Question

The project has the following cash flows and salvage values and cost of capital 8%:

Year	Cash flows	Salvage
0	-5000	4000
1	2500	3500
2	3200	1800
3	1600	900
4	1000	0

What are the physical life and the economic life for this project?  (Please write down the calculation process.)

• A.

  Physical life of this project is 4 years with economic life of 1 year.

• B.

  Physical life of this project is 3 years with economic life of 4 years.

• C.

  Physical life of this project is 4 years with economic life of 3 years.

• D.

  Physical life of this project is 4 years with economic life of 4 years.

• E.

  Physical life of this project is 4 years with economic life of 2 years.

Answer 1

Physical life represents time period for which the asset can be used by the company. Since salvage value = 0 at the end of 4 years, physical life of the project = 4 years.

Calculating NPV's for each year at 8% rate:

NPV for year 0 =  NPV(8%, -1000) = -$926

NPV for year 1 =  NPV(8%, -5000, 6000) = $514

NPV for year 2 =  NPV(8%, -5000, 2500, 5000) = $1,483

NPV for year 3 =  NPV(8%, -5000, 2500, 3200, 2500) = $1,892

NPV for year 4 =  NPV(8%, -5000, 2500, 3200, 1600, 1000) = $1,911

As the project is profitable through year 4, economic life of the project is 4 years.

Hence, option D is the correct answer.