Replacement Chain Method
What Is the Replacement Chain Method?
The replacement chain method is a capital budgeting decision model that compares at least two mutually exclusive capital recommendations with inconsistent lives. The replacement chain method thinks about the different life spans of alternative plans, as well as their expected cash flows. That makes it more straightforward to compare the recommendations.
In replacement chain analysis, the net present value ([NPV])) not entirely set in stone for each plan. At least one emphasess (the "joins" in the replacement chain) can be completed to make comparable time spans for the projects. By contrasting the recommendations over like periods of time, acknowledge reject data for the different projects turns out to be more solid.
Understanding the Replacement Chain Method
The methodology includes determining the number of long stretches of cash flow (the project lives) for every one of the projects and making "replacement chains," or cycles, to fill in the spaces in the more limited lived project. Assume 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, any net investments and net cash flows for every cycle are likewise thought about. The NPV of each project can then be calculated to give dependable acknowledge reject data. The NPV is the current value of the net cash flow stream coming about because of a project, discounted at the firm's cost of capital, less the project's net investment.
Instances of types of projects where replacement chain method analysis can be valuable incorporate a transportation company gauging whether to upgrade its fleet. Another case where it very well may be utilized is in assisting a mining with companying to assess which plant development project to seek after.
Requirements of the Replacement Chain Method
It isn't generally imaginable to utilize the replacement chain method to compare projects. The replacement chain method requires repeatable projects and a consistent discount rate.
Repeatability
As a rule, it is feasible to perform a more limited project on different occasions as required by the replacement chain method. For instance, a firm might need to choose renting office space month-to-month in its current location and leasing office space for one year at another location. One can assess the projects utilizing the replacement chain method by looking at the net investments and net cash flows for 12 one-month cycles renting at the current location to a single year leasing at the proposed new location.
In different cases, the replacement chain method can't be utilized in light of the fact that projects can't be rehashed. A firm might need to pick either redesigning their old PCs or buying new systems. The new systems will last longer and cost more, yet updating old PCs on different occasions is much of the time inconceivable. The old PCs might have the best potential processors upheld by their motherboards after the upgrade, so they can't be upgraded once more.
Steady Discount Rate
It is not difficult to acquire the steady discount rate required by the replacement chain method now and again however unimaginable in others. On the off chance that a municipal government funds projects with general obligation bonds, the government can get a steady discount rate. The municipal government could essentially issue a ten-year bond and utilize the subsequent funds for one ten-year project or two successive five-year projects. On the off chance that the municipal government rather issues revenue bonds, it must fund the projects as they emerge. In that case, the discount rate might have changed extensively following five years. Unique opportunities for funding, like Build America Bonds, additionally travel every which way.
Alternatives to the Replacement Chain Method
The replacement chain method isn't the best way to assess mutually exclusive projects with inconsistent lives. The equivalent annual annuity method (EAA) is an alternative method. The EAA's approach is to survey each project in view of its projected annuity stream (series of equivalent payments). That is finished by first computing the NPVs of each project, then, at that point, changing over each into an equivalent annuity. Utilizing this approach, the project with the highest EAA is viewed as more attractive.
Which method is better for settling on capital investment choices? Since both the replacement chain and the EEA models depend on NPV versus internal rates of return (IRR) computations, they ought to arrive at similar resolutions. Just the approaches contrast.
Features
- The replacement chain method is a capital budgeting decision model that compares at least two mutually exclusive capital recommendations with inconsistent lives.
- The replacement chain method includes rehashing more limited projects on various occasions until they arrive at the lifetime of the longest project.
- The replacement chain method requires repeatable projects and a consistent discount rate.
