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Capital Budgeting: Replacement Chain Method and Equivalent Annual Annuity

The first three methods of capital budgeting; NPV/DCF, IRR* and Payback method are the standard methods used in capital budgeting. The next four methods are not used as often but are good tools to use when comparing different projects. The other four methods are 1.) Replacement Chain Method 2.) Equivalent Annual Annuity (EAA) 3.) Ascending Discount Rates 4.) Area Under the Curve. We will look at Replacement Chain Method and EAA. Replacement Chain Method and EAA are both tools for comparing projects with unequal lives. For example if Project A has a life of five(5) years and Project B has a life of three (3) years it would be unfair to compare their NPV. It is like comparing apples and oranges, they have unequal lives, which means they have an unequal number of cash flows. To compensate for this problem we can use either the Replacement Chain Method or the EAA. Replacement Chain Method Replacement Chain Method takes two or more projects with life spans that are unequal and finds the lowest common denominator and carries the projects out to that lowest common denominator or terminal year. For example, Project A has a life span of 5 years and Project B has a life span of 3 years. The lowest common denominator for these two projects is 15 years. So, taking the following cash flows we can illustrate how this is done. PROJECT A Y0 CF <10> Y1 2 Y2 4 Y3 6 Y4 8 11 Y5

PROJECT B Y0 CF <8>

Y1 2

Y2 5

Y3

Now to carry this out to 15 years, it means that at the end of Y5 for Project A another negative cash flow of <10> ( for example a new purchase ) would have to happen therefore making Y5 cash flow 1 (Y5 + Y0) or (11 + <10>). This would also happen at Y10, but Y15 the end of the project the cash flow would be 11, because it is the end and no new purchase has to occur. The same applies to Project B but it would happen on Y3, Y6, Y9, Y12 and Y15 would be the end of the project.
PROJECT A Y0 Y1 Y9 Y10 CF <10> 2 11 2 4 Y2 Y11 4 Y3 Y12 6 Y4 8 11 Y5 2 Y6 4 Y7 6 Y8 8

ADJUSTED CF Y13 Y14 CF 6 8 11

Y15

<10> 1

<10> 1

PROJECT B Y0 Y1 Y8 Y9 CF <8> 2 7 2 5

<8> ADJUSTED CF <1> > Y13 Y14 CF 2 5 7

Y2 Y3 Y10 Y11 5 7 7 <8> <1> Y15

Y4 Y12

Y5 5 <8> <1> 7

Y6 2

Y7 5 <8> <1

Using these extended adjusted cash flows you would then determine the discount factors and the PV, which you then could determine, the NPV. The project with the largest NPV would be the best project. Lets take a look at a different set of projects: Project A B C D E F G Years 17 23 13 22 7 14 24

What is the lowest common factor (denominator)? You would have to factor out and then multiply by the factors for each project. (Note: if a number appears more than one time in the factor of one number you must multiply by that number as many times as it appears, if a factor appears in more than one number then you only have to multiply one time. For further help with factors, please see Prof. Harding). Project A Years 17 Factor 1 * 17

B C D E F G

23 13 22 7 24 14

1 * 23 1* 13 1 * 2 * 11 1*7 1*2*2*2*3 1*2*7

17 * 23 * 13 * 11 * 7 * 2 * 2 * 2 * 3 = 9,393,384 Note: the 2 from project D and project G are not used because 2 has already been used in project F and it appears three times in project F therefore it must be multiplied three times. Also note that the 7 in project G is not used because it was already multiplied in project E. So in order to find the NPV for all 7 of the projects, you would have to extend the projects out to 9,393,384 years, which is the lowest common denominator, and the terminal year for all 7 projects. This would take a very long time to calculate, so instead of using the Replacement Chain Method we can use the EAA
Equivalent Annual Annuity
The equivalent annual annuity formula is used in capital budgeting to show the net present value of an investment as a series of equal cash flows for the length of the investment. The net present value(NPV) formula shows the present value of an investment that has uneven cash flows. When comparing two different investments using the net present value method, the length of the investment (n) is not taken into consideration. An investment with a 15 year term may show a higher NPV than an investment with a 4 year term. By showing the NPV as a series of cash flows, the equivalent annual annuity formula provides a way to factor in the length of an investment.

How is the Equivalent Annual Annuity Formula Useful?


An example of how the equivalent annual annuity formula may be useful is comparing two new projects where one project has a 15 year term and the other has a 4 year term. Assume that both projects have the same NPV. The 4 year project will receive the return sooner so it will show a higher cash flow when using the equivalent annual annuity formula. In real life, comparing two investments will not always be so obvious and the formula should be applied. Another way of explaining the usefulness of the equivalent annual annuity formula is that an investment with a shorter life span can be reinvested and the earnings on the reinvestment is not taken into consideration when using the NPV formula. The equivalent annual annuity formula provides a comparison relative to time which eliminates the need for considering reinvestment with the same earnings as the current investment.

How is the Equivalent Annual Annuity Formula Derived?


The equivalent annual annuity formula uses the annuity payment formula for when present value is given. Net present value replaces present value to give relevance to the use of the equivalent annual annuity formula.

Example of the Equivalent Annual Annuity Formula


Using the prior example of comparing one project with a 4 year term and another project with a 15 year term, the NPV of the 4 year project is $100,000 and the NPV of the 15 year project is $150,000. The rate used for both is 8%. Putting the variables of the 4 year project in the equivalent annual annuity formula shows

which returns an equivalent annual annuity of $30,192.08. Putting the variables of the 15 year project into the equivalent annual annuity formula shows

which returns an equivalent annual annuity of $17,524.43. Comparing these two projects, the 4 year project will return a higher amount relative to the time of the investment. Although the 15 year project has a higher NPV, the 4 year project can be reinvested and have additional earnings for the 11 years that remain on the 15 year project.

Equivalent annual cost


From Wikipedia, the free encyclopedia

In finance the equivalent annual cost (EAC) is the cost per year of owning and operating an asset over its entire lifespan. EAC is often used as a decision making tool in capital budgeting when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless neither project could be repeated. EAC is calculated by dividing the NPV of a project by the present value of an annuity factor. Equivalently, the NPV of the project may be multiplied by the loan repayment factor.

The use of the EAC method implies that the project will be replaced by an identical project.
[edit]A

practical example

A manager must decide on which machine to purchase:

Machine A Investment cost $50,000 Expected lifetime 3 years Annual maintenance $13,000 Machine B Investment cost $150,000 Expected lifetime 8 years Annual maintenance $7,500 The cost of capital is 5%. The EAC for machine A is: ($50,000/ The EAC for machine B is: ($150,000/ )+$13,000=$31,360 )+$7,500=$30,708

The conclusion is to invest in machine B since it has a lower EAC. Note: The loan repayment factors (A values) are for t years (3 or 8 years) and 5% cost of capital. is given

by

2.723

and

is

given

by

6.463.

(See

ordinary annuity formulae for a derivation.) The larger an A value is, the greater the present value is on a succession of future annuity payments, thus contributing to a smaller annual cost.

Alternative method:1 The manager calculates the NPV of the machines: Machine A EAC=$85,400/ Machine B EAC=$198,474/ =$31,360 =$30,708

Note: To get the numerators add the present value of the annual maintenance to the purchase price. For example, for Machine A: 50,000 + 13,000/1.05 + 13,000/(1.05)^2 + 13,000/(1.05)^3 = 85,402. The result is the same, although the first method is easier it is essential that the annual maintenance cost is the same each year. Alternatively the manager can use the NPV method under the assumption that the machines will be replaced with the same cost of investment each time. This is known as the chain method since 8 repetitions of machine A are chained together and 3 repetitions of machine B are chained together. Since the time horizon used in the

NPV comparison must be set to 24 years (3*8=24) in order to compare projects of equal length, this method can be slightly more complicated than calculating the EAC. In addition, the assumption of the same cost of investment for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.