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Replacement Analysis Techniques in Capital Allocation

Understand when to replace existing assets in EGR 403 course at Cal Poly Pomona. Learn to compare defender vs. challenger costs and optimal replacement timing. Consider factors like obsolescence, depletion, and deterioration.

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Replacement Analysis Techniques in Capital Allocation

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  1. Chapter 12 - ReplacementClick here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona

  2. EGR 403 - The Big Picture • Framework:Accounting& Breakeven Analysis • “Time-value of money” concepts - Ch. 3, 4 • Analysis methods • Ch. 5 - Present Worth • Ch. 6 - Annual Worth • Ch. 7,7A,8 - Rate of Return (incremental analysis) • Ch. 9 - Benefit Cost Ratio & other methods • Refining the analysis • Ch. 10, 11 - Depreciation & Taxes • Ch. 12 - Replacement Analysis EGR 403 - Cal Poly Pomona - SA15

  3. Replacement Analysis • When should a new truck replace the existing truck? • When should a process be redesigned? • When should a product be redesigned? The most common question asked in industry is when should the existing be replaced? EGR 403 - Cal Poly Pomona - SA15

  4. Replacement Analysis Terms • Defender - the existing equipment or building previously implemented. • Challenger - the proposed replacement currently under consideration. EGR 403 - Cal Poly Pomona - SA15

  5. Aspects of Replacement Analysis • Using available data to determine the analysis technique. • Determining the base comparison between alternatives. • Using analysis techniques when: • Defender marginal cost can be computed and is increasing. • Defender marginal cost can be computed and is not increasing. • Defender marginal cost is not available. • Considering possible future challengers. • After-tax analysis. EGR 403 - Cal Poly Pomona - SA15

  6. The Replacement Problem • Engineers replace the existing due to: • Obsolescence - technological change. • Depletion - loss of market value. • Deterioration - wear that is overly expensive to repair. Shall the defender be replaced now or be maintained for one or more periods. EGR 403 - Cal Poly Pomona - SA15

  7. Issues (Consider Before Starting) • Is it morally or ethically right to do this project? • If a unit fails, must it be removed permanently from service? Or repaired? Are standby units available if the system should fail? • Do components or units fail independently of the failure of other components? • Is there a budget constraint? • In the event that the unit can be repaired after failure is their a constraint on the capacity of the repair facility? EGR 403 - Cal Poly Pomona - SA15

  8. Issues(Continued) • Is there only one replacement allowed over the planning horizon? Are subsequent replacements allowed at any time during the study period? • Is their more than one replacement unit (price and quality combination) available at a given point in time? • Do future replacement units differ over time? Are technological improvements considered? • Is preventative maintenance included in the model? EGR 403 - Cal Poly Pomona - SA15

  9. Issues (Continued) • Are periodic operating and maintenance costs constant or variable over time? • Is the planning horizon finite or infinite? • Are consequences other than economic impacts, i.e., sociotechnical issues considered? • Are income tax consequences considered? • Is “inflation” considered? • Does replacement occur simultaneously with retirement, or are there nonzero lead times? • Are cash flow estimates deterministic or stochastic? EGR 403 - Cal Poly Pomona - SA15

  10. Where Compare Defender Marginal Cost Defender Marginal Cost Defender Best Challenger 1 Available Increasing Next-year Marginal Cost EUAC at Minimum Cost Life 2 Available Not increasing EUAC at Minimum Cost Life EUAC at Minimum Cost Life 3 Not available EUAC over Remaining Useful Life EUAC at Minimum Cost Life Replacement Analysis Decision Chart Analysis Techniques EGR 403 - Cal Poly Pomona - SA15

  11. What Is the Basic Comparison? • Identify the defender and the best challenger. • Product. • Machine. • Process. • Personnel. • Mix. Decision Criteria leads to one of the following: If the defender is more economical, it should be retained. If the challenger is more economical, it should be installed. EGR 403 - Cal Poly Pomona - SA15

  12. Minimum Cost Life of the Challenger • Calculate the EUAC for each value of the useful life (e.g., n = 1, n = 2, n = 3, etc.) • The number of years at which the EUAC is minimized is the minimum cost life (economic useful life) • Consider Example 12 - 1 • $7500 initial cost (P) • $900 arithmetic gradient maintenance cost (G) • $500 uniform cost (A) and 400 arithmetic gradient operating cost (G) EGR 403 - Cal Poly Pomona - SA15

  13. EUAC calculations for increasing values of useful life EGR 403 - Cal Poly Pomona - SA15

  14. Graph of EUAC by n. Economic Useful Life is where Total EUAC is minimized EGR 403 - Cal Poly Pomona - SA15

  15. Marginal Costs • Marginal Costs are the year by year costs for keeping an asset. Example 12-2 illustrates the calculation of the marginal costs for a new item. • Marginal Cost includes: • Loss in value of the asset by retaining it for one more year • Lost interest on the money tied up in the asset • Costs and expenses directly related to the project or asset (e.g., insurance, operating and maintenance) EGR 403 - Cal Poly Pomona - SA15

  16. Marginal Cost for a New Item: Example 12-2 EGR 403 - Cal Poly Pomona - SA15

  17. Marginal Cost Data Defender Example 12-3 Is the marginal cost of defender increasing? Here the marginal costs are increasing. EGR 403 - Cal Poly Pomona - SA15

  18. Replacement Analysis Technique #1 Defender Marginal costs are increasing • Replace when the marginal cost of ownership of the defender is more than the EUAC of the challenger. EGR 403 - Cal Poly Pomona - SA15

  19. Analysis Technique # 1 Is Appropriate When Replacement Repeatability Assumptions Hold • The best challenger is available in all subsequent years and will be unchanged in economic cost. • The period of needed service is infinitely long. These assumptions appear to be rather restrictive. EGR 403 - Cal Poly Pomona - SA15

  20. Relaxing the Restrictions • This spreadsheet considers that: • The best challenger is available in subsequent years at the same economic cost. • The project life is known and limited. EGR 403 - Cal Poly Pomona - SA15

  21. Replacement Analysis Technique #2 • If the replacement repeatability assumption holds, compare EUAC of the defender asset at its minimum cost life against the EUAC of the challenger at its minimum cost life. EGR 403 - Cal Poly Pomona - SA15

  22. Replacement Analysis Technique #3 • Compare the EUAC of the defender over its stated life against the minimum EUAC of the challenger. • Here defining defender and challenger first costs can be an issue. • Trade-in value is not a suitable value. • Appropriate value is the market value. EGR 403 - Cal Poly Pomona - SA15

  23. After Tax Replacement Analysis • Adds expanded perspective as changes occur in: • Remaining economic life of defender. • Economic life of challenger. • Defender vs. Challenger comparisons. • Affected by: • Depreciation MACRS. • Assets market value over time. EGR 403 - Cal Poly Pomona - SA15

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