What Is the Replacement Chain Method?
The replacement chain method is a capital budgeting decision model that compares two or more mutually exclusive capital proposals with unequal lives. The replacement chain method takes into consideration the different life spans of alternative plans, as well as their expected cash flows. That makes it easier to compare the proposals. In replacement chain analysis, the Net Present Value (NPV) is determined for each plan. One or more iterations (the "links" in the replacement chain) can be completed to create comparable time frames for the projects. By comparing the proposals over like-periods of time, accept-reject information for the various projects becomes more reliable.
- The replacement chain method is a capital budgeting decision model that compares two or more mutually exclusive capital proposals with unequal lives.
- The replacement chain method involves repeating shorter projects multiple times until they reach the lifetime of the longest project.
- The replacement chain method requires repeatable projects and a constant discount rate.
- The Equivalent Annual Annuity Method (EAA) is an alternative method.
Understanding the Replacement Chain Method
The methodology involves determining the number of years of cash flow (the project lives) for each of the projects and creating "replacement chains," or iterations, to fill in the blanks in the shorter-lived project. Suppose that project A has a five-year life span, while project B has a ten-year life span. Project A's data can be projected to the next five-year period to match project B's ten-year life span. Of course, we take 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 case where it might be used is in helping a mining company to evaluate which plant development project to pursue.
Requirements of the Replacement Chain Method
It is not always possible to use the replacement chain method to compare projects. The replacement chain method requires repeatable projects and a constant discount rate.
In many cases, it is possible to perform a shorter project multiple times as required by the replacement chain method. For example, a firm may have to decide between renting office space month-to-month in its current location and leasing office space for one year at a new location. One can evaluate the projects using the replacement chain method. We can compare the net investments and net cash flows for 12 one-month iterations renting at the current location to a single year leasing at the proposed new location.
In other cases, the replacement chain method cannot be used because projects cannot be repeated. A firm may have to choose between upgrading their old computers or buying new systems. The new systems will last longer and cost more, yet it is often impossible to upgrade old computers multiple times. The old computers may have the best possible processors supported by their motherboards after the upgrade, so they cannot be upgraded again.
Constant Discount Rate
It is easy to obtain the constant discount rate required by the replacement chain method in some cases, but impossible in others. If a municipal government funds projects with general obligation bonds, the government can get a constant discount rate. The municipal government could simply issue a ten-year bond and use the resulting funds for one ten-year project or two successive five-year projects. If the municipal government instead issues revenue bonds, it must fund the projects as they arise. In that case, the discount rate may have changed considerably after five years. Unique opportunities for funding, such as Build America Bonds, also come and go.
Alternatives to the Replacement Chain Method
The replacement chain method is not 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). That 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 is considered 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.