1/12/2020

Replacement Decision
By:
Ahsan Ahmed
(Lecturer, MED)

Types of lives of Asset

1) Economic Life:
 Economic life is the period of time (years) that results in the
minimum equivalent uniform annual cost (EUAC) of owning
and operating an asset.
𝐸𝑈𝐴𝐶 𝑖% = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑖% + 𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
Where,
𝐴 𝐴
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑖% = 𝐼 , 𝑖%, 𝑁 − 𝑆 , 𝑖%, 𝑁
𝑃 𝑃
2) Ownership Life:
 Period between date of acquisition and date of disposal by an
owner

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Types of lives of Asset

3) Physical life:
 Period between date of acquisition and final disposal of asset
over its succession of owners. For example, the car just
described may have several owners over its existence.
4) Useful life:
 Period that an asset is kept in productive service (Primary or
backup) and generates income. It is an estimate of how long
an asset is expected to be used in a trade or business to
produce income

Replacement Analysis Using PW

(Before Taxes)
Q) 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 (Current
Market Value). 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 an 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.

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Replacement Analysis Using PW

 The first step in the analysis is to determine the investment
value of the defender (old pressure vessel).
 Using the outsider viewpoint, the investment value of the
defender is $30,000, its present MV.
 We can now compute the PW of each alternative and decide
whether the old pressure vessel should be kept in service or
replaced immediately.
Defender (Old Pressure Vessel):

Replacement Analysis Using PW

Challenger (New Pressure Vessel):

Decision:
The present worth of challenger is greater than present worth
of defender. Thus the old pressure vessel should be replaced
immediately.

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Replacement Analysis Using EUAC

Q) The 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 operating and maintenance expenses
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Replacement Analysis Using EUAC

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 maintenance and repair
practice is continued. It is estimated that if this pump is
continued in service, its final MV after nine more years will be
about $200.
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.
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Replacement Analysis Using EUAC

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 viewpoint in the
evaluation.

Replacement Analysis Using EUAC

Solution:

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Replacement Analysis Using EUAC

Solution: (Cont.)
For Defender: (Study period : 9 years)

𝐴 𝐴
𝐸𝑈𝐴𝐶 10% = −5,340 − 750 , 10%, 9 + 200 , 10%, 9
𝑃 𝐹
𝐸𝑈𝐴𝐶 10% = −5,340 − 750 0.1736 + 200 0.0736
𝐸𝑈𝐴𝐶 10% = −$5,455
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Replacement Analysis Using EUAC

Solution: (Cont.)
For Challenger: (Study period : 9 years)

𝐴 𝐴
𝐸𝑈𝐴𝐶 10% = −16,000 , 10%, 9 − 3,320 + 3,200 , 10%, 9
𝑃 𝐹
𝐸𝑈𝐴𝐶 10% = −16,000 0.1736 − 3,320 + 3,200 0.0736
𝐸𝑈𝐴𝐶 10% = −$5,862
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Replacement Analysis Using EUAC

Solution: (Cont.)
Decision:
Because Pump A has the smaller EUAC ($5,455 < $5,862), the
replacement pump is apparently not justified, and the defender
should be kept.

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ECONOMIC LIFE OF A NEW ASSET

(CHALLENGER)
 The minimum cost life of any new (or existing) asset is the
number of years at which the Equivalent uniform annual cost
(EUAC) of ownership is minimized.
 This minimum cost life is often shorter than either the
physical or useful life of the asset due to increasing operating
and maintenance costs in the later years of asset ownership.
1) Challenger’s economic life is determined by the minimum
EUAC
2) For any new asset ,perform a cash flow analysis and create
a table finding the EUAC for each year
3) Identify lowest EUAC value - - - Year of lowest EUAC
corresponds to economic life of the asset

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ECONOMIC LIFE OF A NEW ASSET

(CHALLENGER)
 A piece of machinery costs $ 7500 and has no salvage value
after it is installed. The manufacturer's warranty will pay the
first years maintenance and repair costs. In the second year,
maintenance costs will be $900 and this item will increase on
a $900 arithmetic gradient in subsequent years. Also
operating expenses for the machinery will be $ 500 the first
year and will increase on a $ 400 arithmetic gradient in the
following years . If interest rate is 8%. Compute the useful life
of the machinery that results in a minimum EUAC. That is
find its minimum cost life.

 Solution:

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ECONOMIC LIFE OF A NEW ASSET

(CHALLENGER)

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ECONOMIC LIFE OF A NEW ASSET

(CHALLENGER)

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ECONOMIC LIFE OF A NEW ASSET

(CHALLENGER)
 From either the tabulation or the figure, we see hat the
minimum cost life (Economic Useful Life) of the machinery is
4 years, with a minimum EUAC of $4589 for each of those 4
years.
 The total EUAC curve of most assets tends to follow this
concave shape--high at the beginning due to capital recovery
costs, and high at the end due to increased
maintenance/repair and operating expenses.
 The minimum EUAC occurs somewhere between these high
points.

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