Cash Flow Analysis and Other Factors

Replacement Projects

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, 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 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 and the expected cash flows from the replacement project.

A man in blue shirt installing a window. He is holding the window frame against the open window while standing inside a room.

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 considered. 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)

Key Points

The cash flow analysis must take all cash flow components into account, such as opportunity costs and depreciation and maintenance expense.
The replacement project's cash flows are the additional inflows and outflows to be provided by the prospective replacement project.
The comparison between the replacement and the current project informs the decision whether to undertake the replacement and, if applicable, at what point replacement should occur.

Terms

Capital Budgeting – the budgeting process in which a company plans its capital expenditure (the spending on assets of long-term value).
Sunk Cost – a cost that has already been incurred and which cannot be recovered to any significant degree.
Opportunity Cost – the cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.