Benefits

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Removal

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The cash flow diagram of the challenger (see Fig 14.5) is rather similar, as it should be, to the defender's cash flow diagram. The initial investment represents all the costs of acquiring and putting the challenger into service, including initial inventory and training costs. In most cases, the challenger has better productivity, longer MTBF, shorter MTTR, and less operation and maintenance costs. This fact is reflected in the cash flow diagram of Fig. 14.5.

The decision to replace now or later can be made by analyzing the two cash flow diagrams. The cash flow has to be constructed, and the EUAW of both systems has to be calculated year by year for each year from year n0 onwards. For example, we should calculate the EUAW of the defender (the present system) and that of the challenger (the replacement candidate) for year n0+1 (i.e., one year the preset time) and compare. This comparison tells us the benefit of keeping the defender for one more year versus selling the defender and purchasing the

Fig. 14.5

challenger. If the resulting analysis favors the defender, then we carry the process one more year and compare the EUAW of the two alternatives. We continue the process until we arrive at our planning horizon year Np. If at any year n0 to Np the financial analysis favors the challenger, we immediately replace the defender. Otherwise, we will keep the present system. If at any time in the future our planning horizon Np changes, then we have to repeat the replacement analysis. The above analysis can best be understood through an example.

Example 14.4

The Owner of the Clean Car Corporation (Example 14.3) having operated his system for two years using SL depreciation is presented a new car wash system as a replacement for his present one. The new system has an initial cost of $600,000, including the cost of installation. The salesperson for the company producing a new system claims that the higher initial cost is compensated by higher productivity and lower operating cost. Moreover, he is willing to purchase the present system and move it out of the premises for $255,000. He estimates that the income from the new system will be $300,000 in the first year (due to higher initial productivity) reducing by 5% every year due to aging. The operating cost is 10% lower than the old system (due to more automation), increasing at a rate of 5% per year as the system gets older. The resale value is estimated at $350,000 at the end of the first year, reducing by $50,000 the next two years and staying constant at $170,000 thereafter. Assuming the salesperson's assumptions are correct, how do you analyze this problem, and what do you suggest to CCC. (The depreciation schedule remains the same.)

Solution:

Defender's Case:

We first have to calculate the opportunity cost of keeping the present system. The parameters involved are

*The sal« price of the old system, i,e . I 255,000

*The capita] gain Us, i.e., {siltJ prist- book value at year 2) * Tai rate

•Therefore, the opportunity cost is 255000-(-]8000) = 273 000

From here on, the problems turn into a problem like Example 14.3 except that we have to substitute the above opportunity cost for the initial cost and start from year 3 using the values of its income, expense, depreciation, resale, etc. We therefore calculate and plot the EUAW of the defender for one to n more years and compare this with that of the challenger.

Note that although the initial cost is replaced by the opportunity cost, the depreciation values are not changed and are based on the original cost.

Challenger's Case:

The challenger's case is exactly as the case ofExample 14.3, albeit with new numbers representing the cost-benefit parameters of the new system. We can repeat the steps ofExample 14.3 in the challenger's case. Rather than repeating those steps, we will use the spreadsheet to analyze this case. As we discussed before, the manual calculations can be made using the same table as in the spreadsheet. The computer spreadsheet is shown in its total form and broken down by the financial analysis of the defender and challenger. The analysis of the replacement situation is best done by observing the plot of the EUAWs of the defender and the challenger. We can analyze the relative value of the EUAWs against our planning horizon. From the plots shown in Fig. 14.6, we can see that if we are only thinking about the next three years, it is advisable to keep the defender. If our planning horizon is more than four years it is advisable to replace the defender by the challenger right now. Of course, the challenger then becomes a defender and its economics have to defend against a new challenger that may be introduced into the market. The matrix of Table 14.1 presents the defender-challenger economic analysis based on the calculation of the EUAW of the challenger and the defender.

Fig. 14.1

Planning Horizon

Table 14.1

Decision

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R: Replace by the challenger

K: Keep the old equipment

The spreadsheet calculation of the defender-challenger problem is shown in the next page.

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