Replacement Analysis Fundamentals

Lecture No. 56Chapter 14Contemporary Engineering EconomicsCopyright © 2006

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

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

Defender: an old machine

Challenger: a new machine

Current market value: selling price of the defender in the market place

Replacement Terminology

Sunk Cost associated with an Asset’s Disposal

$0 $5000 $10,000 $15,000 $20,000 $25,000 $30,000

Original investment

$10,000 $5000

Market value

$10,000

Lost investment(economic depreciation) Repair cost

$20,000

Sunk costs = $15,000

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.

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

0 1 2 3 0 1 2 3

$8000

$2500

$15,000

$6000

$5500

(a) Defender (b) Challenger

$10,000

Sales proceeds from defender

Replacement Analysis – 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

Replace the

defender now!

Annual Equivalent Cost - Cash Flow Approach

Comparison of Defender and Challenger Based on 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

Replace the defender now!

Annual Equivalent Cost - Opportunity Cost Approach