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Appendix 14.1: The evaluation of mutually exclusive investments with unequal lives
The application of the net present value method is complicated when a choice must be made between two or more projects, where the projects have unequal lives. A perfect comparison requires knowledge about future alternatives that will be available for the period of the difference in the lives of the projects that are being considered. Let us look at the situation in Example 14A.1. In Example 14A.1 it is assumed that both machines produce exactly the same output. Therefore only cash outflows will be considered, because revenue cash inflows are assumed to be the same whichever alternative is selected. Consequently our objective is to choose the alternative with the lower present value of cash outflows. Revenue cash inflows should only be included in the analysis if they differ for each alternative. Suppose we compute the present value (PV) of the cash outflows for each alternative.
End of year cash flows (000) Machine X Y Year 0 1200 600 Year 1 240 360 Year 2 240 360 Year 3 240 PV at 10% 1796.880 1224.960

ADVANCED READING

Machine Y appears to be the more acceptable alternative, but the analysis is incomplete because we must consider what will happen at the end of year 2 if machine Y is chosen. For example, if the life of the task to be performed by the machines is in excess of three years, it will be necessary to replace machine Y at the end of year 2; whereas if machine X is chosen, replacement will be deferred until the end of year 3. We shall consider the following methods of evaluating projects with unequal lives:
1 Evaluate the alternatives over an interval equal to the lowest common multiple of the lives

of the alternatives under consideration. 2 Equivalent annual cash flow method by which the cash flows are converted into an equivalent annual annuity. 3 Estimate terminal values for one of the alternatives.

1. Lowest common multiple method

Assume that the life of the task to be performed by the machines is at least six years. Consequently, both machines will be replaced at the end of their useful lives. If machine X is replaced by an identical machine then it will be replaced every three years, whereas machine Y will be replaced every two years. A correct analysis therefore requires that a sequence of decisions be evaluated over a common time horizon so that the analysis of each alternative will be comparable. The common time horizon can be determined by setting the time horizon equal to the lowest common multiple of the

EXAMPLE 14A.1
The Bothnia Company is choosing between two machines, X and Y. They are designed differently but have identical capacity and do exactly the same job. Machine X costs 1 200 000 and will last three years, costing 240 000 per year to run. Machine Y is a cheaper model costing 600 000 but will last only two years and costs 360 000 per year to run. The cost of capital is 10 per cent. Which machine should the firm purchase?

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APPENDIX 14.1: THE EVALUATION OF MUTUALLY EXCLUSIVE INVESTMENTS WITH UNEQUAL LIVES

lives of the alternatives under consideration. In Example 14A.1, where the lives of the alternatives are two and three years, the lowest common multiple is six years. The analysis for the sequence of replacements over a six-year period is as follows:
End-of-year cash flows (000) 0 Sequence of type X machines Capital investment Operating costs PV at 10% Sequence of type Y machines Capital investment Operating costs PV at 10% 1200 240 3146.400 600 360 3073.200 600 360 600 360 240 1 2 3 1200 240 4 5 6

240

240

240

360

360

360

By year 6 machine X is replaced twice and machine Y three times. At this point the alternatives are comparable, and a replacement must be made in year 6 regardless of the initial choice of X or Y. We can therefore compare the present value of the cost of these two sequences of machines. It is preferable to invest in a sequence of type Y machines, since this alternative has the lowest present value of cash outflows.

2. Equivalent annual cash flow method

Comparing projects over a span of time equal to the lowest common multiple of their individual life spans is often tedious. Instead, we can use the second method the equivalent annual cash flow method. The costs for the different lives of machines X and Y are made comparable if they are converted into an equivalent annuity. The present value of the costs of machine X is 1 796 880 for a three-year time horizon. The equivalent annual cash outflows for the machine can be solved from the following formula: present value of cash flows = equivalent annual cash flow annuity factor for N years of R% (14A.1) Solving for the equivalent annual cash flow, we have equivalent annual cash flow = present value of cash flows n annuity factor for N years at R % (14A.2)

Using the data for machine X, the equivalent annual cash flow is 1 796 880 = 722 509 2.487 The annuity factor is obtained from Appendix B for three years and a 10 per cent discount rate. What does the equivalent annual cash flow represent? Merely that the sequence of machine X cash flows is exactly like a sequence of cash flows of 722 509 a year. Calculating the equivalent annual cash flow for machine Y, you will find that it is 705 622 a year (1 224 960/1.736). A stream of machine X cash flows is the costlier; therefore we should select machine Y. Using this method, our decision rule is to choose the machine with the lower annual equivalent cost. Note that when we used the common time horizon method the present value of a sequence of machine Xs was 3 146 400 compared with 3 073 200 for a sequence of machine Ys; a present value cost saving of 73 200 in favour of machine Y. The equivalent annual cash flow saving for

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machine Y was 16 887 (722 509 705 622). If we discount this saving for a time horizon of six years, the present value is 73 200, the same as the saving we calculated using the lowest common multiple method (note that small differences do exist because of rounding errors). You should note that the equivalent annual cash flow method should only be used when there is a sequence of identical replacements for each alternative and this process continues until a common time horizon is reached.

3. Estimate terminal values

Consider a situation where machines A and B have lives of six and eight years respectively. Assume that the life of the task to be performed by the machines is ten years. Because the task life is shorter than the lowest common multiple (24 years), we cannot use either of the first two methods. An alternative approach is to assume that each machine will be replaced once (machine X at the end of year 6 and machine Y at the end of year 8) and incorporate estimates of the disposal values into the analysis for both machines at the end of the ten-year task life.

Key terms and concepts

balancing allowance (p. 323) balancing charge (p. 323) beta (p. 328) capital allowances (p. 321) capital asset pricing model (pp. 329) capital market line (p. 328) capital rationing (p. 320) depreciation tax shields (p. 321) equivalent annual cash flow method (p. 337) general rate of inflation (p. 325) hard capital rationing (p. 320) lowest common multiple method (p. 336) market portfolio (p. 327) nominal or money rates of return (p. 324) nominal cash flows (p. 324) profitability index (p. 321) post-completion audits (p. 334) real cash flows (p. 324) real rate of return (p. 324) risk premium (p. 327) security market line (p. 328) sensitivity analysis (p. 330) soft capital rationing (p. 320) weighted average cost of capital (p. 330) writing-down allowances (p. 321)

Recommended readings
This chapter has provided an outline of the capital asset pricing model and the calculation of risk-adjusted discount rate. These topics are dealt with in more depth in the business finance literature. You should refer to Brealey and Myers (2006) for a description of the capital asset pricing model and risk-adjusted discount rates. For a discussion of the differences between company, divisional and project cost of capital and an explanation of how project discount rates can be calculated when project risk is different from average overall firm risk see Pike and Neale (2005).

Key examination points

A common error is for students to include depreciation and apportioned overheads in the DCF analysis. Remember that only incremental cash flows should be included in the analysis. Where a question includes taxation, you should separately calculate the incremental taxable profits and then work out the tax payment. You should then include the tax payment in the DCF analysis. Incremental taxable profits are normally incremental cash flows less capital allowances on the project. To simplify the calculations, questions sometimes indicate that capital allowances should be calculated on a straight-line depreciation method. Do not use accounting profits instead of taxable profits to work out the tax payment. Taxable profits are calculated by adding back depreciation to accounting profits and then deducting capital allowances. Make sure that you include any balancing allowance or charge and disposal value in the DCF analysis if the asset is sold. With inflation, you should discount nominal cash flows at the nominal discount rate. Most questions give the nominal discount rate (also called the money discount rate). You should then adjust the cash flows for inflation. If you are required to choose between alternative projects, check that they have equal lives. If not, use one of the methods described in the Appendix to this chapter.

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