14.42 Defender analysis
(a) and (b): Keep the defender for three years.
Defender:
Tax Rat e 35% I nvest ment $12, 725
MA R R 18% Book val ue $15, 000
Per mi t t ed Annual Depr eci at i on Amount s over t he
Hol di ng Hol di ng Per i od Tot al Book
Hol di ng Tot al PW of of A/ T
Per i od 1 2 3 4 5 6 7 8 O& M Co s t s O& M Co s t s
0 `
1$4, 500 $3, 814 $2, 479
2$4, 500 $5, 300 $7, 620 $4, 953
3$4, 500 $5, 300 $6, 100 $11, 333 $7, 366
Challenger:
* Challenger analysis :
Financial Data n0 1 2 3 4 5
Depreciation $6,216 $10,653 $7,608 $5,433 $3,885
Book value $43,500 $37,284 $26,631 $19,023 $13,589 $9,705
Financial Data n6 7 8 9 10
Depreciation $3,880 $3,885 $1,940 $0 $0
Book value $5,825 $1,940 ($0) ($0) ($0)
Salvage value
O&M cos t $1,500 $1,500 $1,500 $1,500 $1,500
14.43 Decision: Do not replace the defender now.
(a) Keep the defender
(-0.6)*(O&M cost) ($10,800) ($10,800) ($10,800) ($10,800) ($10,800) ($10,800) ($10,800) ($10,800) ($10,800) ($10,800)
+(.4)*(Depreciation) $2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000
Opportunity cost ($56,000)
Net proceeds from sale
(-0.6)*(O&M cost) ($2,400) ($2,400) ($2,400) ($2,400) ($2,400) ($2,400) ($2,400) ($2,400) ($2,400) ($2,400)
Investment ($200,000)
Net proceeds from sale $12,000
Net Cash Flow ($200,000) $9,032 $17,192 $11,592 $7,592 $4,744 $4,736 $4,744 $1,168 ($2,400) $9,600
PW (10%) = ($152,404) AEC(10%) = $24,803
14.44 Decision: Do not replace the defender now.
Keep the defender
Financial Data n0 1 2 3 4 5
Depreciation $0 $0 $0 $0 $0
Book value $0 $0 $0 $0 $0 $0
Replace the defender
Financial Data n0 1 2 3 4 5
Depreciation $7,645 $13,102 $9,357 $6,682 $2,386
14.45
• Defender analysis
* Keep defender:
n0123456
Depreciation $2,873 $2,054 $2,052 $2,054 $1,026 $0 $0
Book value $7,185 $5,131 $3,080 $1,026 ($0) ($0) ($0)
Market value $2,000 $1,500
O&M cost $3,800 $3,800 $3,800 $3,800 $3,800 $3,800
• Challenger analysis
Financial Data 0 1 2 3 4 5 6
Depreciation $7,145 $12,245 $8,745 $6,245 $4,465 $4,465
Book value $50,000 $42,855 $30,610 $21,865 $15,620 $11,155 $6,690
Net proceeds from sale
Net Cash Flow ($50,000) $4,658 $6,698 $5,298 $4,298 $3,586 $3,586
Financial Data 7 8 9 10 11 12
Depreciation $4,460 $2,230 $0 $0 $0 $0
Book value $2,230 $0 $0 $0 $0 $0
14.46 Option 1:
Financial Data n012345
Depreciation $6,859 $11,755 $8,395 $5,995 $4,286
Book value $48,000 $41,141 $29,386 $20,990 $14,995 $10,709
Current Market value $6,000
O&M cost $27,000 $27,000 $27,000 $27,000 $27,000
Financial Data n 6 7 8 9 10
Depreciation $4,282 $4,286 $2,141 $0 $0
Book value $6,427 $2,141 $0 $0 $0
Salvage value $5,000
O&M cost $27,000 $27,000 $27,000 $27,000 $27,000
Option 2:
n012345
Depreciation $12,004 $20,572 $14,692 $10,492 $7,501
Book value $84,000 $71,996 $51,425 $36,733 $26,242 $18,740
Net Cash Flow ($84,000) ($9,599) ($6,171) ($8,523) ($10,203) ($11,400)
n678910
Depreciation $7,493 $7,501 $3,746 $0 $0
Book value $11,248 $3,746 ($0) ($0) ($0)
14.47
The remaining useful life of the defender is 1 year. Its annual equivalent cost is $1,666.
When the defender is replaced now by the challenger, its equivalent annual cost is
$2,191, indicating that the defender should be kept for now.
(a) Economic service life = one year
Tax Rat e 30% I nvest ment $1, 050
MA RR 12% Book val ue $0
Per mi t t ed Annual Depr eci at i on Amount s over t he
Hol di ng Hol di ng Per i od Tot al Book
Per i od 1 2 3 4 5 6 7 8
Depr eci at i on
Val ue
0
5$0 $0
Annual O&M Cost s over t he Hol di ng Per i od Tot al PW
Hol di ng Tot al PW of of A/T
Per i od 1 2 3 4 5 6 7 8 O& M Co s t s O& M Co s t s
0 `
Expect ed Net A/T A/ T Oper at i ng Cost s ( i n PW) Tot al
Hol di ng Mar ket Taxabl e Gai ns Mar ket over t he Hol di ng Per i od OC( 12%) CR( 1 2 %) AEC( 1 2 %)
Per i od Val ue Gai ns Tax Val ue O& M Co s t s
Tax Shi el d
Tot al OC
0
1$1, 200 $1, 200 $360 $840 $1, 188 $0 $1, 188 $1, 330 $336 $1, 666
(b) Replace the defender
Financial Data n012345
Depreciation $1,200 $1,920 $1,152 $691 $346
Book value $6,000 $4,800 $2,880 $1,728 $1,037 $691
14.48
Decision: Replace the defender now with the current challenger. Then, replace the
current challenger at the end of 3 years with a similar challenger.
Option 1 : Keep the defender
n0 1 2 3 4 5 6
Depreciation $5,120 $3,072 $1,843 $1,843 $922 $0 $0
Book value $7,680 $4,608 $2,765 $922 $0 $0 $0
Market value $12,000 $2,000
Net Cash Flow ($11,472) ($1,878) ($2,247) ($2,247) ($2,524) ($2,800) ($1,400)
PW (11%) = ($20,703) AEC(11%) = $4,894
Option 2 : Replace the defender
n0 1 2 3 4 5 6
Depreciation (First Cy cle) $2,000 $3,200 $960
Book value (First Cycle) $10,000 $8,000 $4,800 $3,840
14.49
(b) Economic service life = 4 years:
(c) The economic service life varies with the interest rate:
Short Case Studies
ST 14.1
(a)
(b) Now is the time to replace the defender?
=
AEC $10,607 with * = 2 years
D
N
(c)
Marginal cost – Keep the defender for one more year (3rd year):
(d) The future cost of challenger remains the same.
ST 14.2
(a) The current FMS manufacturing technology would prevail for several years with
no major cost and productivity improvement. Therefore, if the present system is
kept for the remaining useful life, it will be replaced by the current FMS
technology with the same investment and O&M costs.
(b) Decision: The challenger should be adopted.
Option1: Keep the defender
n0 1 2 3 4 5
Operating cost $105,000 $115,000 $125,000 $135,000 $145,000
Current market value $140,000
Option 2: Replace the defender
n0 1 2 3 4 5 6 7 8 9 10
Depreciation $185,770 $318,370 $227,370 $162,370 $116,090 $115,960 $116,090 $57,980
Book value $1,300,000 $1,114,230 $795,860 $568,490 $406,120 $290,030 $174,070 $57,980
Savings $664,243 $664,243 $664,243 $664,243 $664,243 $664,243 $664,243 $664,243 $664,243 $664,243
Operating cost $45,000 $47,000 $49,000 $51,000 $53,000 $55,000 $57,000 $59,000 $61,000 $63,000
ST 14.3
(a) Decision: Replace the defender now.
(b) The optimal time to replace the defender is “now.” If the AE cost for the
defender were smaller than that of the challenger, we would need to perform the
marginal analysis, i.e., calculating the incremental cost of operating the
defender for just 1 more year.
Option1: Keep the defender
n0 1 2 3 4 5
Operating cost
$65,000 $65,000 $65,000 $65,000 $65,000
Option 2: Replace the defender
n0 1 2 3 4 5 6 7 8 9 10
Depreciation(Building)
$1,160 $1,210 $1,210 $1,210 $1,210 $1,210 $1,210 $1,210 $1,210 $1,160
Book value (Building)
$47,200 $46,040 $44,830 $43,620 $42,410 $41,200 $39,990 $38,780 $37,570 $36,360 $35,200
Cas h Flow Statement
+(.4)*(Depreciation)
$7,975 $13,356 $9,677 $7,049 $5,178 $5,172 $5,178 $2,828 $484 $464
+(0.60)*(Savings)
$34,737 $34,737 $34,737 $34,737 $34,737 $34,737 $34,737 $34,737 $34,737 $34,737
ST 14.4
(a) Development of a combined productivity index: Combined productivity
means “inherent productivity” × relative hours for challenger.
(b)
• Adjusted annual O&M costs for Defender
n Operating HR
Maintenance
Wages Fuel Total
1 1,800 $46,800 $42,120 $24,408 $113,328
• Adjusted annual O&M costs for Challenger
n Operating
HR M L F
Combined
Productivity
index
Adjusted
M
L
F
Total
1 2,500 $35,000
$58,500
$48,000
1.667 $21,000 $35,100 $28,800 $84,900
$56,160
$53,820
$49,140
$46,800
n Operating hours Ratio Combined productivity index
Defender Challenger
1 1,800 2,500 1.389 1.667
(c) Replacement analysis
• Defender analysis
n
Market
value
Dep. O&M Cost
After tax
Salvage
Dep.
Tax credit
A/T
O&M cost
0
$75,000
1
$60,000
0
$113,328
$36,000
0
$67,997
n Net
O&M cost
Cumulative
O&M cost
Net
Investment
Equivalent Annual Cost
Capital cost
Operating
cost
Total
0
1
$67,997
$59,128
$13,696
$15,750
$67,997
$83,747
2
$67,997
$110,543
$22,316
$13,726
$67,995
$81,721
3
$65,779
$153,794
$33,165
$14,526
$67,362
$81,888
4
$65,779
$191,403
$34,708
$12,158
$67,049
$79,207
5
$63,562
$223,005
$42,017
$12,534
$66,522
$79,056
• Challenger analysis
n
Market
value
Dep. O&M Cost
After tax
Salvage
Dep.
Tax credit
A/T
O&M cost
0
$400,000
1
$300,000
$80,000
$84,900
$308,000
$32,000
$50,940
2
$240,000
$128,000
$87,900
$220,800
$51,200
$52,740
3
$190,000
$76,800
$87,267
$160,080
$30,720
$52,360
4
$150,000
$46,080
$92,933
$117,648
$18,432
$55,760
5
$115,000
$46,080
$95,467
$78,216
$18,432
$57,280
n Net
O&M cost
Cumulative
O&M cost
Net
Investment
Equivalent Annual Cost
Capital cost
Operating
cost
Total
0
1
$18,940
$16,470
$132,174
$152,000
$18,940
$170,940
2
$1,540
$17,634
$233,043
$143,345
$10,847
$154,192
3
$21,640
$31,863
$294,745
$129,098
$13,956
$143,054
4
$37,328
$53,205
$332,734
$116,557
$18,638
$135,195
5
$38,848
$72,519
$361,113
$107,720
$21,633
$129,352
3
$30,000
0
$109,632
$18,000
0
$65,779
4
$30,000
0
$109,632
$18,000
0
$65,779
5
$10,000
0
$105,936
0
$63,562
terms of operating efficiency, its initial cost is too high to justify its purchase at
this point.
(d) Replacement analysis under inflation
• Adjusted operating and maintenance cost by inflation: Sample calculation
for fuel cost – Defender for Year 2:
Defender
n Maintenance Wage Fuel Total
1 $50,544 $48,438 $26,849 $125,831
Challenger
n Maintenance Wage Fuel Total
1 $22,680 $40,365 $31,680 $94,725
• Replacement analysis: Keep the defender for now
Defender
n
Market
value
Dep. O&M Cost
After tax
Salvage
Dep.
Tax credit
A/T
O&M cost
0
$75,000
1
$60,000
$0
$125,831
$36,000
$0
$75,498
n Net
O&M cost
Cumulative
O&M cost
Net
Investment
Equivalent Annual Cost
Capital cost
Operating
cost
Total
0
1
$75,498
$65,651
$13,696
$15,750
$75,498
$91,248
2
$81,737
$127,455
$22,316
$13,726
$78,398
$92,124
3
$83,828
$182,574
$33,165
$14,526
$79,967
$94,493
4
$86,966
$232,297
$34,708
$12,158
$81,374
$93,532
5
$86,918
$275,511
$42,017
$12,534
$82,185
$94,719
• Challenger
n
Market
value
Dep. O&M Cost
After tax
Salvage
Dep.
Tax credit
A/T
O&M cost
0
$400,000
1
$300,000
$80,000
$94,725
$308,000
$32,000
$56,835
2
$240,000
$128,000
$106,275
$220,800
$51,200
$63,765
3
$190,000
$76,800
$111,832
$160,080
$30,720
$67,099
4
$150,000
$46,080
$123,888
$117,648
$18,432
$74,333
5
$115,000
$46,080
$131,573
$78,216
$18,432
$78,944
n Net
O&M cost
Cumulative
O&M cost
Net
Investment
Equivalent Annual Cost
Capital cost
Operating
cost
Total
0
1
$24,835
$21,596
$132,174
$152,000
$24,835
$176,835
2
$12,565
$31,097
$233,043
$143,345
$19,128
$162,473
3
$36,379
$55,016
$294,745
$129,098
$24,097
$153,195
4
$55,901
$86,978
$332,734
$116,557
$30,468
$147,025
5
$60,512
$117,063
$361,113
$107,720
$34,920
$142,640
2
$50,000
$0
$136,228
$30,000
$0
$81,737
3
$30,000
$0
$139,714
$18,000
$0
$83,828
4
$30,000
$0
$144,944
$18,000
$0
$86,966
5
$10,000
$0
$144,864
$6,000
$0
$86,918