TEAM TEACHING
DEPARTMENT OF
INDUSTRIAL AND
SYSTEM ENGINEERING
INSTITUT TEKNOLOGI
SEPULUH NOPEMBER
(ITS)
§ Replacement of an asset is carried out because of:
1) Obsolescence
2) Depletion
3) Deterioration due to aging
4) Economic factors (increased production capacity, increasing
maintenance costs, etc.)
5) Another alternative: rent
1) Defender
o An asset (machine) that is replaced
2) Challenger
o An asset (machine) that is proposed to be a replacement
3) Sunk costs
o Sunk costs of defender is not relevant for making decisions in the
future, so these sunk costs must be ignored.
o Defender value that is relevant for the replacement analysis is the
present value of defender
4) Outsider's perspective
It should be assumed that comparison is based on an outsider's
perspective
o Outsiders will give a fairer rating to defenders and challengers
o
5) The economic life of an asset
o
A time interval that minimizes the total annual equivalent cost of the
asset or maximizes the net annual equivalent income of the asset
Shall we replace the defender now,
or
shall we keep it for one or more additional years?
§ A Machine was purchased 4 years ago at a price of $ 2,200 with an estimated life of
10 years and a remaining value of $ 200. Operating and maintenance costs are $ 700
per year and it is assumed that the machine has a fixed performance for its estimated
life.
§ At present, a salesman offers New Machine at a price of $ 2,400 with an estimated
lifespan of 10 years with a residual value of $ 300 and for operating and maintenance
costs is $ 400 per year.
§ If the machine’s investment uses MARR 15% and the salesman wants to buy Old
Machine for $ 600, should the company replace the Old Machine with the New one?
Describe the market value!
Cash flow
Present time
-$200
Old
Machine
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
10
-$600
-$700 …
-$700 …
-$300
-$2,200
Sunk cost
0
New
Machine
1
2
-$400 …
-$2,400
The Outsider
3
4
5
6
7
8
9
10
§ Because the economic life of both Machine is not equal, then the calculation will use
equivalent annual costs to compare both machine.
§ Annual costs to maintain Old Machines (Defender) and New Machine (Challenger) for 6 years
from an outsider's point of view will be:
CR(15)OM = ($600 – $200)(0.2642) + $200(0.15)
Annual operation and maintenance cost
CR(15)NM = ($2,400 – $300)(0.1993) + $300(0.15)
Annual operation and maintenance cost
§ Recommended decision: Maintain Old Machine (Defender)
$136
700
$836
$464
400
$864
Determining the ECONOMIC LIFE* of an asset
*The economic life: the usage period of an asset in which the EUAC (Equivalent
Uniform Annual Cost) of the asset is MINIMUM
A piece of the machine costs $7500 and has no rescue value once
installed. The manufacturer's warranty will pay for the cost of
maintenance and repair of the first year. In the second year,
maintenance costs will be $900, and they will increase at an arithmetic
gradient of $900 in subsequent years. Also, the operating cost for the
machine will be $500 in the first year and will increase at an arithmetic
gradient of $400 in subsequent years. If the interest is 8%, calculate the
economic life of the machine minimizing the EUAC. That is, find its
minimum cost age!
§ There are 2 special cases where the economic life can be
determined without calculation:
Case #1: The annual operating costs of an asset remain constant
for the duration of its life, while the future residual value does not
change à strategy: maintain assets for as long as possible
2) Case #2: Initial expenditure and future residual value are always
the same and operating & maintenance costs always increase à
strategy: find the shortest economic life as possible
1)