Deck 7: Replacement Decisions

Question 1

In order to make a replacement decision, a firm calculated the equivalent annual cost of owning an asset as follows: When should the firm replace its equipment?

A)in 1 year
B)in 2 years
C)in 3 years
D)in 4 years
E)in 5 years

Answer 1

D

Question 2

Which of the following can be called the challenger?

A)a revenue generated by a company
B)machinery that a company wants to acquire
C)an assembly line that a company wants to replace
D)a piece of land that a company owns
E)payments that a company receives from its clients

Answer 2

B

Question 3

Suppose that operating costs associated with the 5-year service life of an asset start with $1 000 in the first year increasing by $500 thereafter. Calculate the EAC(Operating)if annual rate is 10%.

A)$1 505
B)$1 905
C)$2 005
D)$2 105
E)$2 205

Answer 3

B

Question 4

Which of the following can be called the defender?

A)a building that a company owns
B)a bank account that a company owns
C)a loan that a company has just taken from a bank
D)a fleet of trucks that a company is currently planning to purchase
E)a share held by a company

Question 5

What are the two reasons that a large portion of capacity cost is usually incurred early in the life of the capacity?

A)(i)Maintenance costs are usually higher in the early part of the capacity's life, and (ii)assets lose their value most quickly early in their lives.
B)(i)Installation costs are often large, and are incurred up-front, and (ii)maintenance costs are usually higher in the early part of the capacity's life.
C)(i)Assets lose their value most quickly early in their lives and (ii)installation costs are often large, and are incurred up-front.
D)(i)Installation costs are often large, and are incurred up-front and (ii)there is a substantial cost associated with getting an asset ready for sale as salvage.
E)(i)There is a substantial cost associated with getting an asset ready for sale as salvage (ii)operating costs tend to fall as staff get more expert in using the asset.

Question 6

This table gives the data relevant to a replacement decision: If the MARR is 8.0%, what is the purchase price of this equipment?

A)$65 200
B)$66 700
C)$67 400
D)$68 500
E)$69 300

Question 7

Shultz Ltd. produces portable electric band saws. Currently Shultz Ltd. pays its subcontractor $6.14 per power unit excluding material costs. It is expected that sales of the electric band saws will be as high as 7 500 per year. Should Shultz Ltd. produce power units itself if the equivalent annual cost for the company to install and run the production equipment would be $49 568?

A)Yes, because own production would be cheaper by $0.22 per unit.
B)Yes, because own production would be cheaper by $0.47 per unit.
C)No, because own production would be $0.57 per unit more expensive.
D)No, because own production would be $0.22 per unit more expensive.
E)No, because own production would be $0.47 per unit more expensive.

Question 8

TRINITY Ltd. produces different pieces of furniture. A set of electric drills used in the production of furniture wears out rapidly, after which the firm scraps them. Calculate the equivalent annual cost (capital costs)of a set of electric drills if the firm buys the set for $4 500 and uses it for 5 years. Assume an annual interest rate of 8%.

A)$900
B)$1 082
C)$1 127
D)$1 206
E)$1 284

Question 9

What is the economic life of an asset?

A)the service life that accounts for the costs of an asset replacement
B)the service life that minimizes the marginal cost of an asset
C)the service life that maximizes revenues generated by an asset
D)the service life that minimizes the average cost of an asset over time
E)the service life that minimizes the cost of replacing the asset

Question 10

Which of the following can be treated as a part of installation costs?

A)the costs of purchasing new equipment
B)the costs of personnel retraining
C)the costs of the loss in capacity value
D)the difference between the purchase price and the salvage value
E)the initial investment

Question 11

What asset will most likely contain sunk cost?

A)refrigerator
B)airplane
C)administrative building
D)rail tracks
E)auto repair equipment

Question 12

A replacement study showed that the components of the total costs of an asset are as follows: What is the economic life of an asset?

A)7 years
B)7.5 years
C)8 years
D)9 years
E)12 years

Question 13

What are the two conditions behind the One Year Principle?

A)Capital costs for a defender are small compared to the operating costs, and the annual operating costs are gradually increasing.
B)Capital costs for a defender are higher than the operating costs, and the annual operating costs are gradually increasing.
C)Capital costs for a defender are less than the operating costs, and the increase in annual operating costs is not monotonic.
D)Capital costs for a defender are higher than the operating costs, and the increase in annual operating costs is not monotonic.
E)Capital costs for a defender are less than the operating costs, and the annual operating costs are monotonically declining.

Question 14

If it is said that the economic life of a challenger is four years it means that

A)the payback period is four years.
B)four years are required for the challenger to recover its initial investment.
C)four years are required for the challenger to recover its operating and maintenance costs.
D)the equivalent annual cost in year four is at its minimum.
E)the equivalent annual cost is decreasing over four years.

Question 15

Capital cost per period

A)mostly falls with an increase in the service life of an asset.
B)always rises with an increase in the service life of an asset.
C)can decline at some point in the service life of an asset if it requires a major overhaul.
D)usually increases over time.
E)remains constant over time.

Question 16

Currently a firm replaces its equipment every year. It has calculated the equivalent annual cost of replacement as follows: How much can the firm save by making a replacement decision based on the economic life criterion?

A)16
B)22
C)25
D)38
E)44

Question 17

What is the equivalent annual cost (EAC)?

A)annual cost of the initial investment in an asset spread over its economic life
B)average annual cost of owning and operating an asset over its economic life
C)the market cost of replacing the service provided by an asset
D)the sum of the asset's depreciation and its operating costs in any given year
E)the difference between the profits generated by an asset and the cost of operating it

Question 18

When making a replacement decision

A)capital costs of the challenger are irrelevant.
B)capital costs of the defender are irrelevant.
C)operating costs of the defender are irrelevant.
D)capital costs of the defender incurred in the past are irrelevant.
E)operating costs of the challenger are irrelevant.

Question 19

In order to make a replacement decision when the defender and the challenger are identical, one should assume that

A)the economic lives of the assets are very long relative to the planning time horizon.
B)the technology can be changed during the economic life of an asset.
C)the relative price and interest rate vary over time.
D)the replacement decision is repeated an indefinitely large number of times.
E)the defender and the challenger are made using different technologies.

Question 20

A company bought and installed an assembly line for $5 million and $0.5 million respectively. The company plans to use this assembly line for 8 years and then sell it for $100 000. Calculate the equivalent annual capital costs of the assembly line if the capital recovery factor is 0.1874, and MARR is 10% for the capital investment.

A)$0.997 million
B)$1.012 million
C)$1.022 million
D)$1.027 million
E)$1.046 million

Question 21

A new laptop has just come onto the market that you estimate will have an equivalent annual cost of $500. You could sell your current laptop right away for $1 000, or you could spend $500 on an upgrade. At the end of this year, after the upgrade, it will have a resale value of $800, going down by $200 a year. Once its salvage value reaches zero, its physical life is over. If both laptops provide equivalent functionality, when should you replace your current laptop? Your MARR is 5%.

A)Replace it now.
B)Replace it in 2 years.
C)Replace it in 3 years.
D)Replace it in 4 years.
E)Replace it in 5 years.

Question 22

This table gives the data relevant to a replacement decision: What is the EAC (Maintenance Costs )for year 2 at the MARR of 10%?

A)$5 220
B)$5 690
C)$5 980
D)$6 210
E)$6 740

Question 23

A Tata costs $10 000, its salvage value declines by straight-line depreciation of $1 250 per year, and its maintenance costs are $100 in the first year and go up by 50% a year. Raj and Rashid both like to drive Tata's. Raj trades her car in for a new model when it reaches its economic life, whereas Rashid keeps his until it reaches the end of its physical life. Raj and Rashid both have MARRs of 5%. How much more does Rashid pay for his Tata per year, on average, than Raj?

A)They both pay the same.
B)$53
C)$64
D)$77
E)$112

Question 24

If the challenger is different from the defender, and the challenger does not repeat, what should one do to make an educated decision about replacement?

A)Compute the economic life and the associated EAC of all the challengers.
B)Compute the EAC of the remaining economic life of the defender.
C)Keep the defender.
D)Replace the defender by the challenger immediately.
E)Structure the problem as a set of mutually exclusive alternatives.

Question 25

Capital costs are usually

A)variable costs that directly depend on the level of production.
B)fixed costs that do not directly depend on the level of production.
C)negligible compared with operating costs.
D)the most important factor in determining the economic life of an asset.
E)costs of administrative overhead.

Question 26

If the interest rate is 10%, the depreciation rate of an asset is 10%, its service life is 10 years and its first cost is $10 million then EAC(Capital)for a ten-year life is

A)$1.000 million.
B)$1.060 million.
C)$1.349 million.
D)$1.409 million.
E)$1.977 million.

Question 27

This table gives the data relevant to a replacement decision: What is the Salvage Value in year 4 at the MARR of 10%?

A)$10 640
B)$10 850
C)$11 030
D)$11 210
E)$11 490

Question 28

What is the difference between replacement of an existing physical asset and its retirement?

Question 29

You buy a new car for $20 000. Its salvage value declines by declining-balance depreciation of 10% per year, while its maintenance costs are $500 in the first year and go up by $400 a year. If your MARR is 5%, what is the EAC to you of keeping it until it reaches the end of its economic life?

A)$4 358
B)$4 335
C)$4 327
D)$4 333
E)$4 352

Question 30

Define the concept of the economic life of an asset and describe the circumstances under which the concept is applied to replacement decisions.

Question 31

If a challenger is different from the defender, and the challenger does not repeat, replacement decision should be based on

A)economic life of the first challenger only.
B)comparison of the defender with the last challenger.
C)marginal costs of the sequence of all challengers.
D)all possible combinations of the defender and all challengers over some study period.
E)installation costs of all challengers.

Question 32

A printing and duplicating company owns ten photocopying machines. Which of the following associated expenses is a variable cost?

A)the rental of the office space where the photocopiers are kept
B)supplies of paper and toner
C)the salary of the operator who runs and maintains the machines
D)the interest on the loan the company took out to buy the copiers
E)the lighting and heating of the office in which the photocopiers are kept

Question 33

This table gives the data relevant to a replacement decision: What is the EAC (Capital Costs)for year 3 at the MARR of 10%?

A)$16 840
B)$17 622
C)$18 181
D)$18 210
E)$19 460

Question 34

What is the economic life of the following asset, given that its purchase price is and the MARR = 10%?

A)more than 4 years since EAC is increasing over 4 years
B)1 year and EAC = $46 000
C)2 years and EAC = $45 048
D)3 years and EAC = $47 147
E)4 years and EAC = $45 000

Question 35

You are considering purchase of a new furnace. Its initial cost, including installation, is $3 000, and it will cost $200 a year in fuel over its 10-year life. You expect that it can then be sold for $300. If your MARR is 10%, what is the equivalent annual cost of owning the furnace?

A)$469
B)$569
C)$669
D)$769
E)$869

Question 36

An asset has an initial cost of $10 000. Its maintenance costs are $300 in the first year, and go up by 20% per year thereafter. Its salvage value declines by straight-line depreciation over ten years. If your MARR is 10%, what is its economic life?

A)2 years
B)3 years
C)4 years
D)5 years
E)6 years

Question 37

A BMW costs $35 000, its salvage value declines by declining-balance depreciation of 10% per year, and its maintenance costs are $100 in the first year and go up by $500 a year. Mary and Tom both like to drive BMWs. Mary trades her car in for a new model every year, whereas Tom keeps his until it reaches its economic life, then trades it in. Mary and Tom both have MARRs of 5%. How much more does Mary pay for her car per year, on average, than Tom?

A)They each pay the same.
B)$569
C)$615
D)$769
E)$869

Question 38

Maintenance costs are mostly a part of

A)fixed costs and as such should be included in the evaluation of EAC (Capital).
B)fixed costs and as such should be included in the evaluation of EAC (Operating).
C)variable costs and as such should be included in the evaluation of EAC (Capital).
D)variable costs and as such should be included in the evaluation of EAC (Operating).
E)Maintenance costs are neither fixed or variable costs and therefore, should be excluded from EAC calculations.

Question 39

A stamping machine currently has a salvage value of $10 000, and this will drop by 20% per year from now on. Its expected maintenance costs are $1 000 for this year, but in the following year it is expected to need a major overhaul, costing $3 500. In the year following the overhaul, its maintenance costs will be $500, and these will then go up by 30% per year. Your MARR is 10%. There is a challenger available that will do the same job for an EAC of $3 400. When should you replace the old machine?

A)right now
B)in two years time
C)in four years time
D)in six years time
E)in eight years time

Question 40

A trucking company evaluates its fleet of vehicles. According to its balance sheet, a three-year-old van has the book value of $21 870. Currently its maintenance costs are $1 000 per year. They have increased by 20% annually and are expected to increase by the same percentage in the future. Calculate the equivalent annual costs for the first six years knowing that the van's purchase price was $30 000 and the minimum acceptable rate of return is 15%.

Question 41

An old asset-a piece of equipment-has a current market value of $10 000. Its purchase price 5 years ago was $15 000. Installation costs were $2 000 in year 1 with some adjustment costs in year 2. If you are to calculate the EAC (Capital)to keep this asset in operation, what value should be assigned to P in the formula EAC(Capital)= (P - S)*(A/P, i, N)+ iS?

Question 42

A transportation company has bought a truck 5 years ago for $60 000. Currently its market value is Maintenance costs of the truck are per year, increasing by $500 with each year. A new truck of the same capacity costs with constant maintenance costs of $500 for the duration of its service life of 10 years. Assuming 10% depreciation rate for both trucks and 5% annual interest rate, should the company buy the new truck now?

Question 43

The University has just invested $9 000 in a new desktop publishing system. From past experience, annual cash returns are estimated asA(t)= $8000 - $4000(1 + 0.15)t-1S(t)= $6000(1 - 0.3)twhere A(t)stands for the net cash flow in period t and S(t)stands for the salvage value at the end of year t, and t ≥ 1.If the MARR is 12%, compute the annual equivalent cost in year 2

Question 44

Stan bought a car three years ago for $20 000. Recently he got a promotion and is deciding whether to keep his old car or to buy a new one. His dealer told him that the current market price of his old car is $15 000. The car maintenance costs are $1 000 now, and they are going to increase each year by at least $500. Stan compares his old car with a new one that, he calculates, would have an equivalent annual cost of $4 100. What is Stan's optimal decision if his current interest rate is 7%?

Question 45

What is sunk cost? Explain how it affects replacement decisions.

Question 46

OMON Consulting is evaluating different scenarios to replace its existing technological line to produce compact computer discs. A four-year time horizon is used in this evaluation. One challenger is available at present, and it is expected that a new technology will be available in two years. List all potential scenarios associated with this evaluation.

Question 47

NB Power is considering replacing its existing electricity generator. The current market value of the generator is $15 000. It depreciates at 25% per year. The generator produces 153 megawatt-hours of electricity annually and requires $3 000 in maintenance costs per year. Moreover, the maintenance costs are expected to increase by $1 200 per year in the future. On the other hand, there is another generator in the market that provides electricity at $0.059 per kilowatt-hour. What should NB Power do if the MARR is 8%?

Question 48

What are the three basic replacement schemes discussed in Chapter 7 in the text?

Question 49

A communication system cost $65 000 to buy and $4 000 to install ten years ago. Currently the ten-year-old system can be sold for $7 000, but it will cost $1 000 to remove it. If it's sold in a year's time, the net income, after paying removal costs, will be $1 000. A new communication system costs $50 000 plus $500 to install it. Assuming 5% depreciation rate for the new system, 7% annual interest rate, by how much would the operating costs of the old system have to exceed operating costs of the new one for the old system to be replaced immediately?

Question 50

A new computer costs $4 000. It depreciates at 15% annually. The computer maintenance costs are $200 in the first year increasing by 50% per year thereafter. Calculate the EAC over the first five years of the computer's life, assuming a 20% interest rate. What is the economic life of the computer?

Question 51

The salvage value of an electric generator is $10 000, while its purchase price five years ago was $20 000. It produces 45.5 megawatt-hours of electricity per year and requires $800 in annual maintenance costs. A new generator can produce electricity at $0.05 per kilowatt-hour. Should the new generator be purchased if the annual interest rate is 7%?

Question 52

A three-year-old small crane is being considered for early replacement. Its current market value is $13 000. Estimated future market values and annual operating costs for the next five years are given in the following table:
What is the economic life for this crane if the interest rate is 10% per year?