Replacement chain approach

Definition

The replacement chain approach is a method used in capital budgeting to compare projects with different lifespans by repeating shorter projects until they match the duration of longer projects. This technique ensures a fair comparison of the net present value (NPV) over an equivalent time period.

5 Must Know Facts For Your Next Test

1. Ensures projects with different lifespans are compared on an equal basis.
2. Involves repeating shorter project cycles to match the lifespan of longer projects.
3. Helps in calculating a consistent NPV for all projects being evaluated.
4. Assumes that shorter projects can be replaced indefinitely under similar conditions.
5. Useful when deciding between mutually exclusive projects with varying durations.

Review Questions

• What is the primary purpose of using the replacement chain approach?
• How does the replacement chain approach handle shorter project cycles?
• Why is it important to compare NPVs over an equivalent time period?

Related terms

Net Present Value (NPV): A financial metric that calculates the present value of future cash flows minus initial investment.

Internal Rate of Return (IRR): A rate which makes the net present value of all cash flows from a particular project equal to zero.

Capital Budgeting: The process by which investors decide whether to invest in specific long-term projects based on potential returns and costs.