Replacement Chain Method - Explained
What is the Replacement Chain Method?
Written by J. Mance Gordon
Updated at April 22nd, 2024
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What is the Replacement Chain Method?
The replacement chain method compares two or more mutually exclusive capital proposals that possess unequal lives. This method is used in capital budgeting to rank capital projects with unequal life spans. When using the replacement chain method, it is essential to find out the minimum life span common to all projects and the expected cash flows in order to adequately compare the projects.
How Does the Replacement Chain Method
The replacement chain method is used for the comparison of two or more mutually capital exclusive projects with varying life span. This method is mostly used for projects such as construction, transportations, mining, and other related projects. Using this method entails determining the life span for each project and their cash flows and creating a replacement chain for the projects using projects with shorter life spans. When creating these iterations, the Net Present Value (NPV), Net investments and net cash flows for each project are considered.
Alternatives to the Replacement Chain Method
The replacement chain method recognizes that mutually exclusive projects have varying life spans and different expected cash flows, hence, the Net Present Value (NPV) must be calculated for each of the projects before the comparison is done. There are other means to evaluate, compare or rank mutually exclusive projects aside from using the replacement chain value, this includes the Equivalent Annual Annuity Method (EAA). EAA uses the estimated annuity payments of each project for its assessment. In this method, the NPV also plays an important role given that the NPVs of each project are first calculated before the value is converted into an equivalent annuity stream.