Replacement Chain Method

DEFINITION of 'Replacement Chain Method'

A capital budgeting decision model that is used to compare two or more mutually exclusive capital proposals with unequal lives. The Replacement Chain Method is a decision model that takes into consideration the different life spans of alternative proposals, allowing a more accurate comparison of the proposals. In Replacement Chain Analysis, the Net Present Value (NPV) is determined for each proposal, and one or more iterations (the "links" in the replacement chain) can be completed to create comparable time frames for the proposals. By comparing the proposals over like-periods of time, accept-reject information for the various proposals becomes more reliable.

BREAKING DOWN 'Replacement Chain Method'

The methodology involves determining the number of years of cash flow (the project lives) for each of the projects and creating a "replacement chain," or iterations, to fill in the blanks in the shorter-lived project. For example, if project A has a five-year life span and project B has a 10-year life span, project A's data can be projected to the next five-year period to match project B's 10-year life span, taking into consideration any net investments and net cash flows for each iteration. The NPV of each project can then be calculated to provide reliable accept-reject information. The NPV is the present value of the net cash flow stream resulting from a project, discounted at the firm's cost of capital, less the project's net investment.

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