2.15 Topical Practice Problems: Replacement Chain versus AAA (Problems # 1 – 7)
1. Under what circumstances would you use the Replacement Chain and Annual Annuity Approach respectively? What are their relative advantages and disadvantages? Make a list.
2. Yur Company has two mutually exclusive investment choices for replacing old machinery. Assume that both projects can be repeated (replicated) and that the relevant Weighted Average Cost of Capital (“WACC”), i.e., discount rate, is 14%.
| Machine A | Machine B | |
| Investment Cost | $190,000 | $360,000 |
| Expected Life | 3 Years | 6 Years |
| Free Cash Flow (Per Year) | $87,000 | $98,300 |
Using both the Replacement Chain and Annual Annuity approaches, upon replacement of the old machine, which new machine should it select – A or B?
3. Use the following information for questions # 3 – 5. Show all your math.
- Spread the numbers for the following two mutually exclusive projects:
a. Both projects have an investment cost of $10,000,000
b. Project A has an expected life of 2 years after which time it can be replaced at the same investment cost
c. Project B has an expected life of 4 years
d. Both projects have average risk; the relevant WACC / discount rate = 10%.
e. Project A has Free Cash Flow of $6,000,000 and $8,000,000 for years One and Two respectively
f. Project B has Free Cash Flow of $4,000,000 per year
g. “Question #3” refers just to “spreading the numbers” based on the “givens.”
4. If Project A can be repeated, and using the same assumptions, use the Replacement Chain analysis to determine which project, on an NPV basis should be recommended.
5. Again, using the Annual Annuity Approach, which project has the higher annuity equivalent?
Use the following information to answer question # 6. Show all your math.
6. Yossi’s Company has two mutually exclusive investment choices for replacing old machinery. Assume that both projects can be repeated and that the relevant WACC is 14%.
| Machine A | Machine B | |
| Investment Cost | $100,000,000 | $132,000,000 |
| Replacement Cost | $105,000,000 | NA |
| Expected Life | 5 Years | 10 Years |
| Free Cash Flow | $30,000,000 Per Year | $25,000,000 Per Year |
Use both theReplacement Chain and Annual Annuity approaches.
7. Use the following information for the next question (#7). Assume the projects are mutually exclusive. Both projects have an eight-year life. The WACC is 10%. Show all your math.
| Machine A | Machine B | |
| Investment Cost | $10,000,000 | $15,000,000 |
| Replacement Cost – After 4th Year | $12,000,000 | NA |
| Expected Life | 4 Years | 8 Years |
| Free Cash Flow – First 4 Years | $4,000,000 | $3,500,000 |
| Free Cash Flow- Latter 4 Years | $4,200,000 | Same |
Which machine should be selected?
Problem #8 follows in Section 2.20.