Chapter 13:

Replacement Analysis

Engineering Economic AnalysisCanadian Edition

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Chapter 13 … Demonstrates that an asset replacement

decision is a challenger versus defender decision.

Determines what is the best technique to apply in the replacement decision.

Calculates the minimum cost life (economic life) of a challenger or defender.

Provides various techniques for replacement analysis under various real-life conditions.

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Replacement Analysis When should a new truck replace the existing

truck? When should a process be redesigned? When should a product be redesigned?

Defender: the existing equipment, building, or decision previously implemented.

Challenger: the proposed replacement currently under consideration.

The most common question asked in industry is: when should the existing asset(s) be replaced?

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Replacement Analysis …

1. Use available data to determine the analysis technique.

2. Determine the base comparison between alternatives.

3. Use analysis techniques when: a. The defender’s marginal cost can be computed and

is increasing.b. The defender’s marginal cost can be computed and

is not increasing.c. The defender’s marginal cost is not available.

4. Consider possible future challengers.5. Perform after-tax analysis.

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Should the defender be replaced now or be retained for one or more periods?

The Replacement Problem We replace the existing asset due to:

• Obsolescence: technological change• Depletion: loss of market value• Deterioration: wear that is overly expensive to

repair

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The Replacement Problem … Issues to consider before starting:

• If a unit fails, must it be removed permanently from service, or can it be repaired?

• Are standby units available if the system fails?• Do components or units fail independently of the

failure of other components?• Is there a budget constraint?• If the unit can be repaired after failure, is there a

constraint on the capacity of the repair facility?• Is only one replacement allowed over the planning

horizon? Are subsequent replacements allowed at any time during the study period?

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The Replacement Problem … Issues to consider before starting (continued):

• Is there more than one replacement unit (price and quality combination) available at a given point in time?

• Do future replacement units differ over time? Are technological improvements considered?

• Is preventative maintenance included in the model?

• Are periodic operating and maintenance costs constant or variable over time?

• Is the planning horizon finite or infinite?

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The Replacement Problem … Issues to consider before starting (continued):

• Are consequences other than economic effects considered (i.e., sociotechnical issues)?

• Are income tax consequences considered?• Is inflation considered?• Does replacement occur simultaneously with

retirement, or are there non-zero lead times?• Are cash flow estimates deterministic or

stochastic?

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Replacement Analysis Decision Chart

Where Compare

DefenderMarginalCost

DefenderMarginalCost

Defender BestChallenger

1 Available Increasing Next year’s EACF

EACF at Minimum Cost Life

2 Available Not increasing

EACF at Minimum Cost Life

EACF at Minimum Cost Life

3 Not available

EACF over Remaining Useful Life

EACF at Minimum Cost Life

Ana

lysi

s T

echn

iqu

e

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Decision Criterion leads to one of the following: If the defender is more economical, it should

be retained. If the challenger is more economical, it should

be installed.

What Is the Basic Comparison? Identify the defender and the best challenger:

• Product• Machine• Process• Personnel• Mix

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Minimum Cost Life of a Challenger Example: a machine costs $75,000 to ac-

quire and $8000 to install. Its value depreci-ates at a rate of 30% per year (declining balance). Its annual operating/maintenance costs are $32,500 in the first year and grow at a rate of 10% per year. Find the minimum cost (economic) life of the machine if the company uses a 12% cost of capital.

$75,00030%

$8,000$32,500

10%12%

Life (yrs) Salvage EACF Capital Annual O&M EACF O&M EACF Total0 $75,0001 $52,500 $40,460 $32,500 $32,500 $72,9602 $36,750 $31,776 $35,750 $34,033 $65,809

Depreciation rate:Capital cost:

Cost of capital:Cost growth rate:

Maintenance cost:Installation cost:

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Replacement Analysis Technique #1 The defender’s marginal costs are increasing. Retain the defender if its marginal cost for

one more year < the minimum EACF of the challenger. When the marginal cost of the defender becomes > the minimum EACF of the challenger, replace the defender.

Technique #1 is appropriate when the replacement repeatability assumptions hold:• The best challenger will continue to be available in

all later years at the same economic cost.• The period of needed service is infinite.

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Replacement Analysis Technique #1 Example: the machine from the previous

example is the challenger. The defender has a current salvage value of $32,000 that will decrease by $8000 per year. The annual operating/maintenance costs of the defender are $42,500 and will increase by $4500 per year. When should the challenger replace the defender (cost of capital = 12%)?

$32,000$8,000

$42,500$4,500

12%Year Mkt Value Forgone Interest Annual O&M Marginal Cost

1 $8,000 $3,840 $42,500 $54,3402 $8,000 $2,880 $47,000 $57,8803 $8,000 $1,920 $51,500 $61,420

Cost of capital:Growth amount:

Maintenance cost:

Salvage value now:Decrease in value:

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Replacement Analysis Technique #2 The defender’s marginal costs are not increa-

sing initially; this is usually the case when the defender is at an early point in its useful life.

Retain the defender if its minimum EACF is less than the minimum EACF of the challenger.

If the defender is retained, replace it with the challenger when its marginal cost becomes > the minimum EACF of the challenger.

The replacement repeatability assumptions must hold to justify using this technique.

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Replacement Analysis Technique #2 Example: the machine from the first example

is the challenger. The defender has a current value of $55,000 that depreciates by 30% per year. The annual operating/maintenance costs of the defender are $37,500 and will increase by 10% per year. When should the challenger replace the defender (cost of capital = 12%)?

$55,00030%

$37,50010%12%

Life (yrs) Salvage EACF Capital Annual O&M EACF O&M EACF Total0 $55,0001 $38,500 $23,100 $37,500 $37,500 $60,6002 $26,950 $19,831 $41,250 $39,269 $59,1003 $18,865 $17,309 $45,375 $41,078 $58,387

Cost of capital:Growth rate:

Maintenance cost:

Salvage value now:Depreciation rate:

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Replacement Analysis Technique #3 The defender’s marginal costs are not known;

this can occur when the defender is based on aging technology with a shrinking market.

Compare the EACF of the defender over its remaining stated useful life against the minimum EACF of the challenger.

Choose the asset that yields the more positive EACF in this comparison.

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Replacement Analysis Technique #3 Determining the first costs of the defender

and challenger can be an issue.• The appropriate value is the market value in a

stand-alone sale.• Other values, e.g. the trade-in value and the book

value, are not suitable for use as first costs.

The first cost of the defender should be treated as an opportunity cost to the defender, not as a cash benefit to the challenger.

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After-Tax Replacement Analysis Adds realism and expanded perspective as

changes occur in:• Remaining economic life of defender• Economic life of challenger• Defender versus challenger comparisons

Affected by:• Asset’s market value over time• Tax shields on operating/maintenance costs and

depreciation (CCA)• CCA asset class closed or not closed on disposal

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Suggested Problems 13-20, 21, 22, 23, 26, 27, 31, 32.