Suppose that the investment project’s horizon is shorter than equipment useful life. Calculating terminal value on perpetuity basis using the last CF of the horizon would miss the need to replace equipment in some time. How would you adjust terminal value calculation to deal with that?
Use an equivalent annuity stream.
If you for example machine has 8 year life.
100,000 cost.
Wacc = 10%
N = 8 i/y= 10 PV = 100,000
CPT PMT = 18,774
From year 8 onwards use this as you capx per annum. It is the equivalent of spending 100,999 every 8 years.
MikeyF, thank you. Your point is welcomed, but the issue is that project horizon is shorter than equipment useful life - in this case, it is 3 years. Or, do you mean calculating terminal value as the sum of annuity (without replacement costs) from the end of horizon to the end of equipment useful life and perpetuity (with replacement costs) from there onwards?
Just put in a scrap value for the machine at the end.
Thank you. Maybe the way to go is to include at the horizon end: (1) residual value of the equipment, (2) as you propose, EAA CF calculation for replacement cost? Because I dont see how scrap value can be applied to the time point outside the horizon, since terminal value is calculated for the horizon end.
Or did I got you wrong.
Could you explain exactly what the isssue is?
Does the Project have a finite life?
Or do you just have an explcity forcast period but then are making assumptions about perpetuity?
I don’t think I am understanding.
It’s a project of opening a new store. At T0 suppose we buy equipment, at T9 (after 8 years) it is supposed to be replaced. However, the financial model is designed to forecast CFs for only 3 years (i.e. to T4) and then add terminal value on perpetuity basis, using the last CF of the project horizon (which is standard I think). But there’s evidently no scrap value at T4 as equipment would continue to be used. So based on what you suggested in 2 posts I would derive that terminal value at T4 should be calculated as SUM of (1) residual value of the equipment at T4 (2) T4-T9 annuity with no replacement costs, (3) T9-onwards perpetuity with replacement costs. Another option is to extend project planning horizon to equipment useful life, as far as I understand. Is it now more comprehensible?
My approach to this would be to calcualte the annuity equivlent capx and use it right from the start.
If you have to take into effetc of tax on deprecition just use straight line schedule.
Absolutely. Agree, it would be a practical and efficient solution, but in this case payback period is one of key metrics, and it would be misstated by using EAA from T0. And it was my bad in prev. post, there is no sum of 1+2+3, it can only be SUM of residual value at T4 and T4-onwards perpetuity with EAA for replacement costs, as you suggested.
Sorry I think I don’t really understand what yu are trying to do.
MikeyF, absolutely sorry to hear that.