Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 1 Replacement Decision Models

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 2 of 52 Required Assumptions and Decision Frameworks Planning horizon (study period) Technology Relevant cash flow information Decision Frameworks

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 3 of 52 Replacement Strategies under the Infinite Planning Horizon 1.Replace the defender now: The cash flows of the challenger will be used from today and will be repeated because an identical challenger will be used if replacement becomes necessary again in the future. This stream of cash flows is equivalent to a cash flow of AE C* each year for an infinite number of years. 2.Replace the defender, say, x years later: The cash flows of the defender will be used in the first x years. Starting in year x+1,the cash flows of the challenger will be used indefinitely.

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 4 of 52 Example 11.5 Replacement Analysis under the Infinite Planning Horizon Step 1:Find the remaining useful (economic) service life of the defender.

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 5 of 52 Step 2: find the economic service life of the challenger. N = 1 year: AE(15%) = $7,500 N = 2 years: AE(15%) = $6,151 N = 3 years: AE(15%) = $5,847 N = 4 years: AE(15%) = $5,826 N = 5 years: AE(15%) = $5,897 N C* =4 years AE C* =$5,826

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 6 of 52 Step 3: Replacement Decisions Should we replace the defender now? No, because AE D < AE C If not, when is the best time to replace the defender? Need to conduct a marginal analysis. N C* =4 years AE C* =$5,826

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 7 of 52 Marginal Analysis – When to Replace the Defender Question: What is the additional (incremental) cost for keeping the defender one more year from the end of its economic service life, from Year 2 to Year 3? Financial Data: Opportunity cost at the end of year 2: $3,000 (market value of the defender at the end year 2) Operating cost for the 3 rd year: $5,000 Salvage value of the defender at the end of year 3: $2,000

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 8 of $3000 $2000 $5000 Step 1: Calculate the equivalent cost of retaining the defender one more from the end of its economic service life, say 2 to 3. $3,000(F/P,15%,1) + $5,000 - $2,000 = $6,450 Step 2: Compare this cost with AE C = $5,826 of the challenger. Conclusion: Since keeping the defender for the 3 rd year is more expensive than replacing it with the challenger, DO NOT keep the defender beyond its economic service life. $6,450 23

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 9 of 52 Replacement Analysis with Tax Consideration  Whenever possible, replacement decisions should be based on the cash flows after taxes.  When computing the net proceeds from sale of the old asset, any gains or losses must be identified to determine the correct amount of the opportunity cost.  All basic replacement decision rules including the way of computing economic service life remain unchanged.

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 10 of 52 $0 $4000 $8000 $12,000 $16,000 $20,000 $10,000 $14,693 $20,000 $4693 Cost basis Book value Total depreciation $5307 Market value Loss tax credit Book loss Net proceeds from disposal ($11,877) Determining the Opportunity Cost with Tax Consideration

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 11 of 52 Example 11.6 Replacement Analysis under an Infinite Planning Horizon Economic service life calculation with tax consideration for Defender (Table 11.1) Economic service life calculation with tax consideration for Challenger (Table 11.2) Replacement Decision under the Infinite Planning Horizon

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 12 of 52

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 13 of 52

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 14 of 52

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 15 of 52

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 16 of 52 Annual Equivalent Cost ($) nDefenderChallenger ,078 3,070 3,300 3,576 3,860 5,100 4,290 4,094 4,065 4,110 4,189 4,287 N* D = 2 yearsN* C = 4 years

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 17 of 52 When to Replace the Defender? nPW(15%) Cost Calculation ,100 26,242 25,482 25,353 25,704 26,413

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 18 of 52 Summary In replacement analysis, the defender is an existing asset; the challenger is the best available replacement candidate. The current market value is the value to use in preparing a defender’s economic analysis. Sunk costs—past costs that cannot be changed by any future investment decision—should not be considered in a defender’s economic analysis.

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 19 of 52 Two basic approaches to analyzing replacement problems are the cash flow approach and the opportunity cost approach.  The cash flow approach explicitly considers the actual cash flow consequences for each replacement alternative as they occur.  The opportunity cost approach views the net proceeds from sale of the defender as an opportunity cost of keeping the defender.

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 20 of 52 Economic service life is the remaining useful life of a defender, or a challenger, that results in the minimum equivalent annual cost or maximum annual equivalent revenue of owning and operating the asset. We should use the respective economic service lives of the defender and the challenger when conducting a replacement analysis. Ultimately, in replacement analysis, the question is not whether to replace the defender, but when to do so. The AE method provides a marginal basis on which to make a year-by-year decision about the best time to replace the defender. As a general decision criterion, the PW method provides a more direct solution to a variety of replacement problems, with either an infinite or a finite planning horizon, or a technological change in a future challenger.

Asst. Prof. Dr. Mahmut Ali GÖKÇE, Izmir University of Economics Spring, 2007 (c) 2001 Contemporary Engineering Economics 21 of 52 The role of technological change in asset improvement should be weighed in making long-term replacement plans Whenever possible, all replacement decisions should be based on the cash flows after taxes.