OPTIMAL REPLACEMENT POLICY AT BHARAT TOOLS

At Bharat Tools Ltd., the production manager examines the condition of his tools at the
beginning of each year. He classifies the machine as being either in excellent, good, fair,
or bad condition. One of the machines in question is crucial to their production: the high
precision rolling machine. It is estimated that if the machine is in excellent condition then
it contributes Rs 50 lakhs a year, while if its condition is good, fair or poor, its
contribution reduces to Rs 40 lakhs, Rs 25 lakhs and Rs 10 lakhs, respectively. The
contributions are different primarily because the number of breakdowns and consequently
the downtime is more with deteriorating condition of the machine. Based on the condition
of the machine, the production manager can recommend for a purchase of a new
machine, which costs Rs 1 crore. Of course, the quality of the machine deteriorates over
time. The following process best describes this. An excellent machine will be excellent at
the beginning of next year with probability of 0.85 and good with a probability of 0.15. A
good machine will be good at the beginning of next year with a probability of 0.70 or fair
with probability 0.30. A fair machine will be fair at the beginning of next year with a
probability of 0.60 or poor with probability 0.40. A bad machine will continue to be bad,
till replaced. Based on a 12% interest rate, Bharat Tools wishes to maximize its expected
return from this machine over the next 10 years. Therefore, based on the condition of the
machine, what must the production manager recommend? Replace or not? Assume that
the cash flows occur at the end of the year and replacement decisions are taken at the
beginning of any year.