years
 Ownership Cost

CR(12%)  ($18,000  $11,520)( A / P ,12%,2)

(0.12)($11,520)
 $5,760
 Operating Cost

OR(12%)   $3,000(P / F ,12%,1)  $3,450(P / F ,12%,2)

(A / P ,12%,2)
 $3,212
 Annual Equivalent Cost

AEC(12%)n2  $5,760  $3,212

 $8,429

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 Conversion of an Infinite Number of
Replacement Cycles to Infinite AEC Streams

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 Economic Service Life Calculation Using
Excel
 Economic Service Life = 6 Years
with AEC(12%) = $7,977

 What It Really Means

 You purchase a brand new lift truck
for every 6 years, assuming that the
future replacement cost as well as
operating costs remain constant.
Then the equivalent annual cost of
owning and operating the truck is
$7,977.

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
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 Sensitivity of Economic Service Life

o For an asset with non-increasing operating cost,

keep the asset as long as it lasts.
o If everything remains the same, a higher interest
rate will tend to extend the economic service life (or
defer the replacement decision).

Contemporary Engineering Economics, 6th edition Copyright © 2016 by Pearson Education, Inc.
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