CHAPTER 9 Replacement Analysis - PowerPoint Presentation

CHAPTER 9 Replacement Analysis 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 1

9.1 Introduction Replacement Analysis The evaluation of changes in economics of assets associated with their use in an operating environment. Considers assetreplacement retirement augmentation 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 2

9.2 Reasons for Replacement Analysis Physical Impairment (Deterioration) Altered RequirementsTechnology Financing 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 3

9.2 Reasons for Replacement Analysis - Physical Impairment Efficiency loss resulting from continued use - agingIncreased routine and corrective maintenance costsGreater energy requirements Increased need for operator interventionUnanticipated problems leading to equipment deterioration 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 4

9.2 Reasons for Replacement Analysis - Altered Requirements Significant change in demand for related products or servicesSignificant change in the composition or design of associated products or services May be considered a form of obsolescence 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 5

9.2 Reasons for Replacement Analysis - Technology Impact of technological change varies with associated industryTechnological changes typically reduce cost per unit and improve quality of output Results in earlier replacement of existing assets with improved assetsMay be considered a form of obsolescence 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 6

9.2 Reasons for Replacement Analysis - Financing Considers economic opportunity changes external to physical operation or use of the asset(s)May involve income tax considerations (depreciation and after-tax analysis) EG: rental of assets may become more attractive than ownershipMay be considered a form of obsolescence 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 7

9.3 Factors that Must Be Considered in Replacement Studies Economic Life P eriod of time (years) that results in min Equivalent Uniform Annual Cost (EUAC) of owning and operating an assetEUAC is a term used to identify annual worth of a primarily cost cash flow pattern Assuming good asset management, economic life should coincide with time from date of acquisition to date of abandonment, demotion in use, or replacement from primary intended service 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 8

Sometimes called minimum-cost life or optimum replacement interval For a new asset, economic life can be computed if capital investment, annual expenses, and year-by-year market values are known or can be estimated 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 9 9.3 Factors that Must Be Considered in Replacement Studies Economic Life

9.3 Factors that Must Be Considered in Replacement Studies Ownership Life Period between date of acquisition and date of disposal by a specific owner 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 10

9.3 Factors that Must Be Considered in Replacement Studies Physical Life Period of time between original acquisition and final disposal of an asset over its succession of owners 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 11

9.3 Factors that Must Be Considered in Replacement Studies Useful Life Period in years that an asset is kept in productive service either in primary or backup modeAn estimate of how long an asset is expected to be used in a trade or business to produce income 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 12

Recognition and acceptance of past errors Sunk costs Existing asset value and the outsider viewpointIncome tax considerations Economic life of the proposed replacement (Challenger)Remaining (economic) life of the old asset (defender) 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 13 9.3 Factors that Must Be Considered in Replacement Studies

Past Estimation Errors Past estimation errors are irrelevant unless there are income tax implications i.e., when BV > current MV, frequently attributed to estimation error, while may be due to inadequate capacity or higher than expected maintenance costs Must focus on valid estimation of future replacement, without consideration of loss which may have occurred in past 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 14 9.3 Factors that Must Be Considered in Replacement Studies

The Sunk Cost Trap Only present and future cash flows should be considered in replacement studiesUnamortized values of existing asset considered for replacement are the result of past decisions -- (Sunk costs = BV - MV) Sunk costs are irrelevant to replacement decisions, except to extent they affect income taxes When tax considerations are involved, sunk costs must be included in study 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 15 9.3 Factors that Must Be Considered in Replacement Studies

Existing Asset investment value and Outsider Viewpoint Perspective of impartial third party in establishing fair market value (MV) of your used assetPresent realizable MV modified by appropriate income tax effects defines correct investment amount for asset in replacement studies Consider the opportunity cost of retaining the asset - the defender 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 16 9.3 Factors that Must Be Considered in Replacement Studiesc

Existing Asset investment value and Outsider Viewpoint Total investment in defender = opportunity cost of not selling the existing asset for its current MV + cost of upgrading to be competitive with best available challenger 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 17 9.3 Factors that Must Be Considered in Replacement Studiesc

Existing Asset investment value and Outsider Viewpoint Income Tax ConsequencesReplacement of assets often result in gains or losses from sale of land or depreciable propertyStudies must be made on an after-tax basis Prospective gain from asset disposal can be reduced by as much as 40% or 50% as a result of taxes 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 18 9.3 Factors that Must Be Considered in Replacement Studies

Example 9-1 The purchase price of a certain new automobile (challenger) being considered for use in your business is $21,000. Your firm’s present automobile (defender) can be sold on the open market for $10,000. The defender was purchased with cash three years ago, and its current BV is $12,000. To make the defender comparable in continued service to the challenger, your firm would need to make some repairs at an estimated cost of $1,500. Based on this information, What is the total capital investment in the defender, using the outsider view point? What is the unamortized value of the defender? 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 19

Economic Life (EL) of the Challenger EL of an asset minimizes equivalent uniform annual cost of owning and operating an asset EL is often shorter than useful or physical lifeEconomic data regarding challengers are periodically updatedReplacement studies then repeated to ensure most up-to-date evaluation 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 20 9.3 Factors that Must Be Considered in Replacement Studies

Economic Life of Defender Often one yearBecause different lives are involved, care should be taken when comparing defender with challengerDefender should be kept longer than apparent economic life as long as its marginal cost < min EUAC of challenger over its economic life 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 21 9.3 Factors that Must Be Considered in Replacement Studies

Useful Life(s) of Defender and / or Challenger Inestimable When useful life of defender or challenger is unknown and can’t be reasonably estimated, must rely on: economic lifemin EUAC total year-by-year marginal costs 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 22

Example 9-2 A firm owns a pressure vessel that it is contemplating replacing. The old pressure vessel has annual operating and maintenance expenses of $60,000 per year and it can be kept for five more years, at which time it will have zero MV. It is believed that $30,000 could be obtained for the old pressure vessel if it were sold now. A new pressure vessel can be purchased for $120,000. The new pressure vessel will have a MV of $50,000 in five years and will have annual operating and maintenance expenses of $30,000 per year. Using a before-tax MARR of 20% per year, determine whether or not the old pressure vessel should be replaced. A study period of five years is appropriate. 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 23

Example 9-3 A manager of a carpet manufacturing plant became concerned about the operation of a critical pump in one of the processes. After discussing this situation with the supervisor of plant engineering, they decided that a replacement study should be done, and that a nine-year study period would be appropriate for this situation. The company that owns the plant is using a before-tax MARR of 10% per year for its capital investment projects. The existing pump, Pump A, including driving motor with integrated controls, cost $17,000 five years ago. An estimated MV of $750 could be obtained for the pump if it were sold now. Some reliability problems have been experienced with pump A, including annual replacement of the impeller and bearings at a cost of $1,750. Annual insurance and property tax expenses are 2% of the initial capital investment. It appears that the pump will provide adequate service for another nine years if the present repair and maintenance practice is continued. It is estimated that if this pump is continued in service, its final MV after nine more years will be $200 . 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 24

Example 9-3 An alternative to keeping the existing pump in service is to sell it immediately and to purchase a replacement pump, Pump B, for $16,000. An estimated MV at the end of the nine-year study period would be 20% of the initial capital investment. Operating and maintenance expenses for the new pump are estimated to be $3,000 per year. Annual taxes and insurance would total 2% of the initial capital investment. The data for this example are summarized in table 9-1. Based on these data, should the defender (pump A) be kept [and the challenger (pump B) not purchased], or should the challenger be purchased now [and the defender sold]? Use a before-tax analysis and the outsider view point in the evaluation. 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 25

Example 9-312/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 26 MARR (before tax ) = 10% per year Existing pump A (defender)     Capital investment when purchased 5 years ago   $17,000 Annual expenses:     Replacement of impeller and bearings $1,750   Operating and maintenance 3,250   Taxes and insurance $17,000 x 0.02 340   Total annual expenses   $5,340 Present MV   $750 Estimated MV at the end of 9 additional years $200 Replacement Pump B (challenger)     Capital investment   $16,000 Annual expenses:     Operating and maintenance $3,000   Taxes and insurance $16,000 x 0.02 $320   Total annual expenses   $3,320 Estimated MV at the end of 9 years: $16,000 x 0.02   $3,200

9.5 Determining Economic Life of a New Asset (Challenger) Before-Tax Analysis PW of total costs Sum of PW of initial capital investments PW of MV at end of year k PW of annual expenses through year k   12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 27

Before-Tax Analysis PW of Marginal c ostsMarginal cost = PW of total cost for year ‘k’ minus PW of total cost for year ‘k-1’   12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 28 9.5 Determining Economic Life of a New Asset (Challenger)

Before-Tax Analysis PW of total costs Sum of: loss in MV during year of extended service opportunity cost of capital invested in the asset at beginning of year ‘k’ annual expenses incurred in year ‘k’   12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 29 9.5 Determining Economic Life of a New Asset (Challenger)

Total marginal (Year-by-year) costs are used to find EUAC through each year ‘K’ Min EUACk value during the useful life of the asset, determines its before-tax economic life Before-tax economic life = N*12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 30 9.5 Determining Economic Life of a New Asset (Challenger)

Example 9-4 A new forklift truck will require an investment of $30,000 and is expected to have year-end MVs and annual expenses as shown in column 2 and 5, respectively, in the next table. If the before-tax MARR is 10% per year, how long should the asset be retained in service? Solve by hand and spreadsheet. 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 31

Example 9-412/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 32 (1) EOY, K (2) MV, EOY K (3) Loss in MV during year K (4) Cost of capital = 10% of beginning of year MV (5) Annual expenses ( E k ) (6) [=(3)+(4)+(5)] Total (marginal) cost for year ( TC k ) (7) EUAC through year K 0 $30,000           1 22,500 $7,500 $3,000 $3,000 $13,500 $13,500 2 16,875 5,625 2,250 4,500 12,375 12,964 3 12,750 4,125 1,688 7,000 12,813 12,918 N c * =3 4 9,750 3,000 1,275 10,000 14,275 13,211 5 7,125 2,625 975 13,000 16,000 13,766

Example 9-5 Returning at the question posed at the very beginning of this chapter, we can now determine the economic life of the $800 laptop computer. Annual expenses and year-end resale values are expected to be the following: 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 33   Year 1 Year 2 Year 3 Software upgrades and maintenance $150 $200 $300 Resale value at EOY $600 $450 $200

Example 9-5 The marginal cost of keeping the computer for each of the three years is as follows: 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 34   Year 1 Year 2 Year 3 Upgrades and maintenance $150 $200 $300 Depreciation $200 $150 $250 Interest on capital at 10% $80 $60 $45 Total marginal cost $430 $410 $595 EUAC 1 (10 %) = $ 430 EUAC 2 (10%) = [$ 430 (P/F,10%,1 ) + $ 410(P/F,10%,2 )] ( A,P,10%,2 ) = $ 420 EUAC 3 (10%) = [$ 420(P,A,10%,2 ) + $ 595(P/F,10%,3 )] ( A,P,10%,3 ) = $ 473 Therefore, based upon economics alone, the computer should be kept for two years before being replaced.

9.6 Determining the Economic Life of a Defender When major outlay for alteration or overhaul is required, the life that will yield least EUAC is likely time to next alteration or overhaul When defender MV is 0 and operating expenses expected to increase annually, the remaining life that will yield least EUAC will be 1 yearWhen MVs are greater than 0 and expected to decline from year to year, calculate remaining economic life in same manner as for before-tax analysis By using outsider viewpoint, the present realizable MV is considered its investment value 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 35

Retention of the Defender The defender should be kept longer than the apparent economic life of the defender as long as its marginal cost (total cost for an additional year of service) is less than the minimum EUAC for the best alternative challenger 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 36

9.7 Comparison in which the Defender’s Useful Life Differs from that of the Challenger Requires use of the repeatability or co-terminated assumptionsNormally, the second stipulation of the repeatability assumption can not be met for the (older and used) defenderFailure to meet this stipulation may be circumvented if period of needed service is indefinitely long and purpose of analysis is simply to determine timing of defender replacement 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 37

Example 9-6 It is desired to determine how much longer a forklift truck should remain in service before it is replaced by the new truck (challenger) for which data were given in example 9-4. The defender in this case is 2 years old, originally cost $19,500 and has a present realizable MV of $7,500. It kept, its MV and annual expenses are expected to be as follows : Determine the most economical period to keep the defender before replacing it (if at all) with the present challenger of example 9-4. The before-tax cost of capital MARR is 10% per year. 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 38 End of year, K MV end of year K Annual expenses, E k 1 $6,000 $8,250 2 4,500 9,900 3 3,000 11,700 4 1,500 13,200

9.8 Retirement without Replacement -Abandonment Two assumptions apply:Once capital investment made, firm desires to postpone project abandonment as long as its present equivalent value (PW) is not decreasing The project will be terminated at the best abandonment time and will not be replaced by the firm 12/15/2011 10:37 AM Dr. Mohmmad Abuhaiba, PE 39

Example 9-7 Suppose that we are faced with the same replacement problem as in example 9-6, except that the period of needed service is (a) three years or (b) four years. That is, a finite analysis period under the co-terminated assumption is being used. In each case which alternative should be selected? 12/15/2011 10:44 AM Dr. Mohmmad Abuhaiba, PE 40

Example 9-8 An $80,000 baling machine for recycled paper was purchased by XYZ company 2 years ago. The current MV of the machine is $50,000, and it can be kept in service for 7 more years. MARR is 12% per year and the projected net annual receipts (revenue less expenses) and EOY MV for the machine are shown below. When is the best time for the company to abandon the project? 12/15/2011 10:49 AM Dr. Mohmmad Abuhaiba, PE 41 End of year   1 2 3 4 5 6 7 Net annual receipts $20,000 $20,000 $18,000 $15,000 $12,000 $6,000 $3,000 Market value 40,000 32,000 25,000 20,000 15,000 10,000 5,000

9.9 After-Tax Replacement Studies – After Tax Economic Life Extending Before-Tax Analysis equation to account for income tax effects: Equation finds PW of ATCF through year k by: adding initial capital investment and sum of after-tax PW of annual expenses through year k, including adjustments for annual depreciation amounts adjusting total after-tax PW of costs by the after-tax consequences of gain or loss on disposal of asset at end of year k   12/15/2011 10:57 AM Dr. Mohmmad Abuhaiba, PE 42

Determining Present Worth of Marginal Costs )+i(t)   12/15/2011 11:05 AM Dr. Mohmmad Abuhaiba, PE 43 9.9 After-Tax Replacement Studies – After Tax Economic Life

Example 9-9 Find the economic life on an after-tax basis for the new forklift truck (challenger) described in example 9-4. Assume that the new forklift is depreciated as a MACRS (GDS) three year property class asset, the effective income tax rate is 40%, and the after-tax MARR is 6% per year. 12/15/2011 11:08 AM Dr. Mohmmad Abuhaiba, PE 44

Example 9-10 An existing asset being considered for replacement has a current MV of $12,000 and a current BV of $18,000. Determine the after-tax investment value of the existing asset (if kept) using the outsider view point and an effective income tax rate of 34%. 12/15/2011 11:11 AM Dr. Mohmmad Abuhaiba, PE 45

Example 9-11 An engineering consulting firm is considering the replacement of its CAD workstation. The workstation was purchased four years ago for $20,000. Depreciation deductions have followed the MACRS (GDS) five-year property class schedule. The workstation can be sold now for $4,000. Assuming the effective income tax rate is 40%, compute the after-tax investment value of the CAD workstation if it is kept. 12/15/2011 11:12 AM Dr. Mohmmad Abuhaiba, PE 46

Example 9-12 A manager of a carpet manufacturing plant became concerned about the operation of a critical pump in one of the processes. After discussing this situation with the supervisor of plant engineering, they decided that a replacement study should be done, and that a nine-year study period would be appropriate for this situation. The company that owns the plant is using an after-tax MARR of 6% per year for its capital investment projects. The effective income tax rate is 40%. 12/15/2011 11:13 AM Dr. Mohmmad Abuhaiba, PE 47

Example 9-12 The existing pump, Pump A, including driving motor with integrated controls, cost $17,000 five years ago. The accounting records show the depreciation schedule to be following that of an asset with a MACRS (ADS) recovery period of nine years. Some reliability problems have been experienced with pump A, including annual replacement of the impeller and bearings at a cost of $1,750. Annual expenses have been averaging $3,250. Annual insurance and property tax expenses are 2% of the initial capital investment. It appears that the pump will provide adequate service for another nine years if the present repair and maintenance practice is continued. An estimated MV of $750 could be obtained for the pump if it were sold now. It is estimated that if this pump is continued in service, its final MV after nine more years will be $200. 12/15/2011 11:14 AM Dr. Mohmmad Abuhaiba, PE 48

Example 9-12 An alternative to keeping the existing pump in service is to sell it immediately and to purchase a replacement pump, Pump B, for $16,000. A nine-year class life (MACRS five years property class) would be applicable to the new pump under the GDS. An estimated MV at the end of the nine-year study period would be 20% of the initial capital investment. Operating and maintenance expenses for the new pump are estimated to be $3,000 per year. Annual taxes and insurance would total 2% of the initial capital investment. The data for this example are summarized in next table. Based on these data, should the defender (pump A) be kept [and the challenger (pump B) not purchased], or should the challenger be purchased now [and the defender sold]? Use an after-tax analysis and the outsider view point in the evaluation. 12/15/2011 11:16 AM Dr. Mohmmad Abuhaiba, PE 49

Example 9-1212/15/2011 11:18 AM Dr. Mohmmad Abuhaiba, PE 50 MARR (after tax)= 6% per year Effective income tax rate = 40% Existing pump A (defender)   MACRS (ADS) recovery period 9 years Total annual expenses $5,340 Present MV $750 Estimated MV at the end of 9 additional years $200 Replacement Pump B (challenger)   MACRS (GDS ) property class 5 years Capital investment $16,000 Total annual expenses $3,320 Estimated MV at the end of 9 years $3,200

Example 9-13 The Hokie Metal stamping company is considering the replacement of a spray system. The new improved system will cost $60,000 for installation and will have an estimated economic life of 12 years. The MV of the new system at the end of 12 years is expected to be $6,000. Further, it is estimated that the annual operating and maintenance expenses will average $32,000 per year for the new system and that straight-line depreciation (with a $6,000 terminal MV) will be used. The present system has a remaining useful life of three years. It has a current BV of $12,000 and a present realizable MV of $8,000. The estimated operating expenses, MVs and BVs of the present system for the next three years are as follows: 12/15/2011 11:21 AM Dr. Mohmmad Abuhaiba, PE 51

Example 9-13 A spray system will be needed for as long as the company remains in business (which it hopes a long, long time). Perform an after-tax analysis to determine the most economical period to keep the defender before replacing it with the new system. The after-tax MARR is 15% per year, and the effective income tax rate is 50%. 12/15/2011 11:23 AM Dr. Mohmmad Abuhaiba, PE 52 Year MV at EOY BV at EOY Operating expenses during year 1 $6,000 $9,000 $40,000 2 5,000 6,000 50,000 3 4,000 3,000 60,000

HomeWork Assignment 1, 6, 11, 16, 21Due Wednesday 28/12/2011 12/15/2011 11:25 AM Dr. Mohmmad Abuhaiba, PE 53