What is the Replacement Chain Method
The replacement chain method is a capital budgeting decision model that is used to compare two or more mutually exclusive capital proposals with unequal lives. The replacement chain method takes into consideration the different lifespans of alternative proposals as well as their expected cash flows, 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 lifespan and project B has a 10-year lifespan, project A's data can be projected to the next five-year period to match project B's 10-year lifespan, 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.
Examples of types of projects where replacement chain method analysis can be useful include a transportation company weighing whether to upgrade its fleet. Another example where it might be used is in helping a mining company to evaluate which plant development project to pursue.
Alternatives to the Replacement Chain Method
The replacement chain method isn't the only way to evaluate mutually exclusive projects with unequal lives. The Equivalent Annual Annuity Method (EAA) is an alternative method. The EAA’s approach is to assess each project based on its projected annuity stream (series of equal payments). This is done by first calculating the NPVs of each project, then converting each into an equivalent annuity. Using this approach, the project with the highest EAA would be the more desirable.
Which method is better for making capital investment decisions? Since both the replacement chain and the EEA models rely on NPV, versus internal rates of return (IRR) calculations, they should reach the same conclusions. It is only the approaches that differ.