Question

You are the finance manager for your company. You and your team have been analysing two mutually exclusive projects. The first project initially costs $1,000 and will return cash flows of $200 per year for the next six years. The second project initially costs $1,500 and will return $600 per year for the next three years.

The method that would not be correct when comparing these two projects is:

A. Calculate the net present value of each project over a six year period (by running the second project twice) and select the project with the highest net present value.

B. Calculate the net present value of each project for their lifetimes and select the project with the highest net present value.

C. Calculate the net present value of each project if each project was repeated an infinite number of times and select the project with the highest net present value.

D.Calculate the Equivalent Annual Annuity (EAA) of each project to find the annual annuity payment that has the same net present value as each project and select the project with the highest annuity payment.

Answer 1

B) Calculate the net present value of each project for their lifetimes and select the project with the highest net present value

When projects have different life , than decision shall be made by following method

1) Replacement chain method

here NPV is calculated by running shorter period project multiple times till it reaches life of larger period project

i.e if one project has life of 3 years and one project has life of 6 years , then project with 3 years life will be run 2 times

2) Equivalent Annuity method

In this method , projects are compared by calculating Equivalent annual NPV and decision is made

Thus option B is wrong