Selecting the Project
There are two alternative projects. The company have to
select one project based one project’s NPV and MIRR.
Information of two projects are:
Year
0
1
2
3
CFs Project A
-$200 millions
$100 millions
$120 millions
$150 millions
CFs Project B
-$250 millions
$120 millions
$150 millions
$160 millions
Project’s cost of capital is 12%.
Which project should be selected by the company?
Unequal Lives of Projects
How to select the project
with different lives?
Two methods
• Replacement Chain Method
• Equivalent Annual Cash-flows (EAC)
Replacement Chain Method
• A capital budgeting decision model that is used to compare
two or more mutually exclusive capital proposals with
unequal lives.
• The Replacement Chain Method is a decision model that takes
into consideration the different life spans of alternative
proposals, allowing a more accurate comparison of the
proposals.
• In Replacement Chain Analysis, the Net Present Value (NPV) is
determined for each proposal.
• The methodology involves determining the number of years
of cash flow (the project lives) for each of the projects and
creating a "replacement chain," or iterations, to fill in the
blanks in the shorter-lived project.
Equivalent Annual Cash flows
• One of two methods used in capital budgeting to compare
mutually exclusive projects with unequal lives.
• The equivalent annual cash flows (EAC) approach calculates
the constant annual cash flow generated by a project over its
lifespan if it was an annuity.
• The present value of the constant annual cash flows is exactly
equal to the project's net present value (NPV).
• When used to compare projects with unequal lives, the one
with the higher EAC should be selected.
Year
0
1
2
3
4
CF of Project A
-$300 M
$100 M
$100 M
$150 M
$200 M
Cost of Capital of
Projects: 12%
CF of Project B
-$250
$150 M
$250 M