Replacement analysis Technique can be illustrated as 3 situation:

• Defender Remaining Life Equals Challenger Useful Life
• Defender Remaining Life Different from Challenger Useful Life
• A Closer Look at Challenger

 

Defender Remaining Life Equals Challenger Useful Life:

This condition is valid when defender remaining life (available asset) equals to challenger useful life (new asset). Method to solve this may vary such as  present worth, annual worth, rate of return, benefit-cost ratio. EUAC can be used to determine feasibility of project/investment. Criteria: finding the minimum EUAC based on bench-marked period.

example:

A plan has been released for changing old facility for a new one. Calculator SK-30 will be replaced by EL-40, the estimation is delivered as follow:

• Market value for SK-30 worth to $200 while EL-40 is $1050
• Maintenance and operational cost for SK-30 is $80 per year. EL-40 doesn’t need operational and maintenance cost
• Useful life for both calculator is 5 years.
• SK-30 has no salvage value mean while EL-40 can be sold up to $50 until has no economic life
• EL-40 can produce annual saving $120 per year

to solve the same useful life both defender and challenger is very easy, You just calculate each EUAC’s alternatives:

Answer:

■EUAC for SK-30 :

market value= $200

salvage value= 0

annual operational cost= $80/year

EUAC = (200-0)(A/P,10%,5) + 80 = $132,76

■EUAC for EL-40 :

investment cost= $1050

salvage value= $250

annual benefit= $120/year

EUAC = (1050-250)(A/P,10%,5) – 120 = $116,04

EL-40 produces smaller EUAC than SK-30, then select EL-40

 

Defender Remaining Life Different from Challenger Useful Life

This condition is valid when defender remaining life (available asset) is different to challenger useful life (new asset). Annual worth (EUAC) is suggested method when the analysis period is different. In this condition, there are 2 alternatives replacement:

1. Replace defender now
2. Maintain defender for a while

Example :

A machine requires an overhaul at a cost of $ 4000. Maintenance costs is $ 1800 for the next two years. However the maintenance costs increase gradually $ 1000 per year. After the machine has already perform overhaul, the machine can be used again for 5 years. For your information,  the defender has no residual value   then calculate the remaining service life for challenger (APR is 8%)

Answer

Alright, to solve this complicated problem let’s start by analyzing the defender cash flow and find the annual equivalence. The cost capital for defender is not mentioned. It mostly talk the maintenance and overhaul cost. Since these costs are difference, just split the cost into 2 column independently, EUAC overhaul and EUAC maintenance. Afterwards just add up all the cost every year and find out the smallest one.

EUAC overhaul starts at $4000, and the period analysis takes 5 years, then to compute next equivalent just multiply the OH cost by A/P,8%,n–> just change the “n” with number year until year 5.

EUAC for maintenance is constant for only 2 years but they will be accelerating after that the formula for this situation is 1000 [(P/G,8%,3)(P/F,8%,1)(A/P,8%,4)] —> it means we converted to present first and after that it should be converted  again into annual equivalent.

The smallest EUAC is located at year-3 so after this year the replacement should be conducted.

 

A Closer Look at challenger

Due to technology innovation, this alternative might be change As a consequence, present challenger and future challenger concept may rise up If  future challenger is better than present challenger, is there any impact of replacement analysis? then we can implement a Closer Look at challenger technique

Example:

A machine requires an overhaul at a cost of $ 4000. Maintenance costs is $ 1800 for the next two years. However the maintenance costs increase gradually $ 1000 per year. After the machine has already perform overhaul, the machine can be used again for 5 years. For your information,  the defender has no residual value  with APR is 8%.

The initial investment for challenger is $ 10.000 with no residual value. The first operational and maintenance cost are being covered by the company but after that is increasing gradiently for $600. The useful life for each machine is 8 years

Meanwhile the future challenger with 6 years useful life and EUAC decrease  $100 per year. The replacement analysis can be written as follow:

• Maintain defender
• Change defender with challenger
• Maintain defender for 1 year, then change into future challenger
• Maintain defender for 2 years, then change into future challenger
• Maintain defender for 3 years, then change into future challenger
• Maintain defender for 4 years, then change into future challenger

Which alternative should be taken?

Answer:

lets take a look the table:

■EUAC for all alternatives:

• Maintain defender

EUAC minimum defender = $3660 (take a look the previous answer above)

• Change defender with challenger

EUAC minimum challenger = $3529 (calculate by  using the same step like A)

• Maintain defender for 1 year, then change into future challenger

EUAC Challenger $3529- $100 (because it decreases every year by $100)=$3429

EUAC for Defender (1 year) is 6120 –>see the table above, so the EUAC for maintaining defender for 1 year is:

EUAC = 6120(P/A,8%,1)+3429(P/A,8%,6)(P/F,8%,1)= $3909

• Maintain defender for 2 years, then change into future challenger

D : EUAC = 4043(P/A,8%,2)+3329(P/A,8%,6)(P/F,8%,2)= $3550

• Maintain defender for 3 years, then change into future challenger

EUAC = 3660(P/A,8%,3)+3229(P/A,8%,6)(P/F,8%,3) = $3407

• Maintain defender for 4 years, then change into future challenger

EUAC = 3691(P/A,8%,4)+3129(P/A,8%,6)(P/F,8%,4) = $3406

Analysis :

• The Smallest EUAC is Maintaining defender for 4 years, then change into future challenger
• For a certain period, the best solution keeping the old machine and consider to be replaced in following years
• When defender is being bench marked with challenger, the best solution is replacing defender to challenger.
• When future challenger is coming, the decision will change at all, and need to consider future challenger
• As a consequences, the replacement must be delayed, and do replacement analysis again to produce the best alternative

 

Replacement Value Practice

Defender

• useful life:  3 years
• Operating cost: Rp 9,5 million/year
• Salvage value: Rp 3,5 milion
• can be used for :7 years

Challenger :

• First cost: Rp 28 milion
• Operating cost : Rp 5,5 milion/year
• Salvage value : Rp 2 milion
• useful life :14 years

if the Rate of return is  15%  then compute the minimum replacement value for machine so that the replacement can be favorable!

 

Answer:

■EUAC defender = RV(A/P,15%,7) + 9,5 million – 3,5 million(A/F,15%,7)= 0,20436 RV + 9.183.739

■EUAC challenger = 28 million A/P,15%,14) + 5,5 million– 2 million (A/F,15%,14) = 10.341.901

EUAC defender – EUAC challenger = 0

0,20436 RV + 9.183.739 = 10.341.901

RV = Rp 4.818.447

 

We can conclude that:

• if trade-in value for defender is greater than RV (Rp 4.818.447) –> change with a new one/ select challenger
• if trade-in value for defender is smaller  than RV (Rp 4.818.447) –>maintain the old one/ select defender