Example - 3

A construction company has purchased a piece of construction equipment 3 years ago at a cost of Rs.4000000. The estimated life and salvage value at the time of purchase were 12 years and Rs.850000 respectively. The annual operating and maintenance cost was Rs.150000. The construction company is now considering replacement of the existing equipment with a new model available in the market. Due to depreciation, the current book value of the existing equipment is Rs.3055000. The current market value of the existing equipment is Rs.2950000. The revised estimate of salvage value and remaining life are Rs.650000 and 8 years respectively. The annual operating and maintenance cost is same as earlier i.e. Rs.150000.

The initial cost of the new model is Rs.3500000. The estimated life, salvage value and annual operating and maintenance cost are 8 years, Rs.900000 and Rs.125000 respectively. Company's MARR is 10% per year. Find out whether the construction company should retain the ownership of the existing equipment or replace it with the new model, if study period is taken as 8 years (considering equal life of both defender and challenger).

Solution:

For the replacement analysis, initial cost (Rs.4000000), initial estimate of salvage value (Rs.850000) and remaining life (12 – 3 = 9 years) and current book value (Rs.3055000) of the existing equipment (i.e. defender) are irrelevant. Similarly sunk cost of Rs.105000 (Rs.3055000 – Rs.2950000) is also not relevant for the replacement analysis. For the replacement analysis the current revised estimates of the existing equipment will be used.

For existing equipment (defender),

Current market value (P) = Rs.2950000, Salvage value (F) = Rs.650000,

Annual operating and maintenance cost (A) = Rs.150000, Study period (n) = 8 years.

For new model (challenger),

Initial cost (P) = Rs.3500000, Salvage value (F) = Rs.900000,

Annual operating and maintenance cost (A) = Rs.125000, Study period (n) = 8 years.

Now the equivalent uniform annual worth of both defender (i.e. the existing equipment) and challenger (i.e. the new model) at MARR of 10% (i.e. i = 10%) are calculated as follows;