ENME619.

12 Fundamentals of Pipeline Economics

TOPIC 11 REPLACEMENT

Textbook:
• Riggs, J.L., Bedworth, D.D., Randhawa, S.U., and Khan, A.M., Engineering
Economics, 2nd Canadian Edition, McGraw Hill, 1997, Chapter 7.
Supplementary Readings:
• Blank, L., and Tarquin, A., Engineering Economy, 6th Edition, McGraw Hill, 2005,
Chapter 11.
• Park, C.S., Pelot, R., Porteous, K.C., and Zuo, M.J., Contemporary Engineering
Economics, 2nd Canadian Edition, Addison Wesley Longman, 2001, Chapter 6.
• Steiner, H.M., Engineering Economic Principles, 2nd Edition, McGraw Hill, 1996,
Chapters 16.

11.1 Basic Concepts

• Replacement means that an asset is either removed from service entirely (or
scrapped) or put into some secondary use such as standby. Two types of replacement
problems are considered: identical replacement and different replacement.
• Defender: is an asset, presently in service, whose replacement is being considered.
• Challenger: is the possible replacement.
• A replacement decision should be made at time 0, i.e. now or this moment. Future
decision depends on a new analysis at that time.
• The replacement should do the same job as the defender.
• Annual worth or cost method is often used in replacement decision. However,
different lives must take into consideration.
• The value of an asset is determined by its market value rather these sunk costs, such
as book value, trade-in value, etc.
• Economic life needs to be determined in replacement decision. It is the time when
the equivalent uniform annual cost (EUAC) of an asset is a minimum.

11.2 Identical Replacement

A defender will be replaced by an identical challenger.

Case 1: A small construction company has used a standard, two-door, business coupe as its
company car for the past 20 years. Discussion has arisen in the estimating group as
to the economy of the particular maker and model. To answer this question,
Economic analyses for both before-tax and after tax need to be conducted. The
company is in the 40% tax bracket and uses a 20% before-tax and a 10% after-tax
opportunity cost of capital. The following table shows the original price of the car
and the cost of operating the car as well as the salvage values.

Year First cost Operations cost Maintenance Salvage value

j (1) $ (2) $ (3) $ (4) $
0 -12,000
1 -2400 -1000 8000
2 -2400 -2200 6000
3 -2400 -3400 4000

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4 -2400 -4600 2000

5 -2400 -5800 0
Solution:
Before-tax
Year of EUAC of capital Operations EUAC of EUAB of Total
retirement recovery maintenance salvage annual cost
12000(A/P,20,j) 1000+ Sj(A/F,20,j)
1200(A/G,20,j)
J (1) $ (2) $ (3) $ (4) $ (1+2+3-4)
1 14,400 2400 1000 8000 9800
2 7854 2400 1546 2727 9073
3 5696 2400 2055 1099 9052
4 4636 2400 2529 373 9192
5 4013 2400 2969 0 9382

Figure 11.1 The construction company car’s EUAC.

After-tax
If assume the first year depreciation is $4000 and the rest of four years is $2000 per year, the
salvage value is equal to the book value of the car.

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Year j O+M cost Depreciation Taxable Tax @ 40% After-tax

Income cash flow
0 -12,000 -12000
1 -3400 -4000 -7400 +2960 -440
2 -4600 -2000 -6600 +2640 -1960
3 -5800 -2000 -7800 +3120 -2680
4 -7000 -2000 -9000 +3600 -3400
4 +2000

EUAC1=-12000(A/P,10,1)-440+8000=$5640
EUAC2=-12000(A/P,10,2)-440(P/F,10,1)(A/P,10,2)
[-1960(P/A,10,1)-720(P/G,10,1)](P/F,10,1)(A/P,10,2)+6000(A/F,10,2)
=$5221
EUAC3=-12000(A/P,10,3)-440(P/F,10,1)(A/P,10,3)
[-1960(P/A,10,2)-720(P/G,10,2)](P/F,10,1)(A/P,10,3)+4000(A/F,10,3)
=$5239
EUAC4=-12000(A/P,10,4)-440(P/F,10,1)(A/P,10,4)+
[-1960(P/A,10,3)-720(P/G,10,3)](P/F,10,1)(A/P,10,4)+2000(A/F,10,4)
=$5360
EUAC5=-12000(A/P,10,5)-440(P/F,10,1)(A/P,10,5)
[-1960(P/A,10,4)-720(P/G,10,4)](P/F,10,1)(A/P,10,5)
=$5518

Case 2: If we assume we stand at future, e.g. the end of year 1, year 2, year 3, etc. we will
have the following cash flows:

8000
4600

0 1 0 1

1000

2400

12,000 12,000

6000 1400

1 2 1 2

2200

2400
8000 8000
Solutions:

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AC1=12,000(A/P,20,1)-4600(A/F,20,1)=12000(1.2000)-4600(1.0000)=$9800
AC2=8000(A/P,20,1)-1400(A/F,20,1)=8000(1.2000)-1400(1.0000)=$8200
AC3=6000(A/P,20,1)-(2400+3400-4000)(A/F,20,1)=6000(1.2000)+1800(1.0000)=$9000
AC4=4000(A/P,20,1)+(2400+4600-2000)(A/F,20,1)=4000(1.2000)+5000(1.0000)=$9800
AC5=2000(A/P,20,1)+(2400+5800)(A/F,20,1)=2000(1.2000)+8200(1.0000)=$10,600

EUAC1=9800(P/F,20,1)(A/P,20,1)=9800(0.8333)(1.2000)=$9800
EUAC2=[9800(P/F,20,1)+8200(P/F,20,2)](A/P,20,2)
=[9800(0.8333)+8200(0.6944)](0.6545)=$9072
EUAC3=[9800(P/F,20,1)+8200(P/F,20,2)+9000(P/F,20,3)](A/P,20,3)
=[9800(0.8333)+8200(0.6944)+9000(0.5787)](0.4747)=$9052
EUAC4=[9800(P/F,20,1)+8200(P/F,20,2)+9000(P/F,20,3)+9800(P/F,20,4)](A/P,20,4)
=$9192
EUAC5=[9800(P/F,20,1)+8200(P/F,20,2)+9000(P/F,20,3)+9800(P/F,20,4)
+10,600(P/F/,20,5)](A/P,20,5)
=$9381.

11.3 Different Replacement

A defender will be replaced by a different challenger.

Figure 11.2 Replacement decision flowchart.

Case 2 A grinder was purchased 3 years ago for $40,000. It has provided adequate service,
but an improved version is now available for $35,000 that will reduce operating
costs and cut inspection expenses. Costs and salvage values for the two machines are
shown in the following table. Costs that are the same for either machine are not
included. Also, the operating costs for the challenger are very low due to warranted

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equipment. Should a replacement be made if the required rate of return is 15% and
the services of a grinder will be needed for only 4 more years?

Defender D Challenger C
Year Operating cost Salvage value Operating cost Salvage value
0 12,000 35,000
1 3,400 7,000 200 30,000
2 3,900 4,000 1,000 27,000
3 4,600 2,500 1,200 24,000
4 5,600 1,000 1,500 20,000
5 2,000 17,000
6 2,600 15,000

Solution
Considering the first 4 years
EUAC(D)= [12,000+3400(P/F,15,1)+3900(P/F,15,2)+4600(P/F,15,3)+
(5600-1000)(P/F,15,4)](A/P,15,4)=$8,252

EUAC(C)= (35000-20000)(A/P,15,4)+20000(0.15)+[200(P/F,15,1)+
1000(P/F,15,2)+1200(P/F,15,3)+1500(P/F,15,4)](A/P,15,4)=$9,157

Therefore, the replacement should not be made now.

Should replacement be made at:

Beginning of year 2: EUAC over years 2 through 4,
Beginning of year 3: EUAC over years 3 and 4, or
Beginning of year 4: EUAC over year 4 only?

Calculation for Beginning of year 3:

EUAC(D)years3, 4=(4000-1000)(A/P,15,2)+1000(0.15)+
[4600(P/F,15,1)+5600(P/F,15,2)](A/P,15,2)=$7,061

EUAC(C)years3, 4=(35000-27000)(A/P,15,2)+27000(0.15)+
[200(P/F,15,1)+1000(P/F,15,2)](A/P,15,2)=$9,534

Replacement happened at EUAC(D) EUA(C)

Now $8,252 $9,157
Beginning of year 2 $7,399 $9,170
Beginning of year 3 $7,061 $9,543
Beginning of year 4 $7,475 $10,450

11.4 Tutorial Questions

Problem 1
What is meant by economic life? Explain with an example.

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Problem 2
Two production machines are under consideration. Machine A, the defender, bought
1 year ago, exhibits the following characteristics:
First cost $15,000
Physical life 5 years
Maintenance cost $2400 per year
Salvage value at any time $0

Similar information on machine B, the challenger, is given:

First cost $20,000
Physical life 4 years
Maintenance cost $2400 per year
Salvage value at any time $2000

The opportunity cost of capital for the company considering the machines is 12%.
No taxes or inflation will be considered for this preliminary analysis. Use EUAC to
make your decision.

i) What is the economic life of the challenger?

ii) Should the challenger be purchased at this time? Say why, indicating which
costs and lives should be compared.

Problem 3
Metro, the subway and bus system in the Washington, D.C. area, is considering
replacement of several of its escalators in certain subway stations. The following
table presents the situation for each station.
Replacement Original
First cost ($) 1,350,000 420,000
Physical life (years) 25 25
Remaining life (years) 25 5
Maintenance and operation cost per year 50,000 100,000
Salvage value ($) 0 0

The existing escalators will last 5 more years. The replacement will be performed by
the manufacturer and installer of the original escalators. Metro, as a public entity,
pays no income taxes. Do not consider inflation. The opportunity cost of capital is
10%. Should Metro replace the original escalators?

Problem 4
The Georgetown office copying machine was purchased 3 years ago by your
electrical engineering firm. It may be sold at present for $225 on the open market. Its
resale value at any time in the future is estimated as $125. Operating costs for
material, labor, and maintenance will remain at $4100 per year for the next 4 years,
the study period.
Office Leasing, a reliable company, will furnish a similar machine for $1000 per
year with a guaranteed operating expense of $3200 annually over the next 4 years.

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Should you replace the present machine with the leased one if your MARR is
15% and tax and inflation effects are disregarded?

Problem 5
An electrical contractor has in his service a fleet of 10 vans of varying ages. With a
view to standardizing his fleet with a single make, he wishes to know what the
annual cost, at the economic life, will be for a van with the following characteristics:
Life First cost ($) Operations Cost Maintenance Salvage value
($) cost ($) ($)
0 13,200
1 2160 880 9080
2 2160 1980 7340
3 2160 3080 5600
4 2160 4180 3860
5 2160 5280 2120
6 2160 6380 380
All costs are in constant dollars. His opportunity cost of capital before taxes is 20%.
A before tax analysis is required.

Problem 6
The following data describe the characteristics of two tractor units used in long-
distance household moving.
Make 1 Make 2
First cost ($) 50,000 116,000
Original physical life (years) 4 6
Remaining life (years) 2 6
Net annual revenues ($) 20,000 40,000
The moving company is in the 45% tax bracket for all taxes. The MARR of this
company is 20% after taxes have been accounted for and 35% before taxes. Inflation
effects will be ignored.
The company presently owns Make 1 equipment, bought 2 years ago. At any
point in its life, the resale value of either make of equipment will approximate its
book value.
The depreciations are counted as: Make 2: $14,500 at year 1, $29,000 for years 2,
3 and 4, $14,500 at year 5, and $0 at year 6. Make 1: $6250 at year (-1), $12500 at
year 0, $12,500 at year 1, and $6250 at year 2. Loss or gain on disposal is treated as
ordinary expense or revenue.
Determine whether the defender (i.e. Make 1) should be sold and the challenger
(i.e. Make 2) bought. Because the company intends to continue in the long-distance
moving business, an alternative is certain to be chosen. An after-tax solution is
required.

Answers to the tutorial questions

Problem 1: See teaching nots on pp.11.1.
Problem 2:
i) EUAC1=$22,800, EUAC2=$13,291, EUAC3=$10,131, EUAC4=$8566.

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Economic life =4 years.

ii) EUACj=$2400, j=1,2,3,4. $15,000 is a sunk cost.
Keep defender, comparing $2400 per year to $8566 per year for the challenger.

Problem 3:
Replacement: EUACj=1,350,000(A/P,10,j)+50,000, j=1,2,…, 25.
EUAC25=Min (EUACj)=$198,730. Economic life =25 years.
Original: EUACj=$100,000, j=1,2,…5. Keep original for 5 more years.

Problem 4:
Defender: EUACj=225(A/P,15,j)+4100-125(A/F, 15, j), j=1,2,3,4.
EUAC4=Min(EUACj)=$4154.
Challenger: EUACj=1000+3200=4200/year, j=1,2,3,…
Keep defender for 4 years.

Problem 5:
EUACj=13,200(A/P,20,j)+2160+880+1100(A/G,20,j)-[9080-1740(j-1)](A/F,20,j)
j=1,2,…6.
Economic life is 3 years at EUAC3=$8735/year.

Problem 6:
Make 2: NPV1=-$7646, EUAC1=$9175; NPV2=-$17,542, EUAC2=$11,482.
Make 1: NPV1=$46,103, EUAW1=$55,324; NPV2=$48,750, EUAW2=$31,907.
Keep Make 1.

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