2.11 Benefits and Demerits of the Replacement Chain and Annual Annuity Approaches
Here are some summary points to keep in mind when comparing the RCA and AAA approaches.
- The RCA is easier to explain to people who do not understand TVM.
- The AAA requires fewer calculations.
- It may be unrealistic to assume that the projects will be repeated.
- Projects may be renewed, but only once or not at all.
- Revenues and operating costs may need revision in future project iterations.
- In inflationary circumstances, equipment replacement may be costlier down the road.
- New technologies may provide operating efficiencies and thus alter free cash flow projections.
- Some (or all?) of the above considerations may be built into the RCA, but not the AAA.
- The AAA views the future cash flows as a “no-growth annuity.” We look at the cash flows, in theory as being equal each year, i.e., as an “Annuity Equivalent.”
- Due to there being unequal lives, it is possible that the NPV and IRR rules of thumb will yield conflicting outcomes for competing projects. (Indeed, we saw this in the example above.) When adjusting for equal lives using the RCA, the conflict will disappear.
- In practice, it may be best to project out future Free Cash Flows for extended terms and to calculate the RCAs. Maybe.