MSci261-2007-Ch_7

MSci261-2007-Ch_7 - Chapter 7 Replacement decisions MSci...

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Chapter 7 1 Chapter 7 Chapter 7 MSci 261: Managerial and Engineering Economics Spring 2007 Instructor: Bon Koo Replacement decisions Replacement decisions
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Chapter 7 2 Overview Overview Capital assets age and require regular evaluations. What choices do you make on a capital asset? Keep it in its current use without major changes Overhaul it to improve the performance Retire it without replacement Replace it with another asset In this chapter, we will learn methods of making replacement decisions for long-lived assets. The analysis is mostly based on the annual worth method. We will introduce new cost definitions.
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Chapter 7 3 1. Basic concepts (1) 1. Basic concepts (1) Replacement is necessary when Assets deteriorate over time (e.g., used car) Equipment becomes less productive or more costly to operate Technology change makes current assets obsolete Assets are inadequate due to demand change. Retirement (removed from use) occurs due to changes in customer demand changes in production methods changes in technology: e.g., LP (Long Play) → CD (Compact Disc) → DVD (Digital Video Disc) → …
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Chapter 7 4 1. Basic concepts (2) 1. Basic concepts (2) Capacity cost (or fixed cost) It occurs regardless of actual production A large proportion of the capacity cost is incurred in the early life of the capacity The depreciation of capital assets (“capital cost”) is rapid in early lives. The “installation cost” of a new asset is usually up-front. Operating cost (or variable cost) Electricity, gasoline, other consumables, etc. Once the capacity has been installed, the incremental cost of using the capacity (“marginal cost”) is relatively low.
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Chapter 7 5 Example 1-1: Lawnmower replacement (1) Example 1-1: Lawnmower replacement (1) Consider the replacement decision of a lawnmower. The lawnmower costs $600 and depreciate 40% per year. The repair cost if it breaks down is $60 plus two hours of loss of operation ($20 per hour): total of $100 The breakdown time is zero in the 1st year, 1 in the 2nd, 2 in the 3rd, 4 in the 4th, and 8 in the 5th year. The interest rate is 5%. How often should it be replaced?
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6 Example 1-1: Lawnmower replacement (2) Example 1-1: Lawnmower replacement (2) If replaced frequently, the overall capital cost increases, but the repair cost decreases. Then, we can find the economic life that minimizes the total (capital and repair) costs. We use an AW approach, rather than PW approach, to avoid the calculation of the least common multiple. Equivalent annual cost (EAC) Same as the concept of annual worth; different terminology in the replacement analysis. EAC (total) = EAC (capital) + EAC (operation)
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This note was uploaded on 03/13/2009 for the course MSCI 261 taught by Professor Bonkoo during the Spring '09 term at Waterloo.

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MSci261-2007-Ch_7 - Chapter 7 Replacement decisions MSci...

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