Replacement Analysis
Fundamentals
Lecture No. 56
Chapter 14
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th
edition, © 2007
Chapter Opening Story – Options for
Replacing Alaskan Viaduct

Issue: The Washington
State Department of
Transportation has to
decide whether the state
should replace the
damaged viaduct with a
tunnel or to rebuild the
viaduct in its current
existing structure

Option 1: Build a Tunnel


Cost: $3.6B to $4.1B
Option 2: Rebuild the
Viaduct

Cost: $2.7-$3.1B
Contemporary Engineering Economics, 4th
edition, © 2007
Replacement Terminology



Defender: an old
machine
Challenger: a new
machine
Current market value:
selling price of the
defender in the market
place


Sunk cost: any past
cost unaffected by any
future decisions
Trade-in allowance:
value offered by the
vendor to reduce the
price of a new
equipment
Contemporary Engineering Economics, 4th
edition, © 2007
Sunk Cost associated with an Asset’s
Disposal
Original investment
$20,000
Market value
Lost investment
(economic depreciation)
$10,000
Repair cost
$5000
$10,000
Sunk costs = $15,000
$0
$5000
$10,000
$15,000
$20,000
Contemporary Engineering Economics, 4th
edition, © 2007
$25,000
$30,000
Replacement Decisions

Cash Flow Approach


Treat the proceeds
from sale of the old
machine as down
payment toward
purchasing the new
machine.
This approach is
meaningful when both
the defender and
challenger have the
same service life.

Opportunity Cost
Approach


Treat the proceeds from
sale of the old machine
as the investment
required to keep the old
machine.
This approach is more
commonly practiced in
replacement analysis.
Contemporary Engineering Economics, 4th
edition, © 2007
Example 14.2

Defender





Market price:
$10,000
Remaining useful
life: 3 years
Salvage value:
$2,500
O&M cost: $8,000
Challenger




Cost: $15,000
Useful life: 3 years
Salvage value:
$5,500
O&M cost: $6,000
Contemporary Engineering Economics, 4th
edition, © 2007
Replacement Analysis – Cash Flow Approach
Sales proceeds
from defender
$10,000
$5500
$2500
0
1
2
3
0
2
3
$6000
$8000
(a) Defender
1
$15,000
Contemporary Engineering Economics, 4th
edition, © 2007
(b) Challenger
Annual Equivalent Cost - Cash Flow Approach
 Defender:
PW(12%)D = $8,000 (P/A, 12%, 3) -$2,500 (P/F, 12%, 3)
= $17,434.90
AEC(12%)D = PW(12%)D(A/P, 12%, 3)
= $7,259.10
 Challenger:
PW(12%)C = $5,000 + $6,000 (P/A, 12%, 3)
- $5,500 (P/F, 12%, 3)
= $15,495.90
AEC(12%)C = PW(12%)C(A/P, 12%, 3)
= $6,451.79
Contemporary Engineering Economics, 4th
edition, © 2007
Replace
the
defender
now!
Comparison of Defender and Challenger
Based on Opportunity Cost Approach
Contemporary Engineering Economics, 4th
edition, © 2007
Annual Equivalent Cost - Opportunity Cost
Approach
 Defender:
PW(12%)D = -$10,000 - $8,000(P/A, 12%, 3) + $2,500(P/F, 12%, 3)
= -$27,434.90
AEC(12%)D = -PW(12%)D(A/P, 12%, 3)
= $11,422.64
 Challenger:
PW(12%)C = -$15,000 - $6,000(P/A, 12%, 3) + $5,500(P/F, 12%, 3)
= -$25,495.90
AEC(12%)C = -PW(12%)C(A/P, 12%, 3)
= $10,615.33
Contemporary Engineering Economics, 4th
edition, © 2007
Replace the
defender now!