Capital Budgeting

A Note on Capital Budgeting: Treating a Replacement Project as Two Mutually Exclusive Projects

Su-Jane Chen, Metropolitan State College of Denver Timothy R. Mayes, Metropolitan State College of Denver ABSTRACT This note, with a numerical example, demonstrates that evaluating a replacement project is equivalent to assessing two mutually exclusive projects. This unconventional view requires no more knowledge on the part of students than what is required to evaluate a single expansion project. Textbooks typically use separate sections of a chapter to explain how to evaluate expansion projects and replacement projects, leading students to believe that there are two entirely different methodologies. We show that there is really only one methodology. Conceptually, this is much easier for students to understand. Moreover, this alternative view allows decision makers to avoid a potential pitfall associated with the NPV when the two assets involved in the replacement project do not have the same remaining useful life. This note further revises the MIRR and modifies the PI to reconcile possible ranking conflicts between the two rules and the NPV when dealing with mutually exclusive projects. INTRODUCTION Businesses are formed in order to create value for their owners. For corporations, this value creation goal is transformed into stockholder wealth maximization. To fulfill this goal financial managers have certain responsibilities. One of them is to make wise capital budgeting/investment decisions. Several decision rules have been developed to guide the decision making process. The most widely suggested rule is the Net Present Value (NPV). Arguably, the NPV is the best decision rule on theoretical grounds because it readily captures the dollar benefit of the project to stockholders. According to this rule, only projects with NPV ≥ 0 are worth taking. Projects faced by corporations, depending on their nature, involve different risks with maintenance, replacement, expansion,...