Definition
The possibility of replacement projects must be taken into account during the process of capital budgeting and subsequent project management. A replacement project is an undertaking in which the company eliminates a project at the end of its life and substitutes another investment. This replacement project can serve the purpose of replacing an expiring investment with a new, identical one, or replacing an existing investment that is producing unfavorable results with one that management believes will perform better.
When analyzing a project, and ultimately deciding whether it is a good investment decision or not, one focuses on the expected cash flows associated with the project. These cash flows form the basis for the project's value, usually after implementing a method of discounted cash flow analysis. Most projects have a finite useful life. Analysis can be undertaken in order to determine when the optimum point of replacement will be, as well as if replacement is a viable option in the first place. To accomplish this, one analyzes the cash flows of the current project in relation to the expected cash flows from the replacement project .
Replacing a window sill vs. keeping the old one
Replacement project analysis tells a company whether the costs of a replacement project provide a suitable return on investment.
Analysis
The net cash flows for a project take into account revenues and costs generated by the project, along with more indirect implications, such as sunk costs, opportunity costs and depreciation costs related to the project. All of these considerations taken together allow management to consider the project's incremental cash flows, which are inflows and outflows the project produces over predictable periods of time. Discounted cash flow analysis should be undertaken for both the existing project and the potential replacement project. These analyses can then be used to compare the expected profitability of both projects; which will, in theory, lead management to make the right decision regarding the investments.
In general, there will be some sort of cash inflow from ending the old project -- for example, from the terminal value realized upon the sale of existing equipment -- and a subsequent cash outflow to begin the new project. The loss of expected future cash flows from the previous project, or opportunity cost, must also be taken into account. A general form that can be used to analyze these cash flows is:
Increase in Net Income + (Depreciation on New Investment - Depreciation on Old Investment)