Engineering Economy: Replacement Study To be presented by: Deoneal Bryant Consulta Camille Rose Espares Micaela Casabuena Renz Daet

Objective to address the question of whether a currently owned asset should be kept in service or immediately replaced.

An existing asset is subjected to be: 1. kept (useful) 2. abandoned (may be not useful anymore but not replacing it) 3. replaced (but can also be kept for backup purpose) 4. augmented for its capacity 5. disposed (total replacement)

Three reasons to consider a change: 1. Physical impairment (deterioration) 2. Altered requirements 3. New and improved technology is now available 4. Depletion (loss of market value) Note: The second and third reasons are sometimes referred to as different categories of obsolescence or tecnhnological change.

Terminologies for replacement studies 1. Economic Life: the period of time (years) that yields the minimum equivalent uniform annual cost (EUAC) of owing and operating as asset. 2. Ownership life: the period between acquisition and disposal by a specific owner. 3. Physical life: period between original acquisition and final disposal over the entire life of an asset. 4. Useful life: the time period an asset is kept in productive service (primary or backup)

1. Defender: the existing equipment or building previously implemented 2. Challenger: the proposed replacement currently under consideration.

Aspects of Replacement Analysis 1. Using available data to determine the analysis technique 2. Determine the base comparison between alternatives. 3. Using analysis technique when: Defender marginal cost can be computed and is increasing. Defender marginal cost can be computed and is not increasing. Defender marginal cost is not available. 4. Considering possible future challengers. 5. After-tax analysis.

Issues to be considered before starting: 1. Is it morally or ethically right to do this project? 2. If a unit fails, must it be removed permanently from sevice? Or repaired? Are standby units available if the system should fail? 3. Do components or units fail independently of the failure of other components? 4. Is there a budget constraint? 5. In the event that the unit can be repaired after failure, is there a constraint on the capacity of the repair facility. 6. Is there only replacement allowed over the planning horizon? Are subsequent replacements allowed at any time during the study period?

Issues (continuation) 7. Is their more than one replacement unit (price and quality combination) available at a given point in time? 8. Do future replacement units differ over time? Are technological improvements considered? 9. Is preventive maintenance included in the model? 10. Are periodic operating and maintenance costs constant or available or variable over time? 11. Is the planning horizon finite or infinite? 12. Are consequences other that economic impacts, i.e., sociotechnical issues considered? 13. Are income tax consequences considered?

Issues (continuation) 14. Is “inflation” considered? 15. Does replacement occur simultaneously with retirement, or are there nonzero lead times? 16. Are cash flow estimates deterministic or stochastic?

Replacement Analysis Decision Chart Compare Where Not increasing Increasing Defender Marginal Cost Not available Available EUAC at Minimum Cost Life EUAC over Remaining Useful Life 3 2 Next-year Marginal Cost 1 Best Challenger Defender

Replacement: watch out for the sunk-cost trap 1. Only present and future cash flows are considered in replacement studies. 2. Past decisions are relevant only to the extent that they resulted in the current situation. 3. Sunk costs—used here as the difference between an asset’s BV and MV at a particular point in time—have no relevance except to the extent they affect income taxes.

Replacement: the outsider viewpoint 1. The outsider viewpoint is the perspective taken by an impartial third party to establish the fair MV of the defender. Also called the opportunity cost approach. 2. The opportunity cost is the opportunity foregone by deciding to keep an asset. 3. If an upgrade of the defender is required to have a competitive service level with the challenger, this should be added to the present realizable MV.

Replacement: income taxes 1. Replacement often results in gains or losses from the sale of depreciable property. 2. Studies must be made on an after-tax basis for an accurate economic analysis since this can have a considerable effect on the resulting decision.

Before-tax PW example 1. Acme owns a CNC machine that it is considering replacing. Its current market value is $25,000, but it can be productively used for four more years at which time its market value will be zero. Operating and maintenance expenses are $50,000 per year Acme can purchase a new CNC machine, with the same functionality as the current machine, for $90,000. In four years the market value of the new machine is estimated to be $45,000. Annual operating and maintenance costs will be $35,000 per year. Should the old CNC machine be replaced using a before-tax MARR of 15% and a study period of four years?

Solution Defender PW(15%) = -$25,000 - $50,000(P/a,15%,4) = -$167,749 Challenger PW(15%) = -$90,000 - $35,000(P/A,15%,4) + $45,000(P/F,15%,4) = -$164,195 (PW of the challenger is greater than PW of the defender but is close)

Finding the EUAC of the challenger requires finding the total marginal cost of the challenger, for each year. The minimum such value identifies the economic life. This equation represents the present worth, through year k, of total costs. (Although the sign is positive, it is a cost. Eq. 9-1.)

Sum of PW of initial capital investments occurring after time 0 PW of MV at end of year k PW of annual expenses through year k

Total marginal cost formula Marginal cost is the difference in present worth of total cost for year ‘k’ minus the present worth of total cost for year ‘k - 1 TCk = (PWk - PWk-1)(F/P,i%,k) This can be simplified to (eq. 9-2) TCk(i%) = MVk-1 - MVk + iMVk + Ek

This is the sum of: the loss in MV during year of extended service the opportunity cost of capital invested in the asset at the beginning of year ‘k’ the annual expenses incurred in year ‘k’

The economic life of the defender 1. If a major overhaul is needed, the life yielding the minimum EUAC is likely the time to the next major overhaul. 2. If the MV is zero (and will be so later), and operating expenses are expected to increase, the economic life will the one year. 3. The defender should be kept as long as its marginal cost is less than the minimum EUAC of the best challenger.

Replacement cautions 1. In general, if a defender is kept beyond where the TC exceeds the minimum EUAC for the challenger, the replacement becomes more urgent. 2. Rapidly changing technology, bringing about significant improvement in performance, can lead to postponing replacement decisions. 3. When the defender and challenger have different useful lives, often the analysis is really to determine if now is the time to replace the defender. 4. Repeatability or cotermination can be used where appropriate.

Abandonment is retirement without replacement 1. For projects having positive net cash flows (following an initial investment) and a finite period of required service. 2. Should the project be undertaken? If so, and given market (abandonment) values for each year, what is the best year to abandon the project? What is its economic life? 3. These are similar to determining the economic life of an asset, but where benefits instead of costs dominate. 4. Abandon the year PW is a maximum.

Abandonment Example A machine lathe has a current market value of $60,000 and can be kept in service for 4 more years. With an MARR of 12%/year, when should it be abandoned? The following data are projected for future years. Year 1 Year 2 Year 3 Year 4 Net receipts $50,000 $40,000 $15,000 $10,000 Market value $35,000 $20,000 $5,000

Abandonment Solution Keep for one year Keep for two years Keep for three years (BEST!) Keep for four years

Taxes can affect replacement decisions 1. Most replacement analyses should consider taxes. 2. Taxes must be considered not only for each year of operation of an asset, but also in relation to the sale of an asset. 3. Since depreciation amounts generally change each year, spreadsheets are an especially important tool to use.

The effect of taxes The economic life of an asset becomes, after taxes, (eq. 9-3) which reflects not only annual taxes but also tax effects of the sale of the asset. The total marginal cost, for each year, is (eq. 9-4)

We must also consider the possible tax effects of the sale of the defender. The MV of the asset must be compared to the BV to assess the possible tax implications, and this should be reflected in the opportunity cost of keeping the defender. The net ATCF, if the defender is kept, after taxes, is