Capital Budgeting Replacement Real Option Calculator

Purpose and model boundary

This model compares replacing an existing asset with continuing to operate it, calculates incremental NPV and periodic IRR, and adds a selected probability-weighted abandonment or expansion option. It is a transparent capital-budgeting screen. It does not make an investment decision or provide tax, accounting, engineering, legal, appraisal, or financing advice.

Inputs and units

All amounts use one user-consistent currency in millions. The project life is three through eight annual periods. The option route is no real option, abandonment, or expansion. Tax and discount rates are fractions per the displayed labels.

Initial inputs are replacement cost, existing-asset sale proceeds and tax basis, and initial working capital. Terminal inputs are replacement and existing asset salvage proceeds and tax bases. An option review occurs before the final project year. Abandonment uses a downside probability, abandonment proceeds, and tax basis. Expansion uses an upside probability, expansion investment, and annual after-tax cash-flow uplift. Workbook-authored visibility rules expose only the selected option inputs.

The fixed annual grid contains eight complete candidate rows with year, existing and replacement revenue, cash cost, depreciation, and incremental change in net working capital. The selected project life determines which consecutive rows contribute to the result. The grid has no activation column, so its fixed rows do not receive add/remove controls.

Governing relationships

After-tax disposal proceeds for an asset are:

After-tax proceeds = sale proceeds - tax rate × (sale proceeds - tax basis)

The time-zero investment is:

Initial net investment = replacement cost + initial working capital - after-tax proceeds from existing asset sale

For either asset in year t:

EBIT_t = revenue_t - cash cost_t - depreciation_t

After-tax operating cash flow_t = EBIT_t × (1 - tax rate) + depreciation_t

Annual base incremental cash flow is replacement after-tax operating cash flow less existing after-tax operating cash flow and less incremental working-capital investment. In the selected final year, it also includes replacement after-tax salvage, subtracts existing after-tax salvage, and recovers initial working capital.

Base NPV = -initial net investment + sum(incremental cash flow_t / (1 + discount rate)^t)

Periodic IRR is the rate that makes the same time-zero and annual cash-flow sequence sum to zero. The workbook requires at least one negative and one positive supported cash flow and verifies the zero-NPV solution. Profitability index is the present value of base future incremental cash flows divided by initial net investment.

For an abandonment option, review-year exercise payoff is the positive excess of after-tax abandonment proceeds plus recovered working capital over continuation value. For an expansion option, review-year exercise payoff is the positive NPV of the entered expansion investment and the entered annual after-tax uplift over the remaining project periods. The selected payoff is probability-weighted and discounted to time zero.

Strategic NPV = base incremental NPV + real option value

Equivalent annual annuity converts strategic NPV to a level annual amount over the selected life at the entered discount rate. The decision indication reports POSITIVE STRATEGIC NPV or NONPOSITIVE STRATEGIC NPV from that arithmetic only.

Calculation sequence

1. Validate project life, option route, scalar assumptions, visible option inputs, review timing, and all eight annual rows.
2. Calculate after-tax sale proceeds and time-zero net investment.
3. Calculate existing and replacement after-tax operating cash flow for each selected year.
4. Build base incremental cash flows, including the selected final-year disposal and working-capital bridge.
5. Discount the cash flows, solve and verify periodic IRR, and calculate profitability index.
6. Calculate the selected abandonment or expansion exercise payoff, probability-weight and discount it, and add it to base NPV.
7. Return strategic NPV, equivalent annual annuity, decision indication, the cash-flow chart, and status.

Outputs and interpretation

The headline results are initial net investment, base NPV, base IRR, real option value, strategic NPV, and the arithmetic decision indication. Supporting outputs show profitability index, equivalent annual annuity, continuation value, abandonment and expansion exercise payoffs, and terminal incremental cash flow. The chart compares base incremental and discounted cash flow by year. Positive NPV is not an approval recommendation and does not address qualitative or site-specific consequences.

Validation and status logic

The workbook evaluates status in this order:

There is no CHECK branch. Hidden option inputs do not affect other routes.

Assumptions and limitations

• Annual cash flows occur at equal period ends.
• Depreciation is entered directly. No tax class, recovery method, convention, or jurisdiction is selected.
• Tax is a simplified EBIT-based calculation that allows an immediate shield on negative incremental EBIT. Loss usability and tax limitations are not modeled.
• Working capital is recovered at project end or abandonment. Negative annual changes represent releases.
• Option probabilities and cash flows are user assumptions. The option calculation is a decision-tree expected value, not a traded-option or Black-Scholes value.
• NPV and IRR can conflict for unusual signs, scale differences, or mutually exclusive choices. The model reports both and does not resolve governance decisions.
• Inflation, financing effects, replacement downtime, reliability, nonfinancial benefits, and nominal-versus-real consistency require separate review.

Restrictions and non-computing states

All eight grid rows must remain complete even when the selected project life is shorter. Project life must be three through eight years. An active review year must be at least one and no later than one year before project end. Active probabilities remain within zero and one, financial amounts subject to nonnegative bounds cannot be negative, and initial net investment must be positive. A cash-flow profile without a supported unique periodic IRR does not compute a supported result.

Errors and warnings

Input checking can reject an unknown route, a calculated input outside its allowed range, or an invalid grid shape before calculation. Workbook NOT VALID identifies input, investment-bridge, or IRR and derived-arithmetic failures. OK confirms the entered arithmetic is internally reconciled. A connection or calculation-service error is not a zero NPV.

The discounting approach follows OMB Circular A-94, and the zero-NPV IRR identity is described in the GAO glossary of systems analysis and budgeting terms. Depreciation limitations are informed by IRS Publication 946. Decision-flexibility context follows GAO-04-744. No tax table, prescribed discount rate, external asset data, or source example is embedded.