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Lecture No. 46Chapter 14
Contemporary Engineering EconomicsCopyright © 2010
Contemporary Engineering Economics, 5th edition, © 2010
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Chapter Opening Story Issue: United Airlines (UAL) is in the process of replacing many of its 111-airplane wide-body fleet, as well as some of its 97 aging Boeing 757 narrow-body planes. What basis do they make the fleet-replacement decisions?
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Replacement TerminologyDefender: an old
machine Challenger: a new
machineCurrent market value:
selling price of the defender in the market place
Sunk cost: any past cost unaffected by any future decisions
Trade-in allowance: value offered by the vendor to reduce the price of a new equipment
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Sunk Cost associated with an Asset’s Disposal Given: Original investment = $20,000, current market value = $10,000, repair cost made in the past = $5,000
Find: Relevant cost for replacement analysis
Lost investment value, $10,000 Repair cost made, $5,000 Total sunk cost = $15,000 Relevant cost for replacement analysis = current market value = $10,000
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Example 14.2 -Opportunity Cost Approach
Basic Principle: Treat the proceeds from sale of the old machine as the investment required to keep the old machine.
Defender:Market price: $10,000Remaining useful life: 3 yearsSalvage value: $2,500O&M cost: $8,000
Challenger:Cost: $15,000Useful life: 3 yearsSalvage value: $5,500O&M cost: $6,000
Decision: Replace the defender now
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Definition: Economic service life is the remaining useful life of an asset that results in the minimum annual equivalent cost. Annual Equivalent Cost (AEC) = Capital Cost + Operating Cost
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Mathematical RelationshipCapital Cost:
Operating Cost:
Total Cost:
Objective: Find n* that minimizes AEC(i)
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n*
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Example 14.3 Economic Service Life for a Lift Truck
Given: I = $18,000, i = 12%, Salvage value = -20% over the previous year, O&M = $3,000 during the first year, and 15% increase over the previous year thereafter
Find: Economic Service Life
Contemporary Engineering Economics, 5th edition, © 2010
n = 1:
n = 2:
$18,000
$14,400
$3,000
01
$18,000
$3,000
$11,520
$3,450
0 1 2
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AEC Calculation If you Kept the Truck for 2 Years
Ownership Cost:
Operating Cost:
Annual Equivalent Cost:
Contemporary Engineering Economics, 5th edition, © 2010
CR(12%) ($18,000 $11,520)( / ,12%,2)(0.12)($11,520)$5,760
A P
OR(12%) $3,000( / ,12%,1) $3,450( / ,12%,2)
( / ,12%,2)$3,212
P F P F
A P
2AEC(12%) $5,760 $3,212$8,429
n
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Conversion of an Infinite Number of Replacement Cycles to Infinite AEC Streams
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Economic Service Life Calculation Using Excel Economic Service Life = 6 Years with AEC(12%) = $7,977
What It Really Means? You purchase a brand new lift truck for every 6 years, assuming that the future replacement cost as well as operating costs remain constant. Then the equivalent annual cost of owning and operating the truck is $7,977.
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For an asset with non-increasing operating cost, keep
the asset as long as it lasts.If everything remains the same, a higher interest rate
will tend to extend the economic service life (or defer the replacement decision).
Contemporary Engineering Economics, 5th edition, © 2010
Sensitivity of Economic Service Life