ANOTHER LOOK AT MUTUALLY EXCLUSIVE ALTERNATIVES WITH UNEQUAL LIVES AND REQUIRED RETURN A PEDAGOGICAL COMMENT Javad Kashefi,

Ph. D College of Business Administration Finance, Real Estate, and La De!artment California "tate, Pol#technic $niversit#, Pomona D%ashefine&a'csu!omona.edu (el) *+,+- ./+012+/ INTRODUCTION A recent article in this &ournal 3Jim 4usumeci, 5+++6 offered a !otential mista%e in a!!l#ing 7e8uivalent annuit# method9 and : re!lacement chain method9 hen mutuall# e;clusive !ro&ects have une8ual lives. (he author stated that if the cost of ca!ital for t o mutuall# e;clusive une8ual lives !ro&ects is different the :e8uivalent annuit#9 and :re!lacement chain9 methods ma# result in erroneous choices. (he !ur!ose of this !a!er is to sho that *5- the inherent assum!tion of e8uivalent annuit# method *EA4- and re!lacement chain method *RPC- is that the !ro&ects must <e in the same ris% class and the same constant cost of ca!ital, *1- an# deviation from the a<ove assum!tion ill result in erroneous choices. Finall#, the ad&usted net !resent value *A=P>- is the onl# method that ill result in correct choices for une8ual lives !ro&ects ith different ris% class and cost of ca!ital Consider a !ro&ect hich has e;!ected cash flo s, CFt and =P> *(- ith cost of ca!ital r. (he =P> of an infinite stream of the !ro&ect hich is re!licated ever# ( #ears is e8ual to)
NPV *T , - = NPV *T - + NPV *T NPV *T - NPV *T + + + ...Equation 5 T *5 + r *5 + r - 1T *5 + r - 2T
(1 + r ) ] = Equation 1 *5 + r - T 5
T

E8uation 5 can <e sim!lified as e8uation 1

NPV *T , - = NPV *T - [

?t is often suggested a good ran%ing measurement for une8ual lives !ro&ects is the e8uivalent annuit# method *EA4- hich is o<tained <# multi!l#ing =P> *(, - <# the cost of ca!ital. (hat is) E8uivalent Annuit# 4ethod@ r 3 NPV *T , -6 or
EAM = *r - NPV *T -[ (1 + r )T 1 1 ] = NPV *T - A [ ] Equation 1 T r r(1 + r )T *5 + r - 5

or
EAM = NPV *T PVIFAr ,T Equation 2

E8uation 2 can <e illustrated <# using the Alternative A and B, used <# 4usumeci. 5

(a<le 5 Bear , 5 1 2 C =P>A *'5,D=P>B *'51DEA4A *'5,DEA4B *'51DRPCA *'5,DRPCB *'51DEA4A A*5,DEA4B A*51D-

Alternative A CFA 05,,, C.1 C.1 C.1 5+..//

Alternative B CFB 05,,, C1, C1, C1, C1, E1FG./+

EF+..+ E+,.FF EGCC.25 EG/1.1C F+...G EFG/.2.

(a<le 5 summariHes the result of the net !resent value, e8uivalent annuit# and re!lacement chain methods and !er!etuit# value of EA4 of the t o !ro&ects at the cost of ca!ital of 5,D and 51D as re!orted <# 4usumeci. ?t is o<vious that the Alternative B is recommended <# =P> and RPC, and Alternative A ith EA4 !er!etuit#, as long as the cost of ca!ital is 5,D for A and 51D for B. Io ever, if !ro&ects have different ris% and therefore different costs of ca!ital, the EA4 and RPC should not <e used, <ecause if t o !ro&ects have e;actl# the same NPV *T , - , then the one ith the higher cost of ca!ital *that is, the ris%ier !ro&ect- ill a!!ear *incorrectl#- to have the greater value. ADJUSTED NET PRESENT VALUE METHOD (he Ad&usted =et Present >alue *A=P>- is derived <# multi!l#ing E8uation 1 <# *rAr- and then is sim!lified as E8uation G.
NPV *T , - = NPV *T -*r A r -[ (1 + r )T 1 1 ] = NPV *T -[ ] *5 A r - Equation C r r(1 + r )T *5 + r - T 5

or
ANPV = NPV *T Equation G * PVIFAr ,T - r

UNEQUAL LIVES PROJECTS WITH DIFFERENT COST OF CAPITAL A!!l#ing E8uation G to the a<ove e;am!le #ields an A=P> of EF+...G for !ro&ect A and !ro&ect B A=P> is EFG/.2.. ?f the cost of ca!ital for !ro&ect B ere 5,D, the =P>, EA4, RPC, and A=P> ould <e e8ual to E225.2C, E5,C.G2, E+,F..C, and E5,CG.1+ as sho n in the a<ove (a<le 1. ?t is o<vious that the !ro&ect B is a <etter alternative than A hen the cost of the ca!ital is 5,D or 51D for <oth !ro&ects. (his is the inherent assum!tion of EA4 and RPC that the cost of ca!ital must <e the same for all of the !ro&ects. Jhen the !ro&ects are in different ris% class ith 1

different cost of ca!ital then the A=P> results in correct decision. (a<le 1 Com!arison of Alternative A and B at Different Cost of Ca!ital Alternative A Alternative B =P> *'5,DE5+..// E225.2C =P> *'51DE5GF./. E1FG./+ EA4 *'5,DEF+..+ E5,C.G2 EA4 *'51DE/G./G E+,.FF RPC *'5,DEGCC.25 EE+,F..C RPC *'51DEEC,/./F EG/1.1C EA4 A*5,DEF+...G E5,CG.1+ EA4 A*51DEGCF.,+ EFG/.2. A=P> *'5,DEF+...G E5,CG.1+ A=P> *'51DEGCF.,+ EFG/.2. CONCLUSION 4usumeci has identified reasons that the e8uivalent annuit# method and re!lacement chain method ma# fail hen the !ro&ects have une8ual lives ith different cost of ca!ital. Io ever, the failure of these methods is due to erroneous assum!tion that as made in his !a!er. Both methods ill result in the correct decision as long as the inherent assum!tions of <oth methods are made correctl#. ?n this !a!er, it has <een sho n that the EA4 and RPC result in correct decision as long as the assum!tion of methods *same cost of ca!ital- is maintained. Jhen the investments are in different ris% class ith different cost of ca!ital, the Ad&usted =et Present value is onl# method that ill result in correct decision. REFERENCES Jim 4usumeci, :Another Loo% At 4utuall# E;clusive Alternatives Jith $ne8ual Lives And Re8uired Returns,9 Journal of Financial Education, "!ring 5+++, >ol. 1G, !!.5.01,.