TYPES OF REPLACEMENT DECISIONS

1
TYPES OF REPLACEMENT DECISIONS

• Aging assets may be
• kept without major change
• retired (removed) without replacement
• overhauled to improve performance
• replaced with another asset.

2
WHY REPLACE ONE ASSET WITH ANOTHER?

• If the current asset is inadequate and has to be
  replaced
• If the current asset is adequate, but there is a
  less expensive or more efficient way to obtain
  the same service

3
RELEVANT COSTS FOR ANALYZING ASSET REPLACEMENT

• Capital costs
• Installation costs
• Installation costs occur at the beginning of the
  life of new assets and are not reversible once
  the asset has been put in place
• Operating and maintenance costs
• Operating and maintenance costs typically
  increase as the asset ages.
• Disposal costs and salvage costs

4
MAKING REPLACEMENT DECISIONS

• Once a new asset has been put in place, the
  incremental cost of keeping it typically is low.
  This gives the existing asset (called the
  defender) an advantage over a potential
  replacement (called the challenger).
• To make a replacement decision, all relevant
  costs must be considered. Typically, this is
  done through equivalent annual cost (EAC)
  computations.

5
TYPES OF REPLACEMENT DECISIONS

• Case 1 Challenger is the same as the Defender
  (the economic life problem).
• Case 2 Challenger is different than the
  Defender, and succeeding Challengers are the same
  as the first Challenger.
• Case 3 Challenger is different than the
  Defender, and succeeding Challengers are
  different from the first Challenger.

6
CASE 1 CHALLENGER IS THE SAME AS DEFENDER

• In the case when technology is not changing
  quickly and when prices and interest rates are
  not changing rapidly, an asset often will be
  replaced with the same type of asset.
• Each asset is replaced when its lifetime cost is
  minimized. At this time, the asset is said to
  have reached the end of its economic life.
• The lifetime will be the same for all replacement
  assets for the time period over which the asset
  is needed (assumed to be a long time). This
  results in cyclic replacement.

7
ECONOMIC LIFE OF AN ASSET

• Equivalent annual cost (EAC) of capital costs
  decrease as the asset is kept longer.
• EAC of operating and maintenance costs increase
  as the asset is kept longer.
• There will be a lifetime that will minimize
• (EAC of capital costs)
• (EAC of operating and maintenance costs)
• This is the economic life of the asset.

8
CASES 2 AND 3 CHALLENGER IS DIFFERENT FROM
DEFENDER

• Case 2 All succeeding challengers are the same
  as the current challenger.
• Case 3 The challengers after the current
  challenger will be different (most likely
  better).

9
CASE 2 SEQUENCE OF IDENTICAL CHALLENGERS

• Step 1 Find EAC at the economic life of the
  challenger.
• Step 2 Find the cost of keeping the defender one
  year.
• Step 3a If EAC(defender, one more year) ?
  EAC(challenger), keep the defender at least one
  more year
• Step 3b ELSE
• IF
• there is a life for the defender that will give
  an EAC less than EAC(challenger), keep the
  defender for that life and then replace
• ELSE
• replace the defender immediately

10
ASSUMPTIONS MADE IN THE SOLUTION OF EXAMPLE 2

• The challenger will be replaced by a stream of
  machines with identical technology (that is what
  allowed us to compute the economic life of the
  challenger).
• The installation cost of the Defender is
  irrelevant because we cannot change the past
  ie., it is a sunk cost.
• The first cost of keeping the Defender is its
  salvage value now, i.e. the revenue that we would
  receive if we sold it now. This is the
  opportunity cost of keeping it.

11
CASE 3 SEQUENCE OF DIFFERENT CHALLENGERS

• Normally, we may expect the future challengers to
  be better than the current challenger.
• Then, do we skip over the current challenger and
  wait for the next new and improved challenger?
• Do we wait even longer for the next-generation
  new and improved challenger?
• We would have to enumerate all possible
  combinations of decisions and evaluate all
  decisions to make a choice.

12
CASE 3 SEQUENCE OF DIFFERENT CHALLENGERS

• The EAC for each project would have to be
  calculated (quite a bit of work!).
• The list would increase geometrically if we
  expect that each Challenger was different from
  the preceding one.
• Typically, we will have very little information
  about the costs and benefits of new challengers.
• It is often reasonable to assume that all
  challengers in the future will be approximately
  the same as the current challenger.
• How do we make a replacement decision when we
  need the asset for a finite period of time (e.g.,
  for a contract of specified length)?