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Unformatted text preview: 2,000 Initially, it would appear that Project C is the better investment, based upon its higher NPV. However, if the firm chooses
P roject F, it would have the opportunity to make the same investment three years from now. Therefore, we must reevaluate
P roject F 'using extended common life of 6 years. The time lines are shown below. Note that only F's is changed.
Common Life Approach
End of Period:
($4 0,000) 1
I RR 5
$ 11,000 $7,165
$ 14 ,000 3
$ 13,000 4
$ 12,000 6
$ 10,000 3
($8,000) 4 5 6 $7,000
$7,000 $ 13,000
$ 13,000 $ 12,000
$ 12,000 Project F
$ 13,000 ($20,000) $7,000 $ 13,000 NPV
I RR B304:F304
100 P roject L $9,281
25.2% On the basis of this extended analysis, it is clear that Project F is the better of the two investments (with both the
NPV and IRR methods).
Equivalent Annual Annuity (EAA) Approach (See the Chapter 10 Web Extension for details.)
Here are the steps in the EAA approach.
1. Find the NPV of each project over its initial life (we already did this in our previous analysis).
2 . Convert the NPV into an annuity payment with a life equal to the life of the project.
Note: we used the Function Wizard for the PMT function.
P roject F has a hig her EEA, so it is a better project.
ECONOMIC LIFE VS. PHYSICAL LIFE
Sometimes an asset has a physical life that is greater than its economic life. Consider the following asset
which has a physical life of three years. During its life, the asset will generate operating cash flows.
However, the project could be terminated and the asset sold at the end of any year. The following table
shows the operating cash flows and the salvage value for each year-- all values are shown on an after-tax
basis. Operating Salvage
Cash Flow Value
461 T he cost of capital is 10%. If the asset is operated for the entire three years of its life, its NPV is:
3-Year NPV = Intial Cost
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This document was uploaded on 01/20/2014.
- Fall '13