Question 9.3: Before-Tax Replacement Analysis Using EUAC The manager of a ...
Before-Tax Replacement Analysis Using EUAC
The manager of a carpet manufacturing plant became concerned about the operation of a critical pump in one of the processes. After discussing this situation with the supervisor of plant engineering, they decided that a replacement study should be done, and that a nine-year study period would be appropriate for this situation. The company that owns the plant is using a before-tax MARR of 10% per year for its capital investment projects. The existing pump, Pump A, including driving motor with integrated controls, cost $17,000 five years ago. An estimated MV of $750 could be obtained for the pump if it were sold now. Some reliability problems have been experienced with Pump A, including annual replacement of the impeller and bearings at a cost of $1,750. Annual operating and maintenance expenses have been averaging $3,250. Annual insurance and property tax expenses are 2% of the initial capital investment. It appears that the pump will provide adequate service for another nine years if the present maintenance and repair practice is continued. It is estimated that if this pump is continued in service, its final MV after nine more years will be about $200. An alternative to keeping the existing pump in service is to sell it immediately and to purchase a replacement pump, Pump B, for $16,000. An estimated MV at the end of the nine-year study period would be 20% of the initial capital investment. Operating and maintenance expenses for the new pump are estimated to be $3,000 per year. Annual taxes and insurance would total 2% of the initial capital investment. The data for Example 9-3 are summarized in Table 9-1. Based on these data, should the defender (Pump A) be kept [and the challenger (Pump B) not purchased], or should the challenger be purchased now (and the defender sold)? Use a before-tax analysis and the outsider viewpoint in the evaluation.
TABLE 9-1 Summary of Information for Example 9-3
| MARR (before taxes) = 10% per year | |||||
| Existing Pump A (defender) Capital investment when purchased five years ago $17,000 | |||||
| Annual expenses: | |||||
| Replacement of impeller and bearings $1,75 | |||||
| Operating and maintenance 3,250 | |||||
| Taxes and insurance: $17,000 × 0.02 \underline{340} | |||||
| Total annual expenses $5,340 | |||||
| Present MV $750 | |||||
| Estimated market value at the end of nine additional years $200 | |||||
| Replacement Pump B (challenger) | |||||
| Capital investment $16,000 | |||||
| Annual expenses: | |||||
| Operating and maintenance $3,000 | |||||
| Taxes and insurance: $16,000 × 0.02 \underline{320} | |||||
| Total annual expenses $3,320 | |||||
| Estimated MV at the end of nine years: $16,000 × 0.20 $3,200 |
In an analysis of the defender and challenger, care must be taken to correctly identify the investment amount in the existing pump. Based on the outsider viewpoint, this would be the current MV of $750; that is, the opportunity cost of keeping the defender. Note that the investment amount of Pump A ignores the original purchase price of $17,000. Using the principles discussed thus far, a before-tax analysis of EUAC of Pump A and Pump B can now be made. The solution of Example 9-3 using EUAC (before taxes) as the decision criterion follows:
| Study Period = 9 Years | Keep Old Pump A | Replacement Pump B |
| EUAC(10%): | ||
| Annual expenses | $5,340 | $3,320 |
| Capital recovery cost (Equation 5-5): | ||
| [$750(A/P, 10%, 9) − $200(A/F, 10%, 9)] | 115 | |
| [$16,000(A/P, 10%, 9) − $3,200(A/F, 10%, 9)] | 2,542 | |
| Total EUAC(10%) | $5,455 | $5,862 |
Because Pump A has the smaller EUAC ($5,455 < $5,862), the replacement pump is apparently not justified and the defender should be kept at least one more year. We could also make the analysis using other methods (e.g., PW), and the indicated choice would be the same.