Chapter 11

Replacement and
Retention Decisions

 Learning Outcomes:
Perform a replacement/retention study
between an in-place asset, process, or
system and one that could replace it.

Replacement and Retention

The Fundamental Question:
Should it be replaced now or later?
Answers the question when,not if, to
replace

Replacement Study
Replacement Study usually designed
to first make the economic decision
to retain or replace now .
To replace->study is complete
To retain->revisit cost estimates and
decision

application of the AW method of

comparing unequal-life alternatives

11.1-Basics of Replacement
Study

Why we should Replace?

Reduced Performance-Because of
physical deterioration, the ability
to perform at an expected level of
reliability (being available and
performing correctly when needed)
or productivity(performing at a
given level of quality and quantity) is
not present

Reduced Performance

Why we should Replace?

Altered Requirements-New
requirements of accuracy, speed, or
other specifications cannot be met
by the existing equipment or system.

Altered Requirements

Why we should Replace?

Obsolescence-International
competition and rapidly changing
technology make currently used
systems and assets perform
acceptably but less productively
than equipment coming available.

Obsolescence

Terminologies
Defender-is the currently installed
asset.
Challenger-the potential
replacement.
Market Value-is the current value of
the installed asset if it were sold or
traded on the open market. Also
called Trade-in Value.
AW values-primary economic

Terminologies
Economic Service Life (ESL)-the
number of years at which the lowest
AW of cost occurs .
Defender First Cost-initial investment
amount P used for the defender.
Challenger First Cost-the amount of
capital that must be recovered
(amortized) when replacing a
defender with a challenger.

Sunk Cost
A sunk cost is a prior expenditure or loss
of capital (money) that cannot be
recovered by a decision about the
future. The replacement alternative for
an asset, system, or process that has
incurred a non recoverable cost should not
include this cost in any direct fashion;
sunk costs should be handled in a realistic
way using tax laws and write-off
allowances.

Sunk Cost Reminder

A sunk cost should never be added to
the challengers first cost, because it
will make the challenger appear to
be more costly than it actually is .

Non-owners Viewpoint
The non-owners viewpoint , also called the
outsiders viewpoint or consultants viewpoint,
provides the greatest objectivity in a
replacement study. This viewpoint performs
the analysis without bias; it means the
analyst owns neither the defender nor
the challenger. Additionally, it assumes the
services provided by the defender can be
purchased now by making an initial
investment equal to the market value of
the defender.

Planning Horizon

If the planning horizon is unlimited , that is, a study period

is not specified, the assumptions are as follows:
1. The services provided are needed for the indefinite
future.
2. The challenger is the best challenger available now and
in the future to replace the defender. When this challenger
replaces the defender (now or later), it will be repeated for
succeeding life cycles.
3. Cost estimates for every life cycle of the defender and
challenger will be the same as in their first cycle.

When the planning horizon is limited to a specified study

period, the assumptions above do not hold.

Example

11.2-Economic Service Life

Economic Service Life

The economic service life (ESL) is the
number of years n at which the
equivalent uniform annual worth
(AW) of costs is the minimum,
considering the most current cost
estimates over all possible years that
the asset may provide a needed
service.
also referred to as the economic life

Economic Service Life

ESL indicates that the asset should
be replaced to minimize overall
costs.
To perform a replacement study
correctly, it is important that the ESL
of the challenger and the ESL of the
defender be determined, since their
n values are usually not pre
established.

Determining ESL
Calculate the Total AW of costs- sum of capital
recovery (CR), which is the AW of the initial investment and any salvage
value, and the AW of the estimated annual operating cost (AOC

The ESL is the n value for the smallest total

AW of costs .
Remember: These AW values are cost
estimates, so the AW values are negative
numbers. Therefore, $200 is a lower cost
than $500.

Determining ESL-The two ESL components

Decreasing cost of capital

recovery. The capital recovery is the AW of
investment; it decreases with each year of
ownership. The salvage value S , which usually
decreases with time, is the estimated market
value (MV) in that year.
Capital recovery P (AP,i,n) S (AF,i,n)

Determining ESL-The two ESL components

The current MV is used for P when the asset is the

defender, and the estimated future MV values are
substituted for the S values in years 1, 2, 3, . . . .
Plotting the AW k series clearly indicates where
the ESL is located and the trend of the AW k curve
on each side of the ESL.

Expected Life

When the expected life n is known and specified for

the challenger or defender, no ESL computations are
necessary. Determine the AW over n years, using the first
cost or current market value, estimated salvage value after
n years, and AOC estimates. This AW value is the correct
one to use in the replacement study.
However, when n is not fixed, the following is useful. First
the market/salvage series is needed. If it is reasonable to
predict the MV series on a year-by-year basis, it can be
combined with the AOC estimates to produce what is called
the marginal costs for the asset.

Marginal Costs
Marginal costs (MC) are year-by-year estimates of
the costs to own and operate an asset for that year.
Three components are added to determine the marginal
cost:
Cost of ownership (loss in market value is the best estimate of this
cost)
Forgone interest on the market value at the beginning of the year
AOC for each year

The sum of the AW values of the first two of these

components is the capital recovery amount (CR). It will
follow that the sum of the 3 components of Marginal Costs
is just equal to your Total AW Cost over k years (11.3)
AW of marginal costs =total AW of costs (11.5)

 ESL analysis: Equation [11.4] is applied repeatedly for k 1, 2, . . . , 12

years (columns C, D, and E) in the top of Figure 113. Row 16 details the
spreadsheet functions for year 12. The result in column F is the total AW
series that is of interest now.
Marginal cost (MC): The functions in the bottom of Figure 113 (columns
C, D, and E) develop the three components added to obtain the MC
series. Row 33 details the functions for year 12. The resulting AW of
marginal costs (column G) is the series to compare with the
corresponding ESL series above (column F).
The two AW series are identical, thus demonstrating that Equation
[11.5] is correct. Therefore, either an ESL or a marginal cost analysis will
provide the same information for a replacement study. In this case, the
results show that the new kiln will have a minimum AW of costs of $
12.32 million at its full 12-year life.

Conclusion about n and AW

Year-by-year market value estimates are
made.
Yearly market value estimates are not
available.

Conclusion about n and AW

Upon completion of the ESL analysis, the
replacement study procedure in Section 11.3 is
applied using the values
Challenger alternative (C): AWC for nC years
Defender alternative (D): AWD for nD years

11.3-Performing a
Replacement Study

Performing a Replacement Study

Replacement studies are performed
in one of two ways:
with a study period specified
without a study period specified

Performing a Replacement Study

The replacement study procedure is:
New replacement study:
1. On the basis of the better AW C or AW D
value, select the challenger C or defender D.
When the challenger is selected, replace the
defender now, and expect to keep the
challenger for nC years. This replacement
study is complete. If the defender is
selected, plan to retain it for upto nD more
years.Next year, perform the following steps.

Performing a Replacement Study

One-year-later analysis:
2. Determine if all estimates are still current for
both alternatives, especially fi rst cost, market
value, and AOC. If not, proceed to step 3. If yes
and this is year nD , replace the defender. If this is
not year nD , retain the defender for another year
and repeat this same step. This step may be
repeated several times.
3. Whenever the estimates have changed, update
them and determine new AW C and AW D values.
Initiate a new replacement study

Example

11.4-Additional Considerations
in a Replacement Study

Additional Considerations in a
Replacement Study
There are several additional aspects of
a replacement study that may be
introduced. Three of these are identified
and discussed in turn.
Future-year replacement decisions at the
time of the initial replacement study
Opportunity cost versus cash flow
approaches to alternative comparison
Anticipation of improved future challengers

Additional Considerations in a
Replacement Study
The first costs for the C and D have been
correctly taken as the initial investment for
the Challenger and current market value
for the Defender. This is called the
opportunity cost approach because it
recognizes that a cash inflow of funds
equal to the market value is forgone if the
defender is selected. This approach, also
called the conventional approach, is
correct for every replacement study.

Additional Considerations in a
Replacement Study
A second approach, called the cash flow
approach, recognizes that when C is
selected, the market value cash inflow for D is
received and, in effect, immediately reduces
the capital needed to invest in the challenger.
Use of the cash flow approach is strongly
discouraged for at least two reasons:
Possible violation of the equal-service requirement
Incorrect capital recovery value for C.

Additional Considerations in a
Replacement Study
the cash flow approach can work only
when challenger and defender lives
are exactly equal. This is commonly
not the case; in fact, the ESL analysis
and the replacement study procedure
are designed to compare two
mutually exclusive, unequal-life
alternatives via the annual worth
method.

Additional Considerations in a
Replacement Study
A basic premise of a replacement study is
that some challenger will replace the
defender at a future time, provided the
service continues to be needed and a
worthy challenger is available. The
expectation of ever-improving challengers
can offer strong encouragement to retain
the defender until some situational
elementstechnology, costs, market
fluctuations, contract negotiations, etc

Additional Considerations in a
Replacement Study
There are several additional aspects of
a replacement study that may be
introduced. Three of these are identified
and discussed in turn.
Future-year replacement decisions at the
time of the initial replacement study
Opportunity cost versus cash flow
approaches to alternative comparison
Anticipation of improved future challengers

Additional Considerations in a
Replacement Study
The replacement study is no
substitute for forecasting challenger
availability. It is important to
understand trends, new advances,
and competitive pressures that can
complement the economic outcome
of a good replacement study .

Additional Considerations in a
Replacement Study
It is often better to compare a
challenger with an augmented
defender in the replacement study.
Adding needed features to a
currently installed defender may
prolong its useful life and
productivity until challenger choices
are more appealing.

11.5 Replacement Study over

a
Specified Study Period

Replacement Study over a

Specified Study Period
When the time period for the replacement study
is limited to a specified study period or planning
horizon, for example, 6 years, the Economic
Service Life (ESL) analysis is not performed.

The Annual Worth (AW) values for the challenger and for
the remaining life of the defender are not based on the
economic service life; the Annual Worth (AW) is
calculated over the study period only. What happens to
the alternatives after the study period is not considered
in the replacement analysis.

Replacement Study over a

Specified Study Period
When performing a replacement study over a
fixed study period, it is crucial that the
estimates used to determine the Annual Worth
(AW) values be accurate and used in the study.
This is especially important for the defender.
Failure to do the following violates the
requirement of equal-service comparison.
When the defenders remaining life is shorter than the
study period, the cost of providing the defenders
services from the end of its expected remaining life to the
end of the study period must be estimated as accurately
as possible and included in the replacement study.

Overview of the replacement study

procedure for a stated study period.
1. Succession options and Annual Worth (AW )values .
Develop all the viable ways to use the defender and
challenger during the study period. There may be only one
option or many options; the longer the study period, the
more complex this analysis becomes. The AW values for
the challenger and defender cash flows are used to build
the equivalent cash flow values for each option.
2. Selection of the best option .
The Present Worth (PW) or Annual Worth (AW) for each
option is calculated over the study period. Select the option
with the lowest cost, or highest income if revenues are
estimated. (As before, the best option will have the
numerically largest Present Worth (PW) or Annual Worth
(AW) value.)

Replacement Study over a

Specified Study Period
When a study period shorter than the life of the
challenger is defined, the challengers capital
recovery amount increases in order to recover
the initial investment plus a return in this
shortened time period. Highly abbreviated
study periods tend to disadvantage the
challenger because no consideration of time
beyond the end of the study period is made in
calculating the challengers capital recovery
amount.

Replacement Study over a

Specified Study Period

If there are several options for the number of years that the
defender may be retained before replacement with the
challenger, the first step of the replacement study
succession options and AW valuesmust include all the
viable options. For example, if the study period is 5 years
and the defender will remain in service 1 year, or 2 years,
or 3 years, cost estimates must be made to determine AW
values for each defender retention period. In this case,
there are four options; call them W, X, Y, and Z.

11.6 Replacement Value

Replacement Value
Often it is helpful to know the minimum market value of the
defender necessary to make the challenger economically
attractive. If a realizable market value or trade-in of at least
this amount can be obtained, from an economic perspective
the challenger should be selected immediately. This is a
breakeven value between AW C and AW D ; it is referred to
as the replacement value (RV) . Set up the relation AW C
= AW D with the market value for the defender identified as
RV, which is the unknown. The AW C is known, so RV can be
determined. The selection guideline is as follows:
If the actual market trade-in exceeds the breakeven
replacement value , the challenger is the better
alternative and should replace the defender now.