Chapter 7.

REPLACEMENT ANALYSIS

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1
 Introduction

Replacement analysis plays an important role in the economic running of

any concern for years or decades. As a business firm, they have to face
different types of replacement decisions such as, the replacement of capital
equipment as it wear out or becomes obsolete, the capital equipment
required for expansion and the displacement of old technology by the new
one.

Replacement decision is not an easy job, you need to consider all the
possible factors affecting an assets, its productivity, maintenance and
especially its economic aspects.
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 Learning Objectives

• Determine and analyze the

economic life of a certain
assets.

• Evaluate the performance of

existing assets and its possible
replacement.
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 Major Reasons for Replacement

The Four Major Reasons for Replacement

1. Physical Impairment
The existing asset is completely or partially worn
out and will no longer function satisfactorily without
extensive repairs.

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 Major Reasons for Replacement

The Four Major Reasons for Replacement

2. Inadequacy
The existing asset does not have sufficient
capacity to meet the present demands that are placed
on it.

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 Major Reasons for Replacement

The Four Major Reasons for Replacement

3. Obsolescence
This may be caused either by a lessening in the
demand for the service rendered by the asset or the
availability of more efficient assets which will
operate with lower out-of-pocket costs.

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 Major Reasons for Replacement

The Four Major Reasons for Replacement

4. Rental or lease possibilities

It is possible to rent identical or comparable asset
or property, thus freeing capital for other and more
profitable use.

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 Sunk Cost Due to Unamortized Value

Unamortized value of an equipment or property

is the difference between its book value and its resale
value when replaced. Unamortizedva should be
considered a sunk cost or a loss.

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 Basic Patterns for Replacement Studies

Replacement economy studies may be made by

any of the basic procedures or patterns which have
been discussed previously. However, in most cases
either the rate of return method or the annual cost
method is used.

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 Sample Problems
An existing factory must be enlarged or replaced to accomodate new
production machinery. The structure was built at a cost of P2.6 million. Its
present book value, based on straight line depreciation is P700,000 but it has
been appraised at P800,000. If the structure is altered, the cost will be P1.6
million and its service life will be extended 8 years with a salvage value of
P600,000. A new factory could be purchased or built for P5.0 million. It would
have a life of 20 years and a salvage value of P700,000. Annual maintenance
of the new building would be P160,000 compared with P100,000 in the
enlarged structure. However, the improved layout in the new building would
reduce annual production cost by P240,000. All other expenses for the new
structure are estimated as being equal. Using an investment rate of 8 percent,
determine which is more attractive investment for this firm.
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 Sample Problems
Solution:
Enlarged Building
Annual Costs:
P800,000 + P1,600,000 - P600,000
Depreciation =
F/A, 8%, 8
P1,800,000
= = P169,227
10 . 6366
Maintenance = P 100,000
Production (excess) = P 240,000
Total Annual Cost = P 509,227

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 Sample Problems
Solution:
New Building
Annual Costs:
P5,000,000- P700,000
Depreciation =
F/A, 8%, 20
P4,300,000
= = P93,964
45.7620
Maintenance = P 160,000
Total Annual Cost = P 253,964

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 Sample Problems

Annual Savings = P509,227 - P225,263

Additional Investment = P5,000,000 -P800,000 - P1,600,000
= P2,600,000 P255,263
Rate of Return on additional investment = x 100
P2,600,000
= 9.82%

Construct the New Building

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 Sample Problems
A decision must be made whether to replace a certain engine wi a new one, or
to rebore the cylinder of the old engine and thoroughly recondition it. The
original cost of the old engine 10 years ago was P70,000; to rebore and
recondition it now will cost P28,000, but would extend its useful life for 5
years. A new engine will have a first cost of P62,000 and will have an
estimated life of 10 years. It is expected that the annual cost of fuel and
lubricants with the reconditioned engine will be about P20,000 and that this
cost will be 15% less with the new engine. It is also believed that repairs will
be P2,500 a year less with the new engine that with the reconditioned one.
Assume that neither engine has any net realizable value when retired. If money
is worth 16%, what would you recommend?

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 Sample Problems
Solution:
Reconditioned engine
Annual costs: P 28,000 P 28,000
Depreciation = = = P4,071
F/A,16%,5 6.877

Fuel and Lubricants = P 20,000

Repairs (excess) = P 2,500
Interest on capital = P28,000(0.16) = P 4,480
Total Annual Cost P 31,051

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 Sample Problems

Solution:
New engine
Annual costs:
P62,000 P62,000
Depreciation = = = P 2,908
F/A, 16%,10 21.32

Fuel and Lubricants = P 17,000

Interest on capital = P62,000(0.16) = P 9,920
Total Annual Cost P 29,828

The old engine should be replaced

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 Sample Problems
Four years ago an ore-crushing unit was installed at a mine which cost P81,000.
Annual operating costs for this unit are P3,540. This unit was estimated to have a life
of 10 years. The quantity of ore to be handled is to be doubled and is expected to
continue at this higher rate for at least 10 years. A unit that will handle the same
quantity of ore and have the same operating costs as the one now in service can be
installed for P75,000. This unit will have a useful life of 6 years.
A unit with double the capacity of the one now in use can be installed for P112,000.
Its life is estimated at 6 years and its annual operating costs are estimated at P4,950.
The present realizable value of the unit now in use is P26,000. All units under
consideration will have an estimated salvage value at retirement age of 12% of the
original cost. Interest rate is 20%. Annual taxes and insurance are 2.5% of the
original cost. What would you recommend?

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 Sample Problems
Solution
Augmentation
Annual Costs:
Old Unit
P26,000 - (P81,000)( 0.12)
Depreciation =
F/A, 20%, 6
P16,280
= = P1,639
Operation 9 . 9299 = P3,540
Taxes and Insurance = (P81,000)(0.025) = P2,025
New small unit
P75,000- (P75,000)(0.12)
Depreciation =
F/A, 20%, 6
P66,000
= = P6,647
9.9299
Operation = P3,540
Taxes and Insurance = (P75,000)(0.025) = P1,875
Total annual cost P19,266
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 Sample Problems
Solution
Replacement
Annual Costs:
New Big Unit
P112,000- (P112,000)(0.12)
Depreciation =
F/A, 20%, 6
P98,560
= = P9,926
Operation 9.9299 = P4,950
Taxes and Insurance = (P112,000)(0.025) = P2,800
Total annual cost P17,676

Annul Savings = P19,266 - P17,676 = P1,590

Additional Investment = P112,000 - P26,000 = P11,000

ROR on additional investment = P1,590

x100 = 14.5%
P11,000
Buy the new small unit to augment the old unit.
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 Sample Problems

A car can be purchased for P600,000 when new. There follows a

schedule of annual operating expenses for each year and trade-in-values
at the end of each year. Assume that these amounts would be repeated for
future replacements, and that the car will not be kept more than 3 years. If
interest on invested capital is 15% before taxes, determine at which year's
end the car should be replaced so that costs will be minimized.
Year 1 Year 2 Year 3
Operating expenses for year P34,000 P38,000 P41,000

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 Sample Problems

Solution
Cost of Keeping each year
1 2 3
Operation P34,000 P38,000 P41,000
Depreciation 192,000 144,000 96,000
Interest on Capital (15%) 90,000 61,200 50,400
Total P316,000 P243,200 P187,400

1 year: 0 1 0 1

P316,000 EUAC
EUAC = P316,000
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 Sample Problems

2 years: 0 1 2 0 1 2

P243,000
P316,000 EUAC EUAC

EUAC = [P316,000 +P243,000 (P/F, 15%, 2)] (A/P, 15%, 2)

= P307,385

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 Sample Problems

3 years: 0 1 2 3 0 1 2 3

P187,000
P243,000 EUAC EUAC EUAC

P316,000

EUAC = [P316,000 +P243,000 (P/F, 15%, 2) + P187,400 (P/F, 15%, 3)] (A/P, 15%, 3)
= P272,851

Thus it is cheaper to keep the car three years.

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 Chapter Test
1. A recapping plant is planning to acquire a new Diesel generating set to
replace its present unit which they run during brownouts. The new set
would cost P135,000 with a five (5) year-life, and no estimated salvage
value. Variable cost would be P150,000 a year.
The present generating set has a book value of P75,000 and a remaining
life of 5 years. Its disposal value now is P7,500, but it would be zero after
5 years. Variable operating cost would be P187,500 a year. Money is
worth 10%.
Which is profitable, to buy the new generator set or retain the present set?
Support your answer by showing your computation.
Answer: Buy the new generating set.
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 Chapter Test
1. A company that sells computers has proposed to a small public utility company that it
purchase a small electronic computer for P1,000,000 to replace ten calculating machines and
their operators. An annual service maintenance contract for the computer will be provided at
a cost of P100,000 per year. One operator will be required a salary of P96,000 per year and
one programmer at a salary of P144,000 per year. The estimated economic life of the
computer is 10 years.
The calculating machine costs P7,000 each when new, 5 years ago, and presently can be
sold for P2,000 each. They have an estimated life of 8 years and an expected ultimate trade-
in value of P1,000 each. Each calculating machine operator receives P84,000 per year.
Fringe benefits for all labor cost 8% of annual salary. Annual maintenance costs on the
calculating machines have been P500 each. Taxes and insurance on all equipment is 2% of
the first cost per year.
If capital costs the company about 25%, would you recommend the computer installation.
Answer: The calculators should be replaced
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