REPLACEMENT CHAIN METHOD:

 

Application:  The Replacement Chain Method is used to compare two mutually exclusive capital proposals of unequal lives.   The result of applying the model to the projects is an NPV for each project for one or more iterations (the "links" of the chain) of each project.  The model can be applied to more than two mutually exclusive projects, but the set-up becomes cumbersome and the Equivalent Annual Annuity method may be more appropriate.

 

Methodology: 

1)  Determine the number of years of cash flow (the "project lives") for each project by finding the lowest common denominator (LCD) of all the "project lives".  This LCD is the number of years for which each projects cash flows must be recalculated. 

2)  For each project assume that during the last year of each iteration a reinvestment (equal to the original investment) must be made in order to generate positive cash flows for the following iteration.  This is true for every iteration of the project except for the very last year when all projects reach a common terminal finish time.  In the very last year there is no reinvestment for future cash flows, so the value of the cash flows of the very last year equals the cash flow of the last year of the original project.
3) Once the revised cash flows have been determined, generate the discount factors for those years.  Calculate the present value for each cash flow. Calculate the Net Present Value for the project.  Compare projects; choose that project with largest NPV.