Corporate Finance - Comparing Projects With Unequal Lives: Example
Corporate Finance - Comparing Projects With Unequal Lives: Example
Example:
Once again, assume Newco is planning to add new machinery to its current plant. There
are two machines Newco is considering, with cash flows as follows:
Compare the two projects with unequal lives using both the replacement-chain method and
the equivalent annual annuity (EAA) approach.
1. Replacement-Chain Method
In this example, Machine A has an operating lifespan of six years. Machine B has an
operating lifespan of three years. The cash flows for each project are discounted by
Newco's calculated WACC of 8.4%.
The initial analysis indicates that Machine A, with the greater NPV, should be the project
chosen.
For Machine A (project 1), the lifespan is six years. For Machine B (project 2), the lifespan is
three years. Given that the lifespan of the longest project is six years, in order to measure
both over a common life, we must adjust the lifespan of Machine B to six years.
Because the lifespan of Machine B is three years, the lifespan of this project needs to be
doubled to equal the six-year lifespan of Machine A. This indicates that another Machine B
would have to be purchased (to get two machines with a lifespan of three years each) to get
to the six-year lifespan of Machine A - hence, the replacement-chain method.
The initial analysis indicates that Machine B, with the greater NPV, should be the project
chosen. Recall, this is different from our first analysis where Machine A was chosen given
its greater NPV.
Look Out!
Note, while the NPV has changed given the additional cash flows, the IRR for the projects remain th
This analysis indicates that Machine B, with the greater IRR, should be the project chosen.
Recall, this is the same as our first analysis, where Machine B was chosen given its greater
IRR.
With the cash flows adjusted with the replacement-chain method, both the NPV and the IRR
arrive at the same conclusion. With this adjusted analysis, Machine B (project 2), should be
the project accepted.
2. Equivalent-Annual-Annuity Approach
While easy to understand, the replacement-chain method can be time consuming. A simpler
approach is the equivalent-annual-annuity approach.
Answer
Machine B should be the project chosen as it has the highest EAA, which is $678.10,
relative to Machine A whose EAA is $640.64.