Developed By:
Dr. Don Smith, P.E.
Department of Industrial
Engineering
Texas A&M University
College Station, Texas
Executive Summary Version
Chapter 11
Replacement and
Retention Decisions
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-1
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
LEARNING OBJECTIVES
1. Basics
2. Economic service
life
3. Replacement
study
4. Additional
considerations
5. Study period
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Economy, 6th Edition, 2005
11-2
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Sct 11.1 Basics of Replacement Study
 Reduced Performance:
 Wear and tear
 Decreasing reliability and productivity
 Increasing operating and maintenance costs
 Altered Requirements:
 New production needs, accuracy, speed, etc.
 Obsolescence:
 Current assets may be less productive
 Not state of the art – need to meet competition
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-3
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Terminology
 Defender Asset:
 Currently installed asset;
 Challenger Asset:
 The potential replacement or “challenging” asset;
 Under consideration to replace the defender asset.
 Together, Defender (D) and Challenger (C)
 Constitute mutually exclusive alternatives;
 Select one and reject the other.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-4
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Terminology - continued
 AW values are typically calculated
 EUAC –Equivalent Uniform Annual Cost
Includes mostly costs estimates
 Economic Service Life (ESL)
 For a given alternative is:
Number of years at which the lowest AW-of-cost occurs
 Defender First Cost
 Initial investment in the defender – P
 Current Market value now – correct estimate to assign
to keeping a defender
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-5
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Terminology - continued
 Challenger first cost
 Amount of capital that must be recovered when replacing a
defender with a challenger
 Sunk cost
 Cost that has occurred in the past and cannot be altered
 Sunk costs are generally of no use in a before-tax
replacement analysis
 Consultant’s viewpoint
 The analyst assumes that he/she is an outsider (a consultant)
 Thus, the analyst owns neither asset and must assign
reasonable value to the defender and challenger
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-6
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The Proper Viewpoint
For a replacement analysis two investment costs
are critical:

1.
The proper investment cost to apply to keeping the
defender in service;
2.
The proper investment cost to apply to any
challenger asset that might replace the current
defender asset.
While it may seem strange to charge an investment cost for keeping one’s own asset
(the defender) this is what must occur. Keeping the defender is not free! Why?
Because the firm is giving up the opportunity to receive a possible cash flow from
selling the current defender.
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Economy, 6th Edition, 2005
11-7
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Investment Concerns

One must assign an investment cost to KEEPING
the defender asset

The appropriate investment cost to assign to the
defender asset is:

The current fair market value of the defender at the
time the replacement decision is being examined.
Challenger Investment


This is the total investment (Pchallenger) required for a new
(challenger) asset that will possibly replace the current
defender.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-8
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Sct 11.2 Economic Service Life (ESL)
 ESL is:
 Number of years n at which the equivalent annual
worth (AW) of costs is minimized considering the most
current cost estimates over all possible years that the
asset may provide a needed service
 ESL is the n where total AW is a minimum for
tabulation at i% over a selected range of years.
 Plot n versus
 Total AW = – CR – AW of annual operating costs
 Seek the time period that minimizes the Total AW for the
range of lives selected
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Economy, 6th Edition, 2005
11-9
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Typical Annual Worth Plot
Seek the n value resulting in minimum
Total AW
Represents the n for
Economic Service Life
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Economy, 6th Edition, 2005
11-10
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Tabulating the Total AW of Costs
Note the following
 Capital recovery costs decline as time
increases
 AW of costs increase over time
 Total AW = - CR - AWcosts
 See Figure 11-1 and Equation 11.3
 Study Example 11.2
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Economy, 6th Edition, 2005
11-11
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Important Points
 Marginal costs (MC) are year-by-year
estimates of the costs to own and operate an
asset for one year
 AW of marginal costs = total AW of costs
 The analysis is best performed via a
spreadsheet model
 Refer to Example 11.3
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Economy, 6th Edition, 2005
11-12
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Sct 11.3 Performing a Replacement Study
Two approaches:
1. Without a study period
2. With a study period
 See Figure 11-4
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Economy, 6th Edition, 2005
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New Replacement Study
 Given: (C) and (D) estimates, select one
 Apply:
 AWD vs. AWC
 Select the better alternative
Stay with the Defender for nD years or,
Go with the challenger for nC years.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-14
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One-Year Later Analysis
 Validate all cost and market value estimates;
 If estimates are still good, is the current year nD?
 If “YES”, replace (D) with (C);
 If “NO”, retain defender for one more year and re-
evaluate then.
 If cost estimates have changed then:
 Update all estimates
 Calculate AWC and AWD
 Initiate a new replacement study.
 See Example 11.4
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Economy, 6th Edition, 2005
11-15
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Market Value of Defender
 What minimum market value of the defender
will make the current challenger economically
attractive?
 If a high enough market value (trade-in) is
possible for the defender asset, one should
take it and go with the challenger immediately!
 Break-even or replacement value (RV)
If the actual market value (trade-in) exceed the breakeven
replacement value, the challenger is the better alternative.
If this is the case, replace now with the challenger!
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Economy, 6th Edition, 2005
11-16
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Sct 11.4 Additional Considerations in a
Replacement Study
Several additional aspects of a replacement study
1.
Future-year replacement decisions;
2.
Opportunity cost vs. Cash flow approaches;
3.
Anticipation of improved future challengers.
The analyst must understand trends, advances, changes in
technology, and competitive pressures that often impact the
remaining life of a defender and the challenger
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Economy, 6th Edition, 2005
11-17
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Future Replacement Decisions
1.
Future-year replacement decisions:
 Replace now? One year from now? Two
years from now? etc.
 The procedure just presented does assist
with answering this question provided:
The cost estimates for (C) and (D) do not
change!
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-18
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Future Replacement Decisions
1.
Future-year replacement decisions:
If cost estimates change for either (D) or (C)
then the analysis should be initiated again
within a reasonable time frame.
With changing estimates the decision to
replace may be altered
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Economy, 6th Edition, 2005
11-19
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2. Opportunity Cost vs. Cash Flow
Opportunity cost approach

The method just presented applies the opportunity
cost approach:
Investment in D now is the fair market value of D now;
Represents the opportunity cost foregone by not disposing of
D now;
Investment in C now is the first cost of C

This is a correct approach for a replacement
analysis.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-20
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Cash Flow Approach
Cash Flow Approach

Assumes that when the challenger is selected and
the defender trade-in is a cash inflow, then:


The investment in the challenger is immediately
reduced by the trade-in amount.
Discourage this approach;
 Works only if the lives of C and D are
equal!
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-21
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Anticipation of Future Challengers
3. Assumption: At some time in the future a
worthy challenger will appear and replace
the defender.

Always study future trends of challengers;

May be best to augment the defender until such
time that a more worthy challenger becomes
available.

Tax considerations should be considered (see
Chapter 17)
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-22
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Sct 11.5 Specified Study Period
 At times, a fixed study period will apply to
both the challenger and defender.
 Such a study may not be based upon the ESL
approach for one or both alternatives.
If a fixed study period then approach is……
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Economy, 6th Edition, 2005
11-23
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Specified Study Period
 Determine AW for both C and D over the
prescribed study period;
 No need to perform an ESL analysis;
 Assumption is that the services of C and D
are not needed beyond the study period.
 Use the AW relations over the study period to
select C or D
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-24
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Defender’s Remaining Life
 If the defender’s remaining life is shorter than the
study period …
Focus on upgrading the defender and
obtain cost estimates in order to extend the
defender out to the study period.
These costs become part of retaining the
defender out to the prescribed study period
and are used in the replacement study
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-25
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Chapter Summary
 Compare the best challenger to the current defender;
 “Best” is defined as the option with the lowest AW of
costs over the specified period of time;
 Apply the ESL method to find the economic life of the
defender and challenger;
For ESL, need estimates of future market values and
annual operating costs for both C and D.
 AW is the best method, especially if alternative lives are
unequal.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-26
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Summary - continued
 For a fixed study period, apply the traditional
AW method for both D and C.
 Always focus on the estimates of future costs
and market values using sound principles
of estimation.
 Avoid the trap of incorporating sunk costs
into a replacement analysis
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-27
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Chapter 11
End of Set
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6th Edition, 2005
11-28
© 2005 by McGraw-Hill, New York, N.Y All Rights Reserved