Question 9.10: CASE STUDY−−Replacement of a Hospital’s Emergency Electrical...
CASE STUDY−−Replacement of a Hospital’s Emergency Electrical Supply System Sometimes in engineering practice a replacement analysis involves an existing asset that cannot meet future service requirements without augmentation of its capabilities. When this is the case, the defender with increased capability should be competitive with the best available challenger. The analysis of this situation is included in the following case study . The emergency electrical supply system of a hospital owned by a medical service corporation is presently supported by an 80-kW diesel-powered electrical generator that was put into service five years ago [capital investment = $210,000; MACRS (GDS) seven-year property class]. An engineering firm is designing modifications to the electrical and mechanical systems of the hospital as part of an expansion project. The redesigned emergency electrical supply system will require 120 kW of generating capacity to serve the increased demand. Two preliminary designs for the system are being considered. The first involves the augmentation of the existing 80-kW generator with a new 40-kW diesel-powered unit (GDS seven year property class). This alternative represents the augmented defender. The second design includes replacement of the existing generator with the best available alternative, a new turbine-powered unit with 120 kW of generating capacity (the challenger). Both alternatives will provide the same level of service to the operation of the emergency electrical supply system.
The challenger, if selected, will be leased by the hospital for a 10-year period. At that time, the lease contract would be renegotiated either for the original piece of equipment or for a replacement generator with the same capacity. The following additional estimates have been generated for use in the replacement analysis.
| Alternative | |||
| Defender | |||
| 80 kW | 40 kW | Challenger | |
| Capital investment | 90000^{a} | $140,000 | $10,000^{b} |
| Annual lease amount | 0 | 0 | $39,200 |
| Operating hours per year | 260 | 260 | 260 |
| Annual expenses (year zero $): | |||
| expense per hour | $80 | $35 | $85 |
| Other expenses | $3,200 | $1,000 | $2,400 |
| Useful life | 10 years | 15 years | 15 years |
a Opportunity cost based on present MV of the defender (outsider viewpoint).
b Deposit required by the terms of the contract to lease the challenger. It is refundable at the end of the study period.
The annual lease amount for the challenger will not change over the 10-year contract period. The operating and maintenance expense per hour of operation and the other annual expense amounts for both alternatives are estimated in year-zero dollars and are expected to increase at the rate of 4% per year (assume base year, b, is year zero; see Chapter 8 for dealing with price changes). The present estimated MV of the 80-kW generator is $90,000, and its estimated MV at the end of an additional 10 years, in year-zero dollars, is $30,000. The estimated MV of the new 40-kW generator, 10 years from now in year-zero dollars, is $38,000. Both future market values are estimated to increase at the rate of 2% per year.
The corporation’s after-tax, market-based MARR (i_{m}) is 12% per year, and its effective income tax rate is 40%. A 10-year planning horizon (study period) is considered appropriate for this decision situation. (Note that, with income tax considerations and price changes in the analysis, a study period based on the coterminated assumption is being used.) Based on an after-tax, actual-dollar analysis, which alternative (augmentation of the defender or lease of the challenger) should be selected as part of the design of the modified emergency electrical power system?
The after-tax analysis of the first alternative (defender), keeping the existing 80-kW generator and augmenting its capacity with a new 40-kW generator, is shown in Figure 9-6. The initial $230,000 before-tax capital investment amount (cell B11) is the sum of (1) the present $90,000 MV of the existing 80-kW generator, which is an opportunity cost based on an outsider viewpoint, and (2) the $140,000 capital investment for the new 40-kW generator. The −$43,145 of taxable income at time zero (cell E11) is because of the gain on disposal, which is not incurred when the 80-kW generator is kept instead of sold. The after-tax PW of keeping the defender and augmenting its capacity is −$282,472.
A spreadsheet analysis of the leasing alternative (challenger) is shown in Figure 9-7. Under the contract terms for leasing the challenger, there is an initial $10,000 deposit, which is fully refundable at the end of the 10-year period. There are no tax consequences associated with the deposit transaction. The annual beforetax cash flow (BTCF) for the challenger is the sum of (1) the annual lease amount, which stays constant over the 10-year contract period, and (2) the annual operating and maintenance and other expenses, which increase at the rate of 4% per year. For example, the BTCF for the challenger in year one is −$39,200 − [$85(260) + $2,400](1.04) = −$64,680. These annual BTCF amounts for years one through ten are fully deductible from taxable income by the corporation, and they are also the taxable income amounts for the alternative (the corporation cannot claim any depreciation on the challenger because it does not own the equipment). Hence, the after-tax PW of selecting the challenger, assuming it is leased under these contract terms, is −$239,695.
Based on an after-tax analysis, the challenger or a new turbine-powered unit with 120 kW of generating capacity is economically preferable for use in the emergency electrical supply system because its PW has the least negative value. This case study also illustrates the importance of a life cycle costing (LCC) approach to the economic evaluation of engineering alternatives. In the foregoing case, not only is the initial capital investment considered but annual operating and maintenance costs for each alternative as well. Leasing the 120-kW generator over a 10-year period is economically preferable to the other alternatives in this case.
