FIN 614: Financial Management Larry Schrenk, Instructor

1.Projects with Unequal Lives 1.Replacement Chains 2.Equivalent Annual Annuities (EAA) 2.Final Thoughts

If two projects have unequal time horizons, we need to make adjustment before computing NPV. (Equivalent) Solutions Replacement Chains Equivalent Annual Annuities (EAA)

Consider these two mutually exclusive projects (r = 10%): NPV A = $ and NPV B $ Is B the better project? What about the return on our funds in years 3 and 4, if we accept Project A? Project01234 A-10,0006,000 B-10,

Evaluate each project over an equal time horizon. Compare NPV and IRR over extended periods.

Evaluate each project over an equal time horizon. Repeat Project A, so that it covers the same time horizon as Project B (r = 10%). Recalculate NPV* A over 4 years horizon. NPV* A = $ > NPV B $568.27→ Project A Project01234 A-10,0006, ,0006,000 B-10,

Find NPV for each project. Convert these NPV’s into equivalent annual annuity payments. Select the project with the higher equivalent annual annuity payments

NPV A = $ and NPV B $ EEA A N = 2; I% = 10; PV = ; PMT = ???; FV = 0 PMT (EEA) = $ EEA B N = 4; I% = 10; PV = ; PMT = ???; FV = 0 PMT (EEA) = $ EEA A > EEA B → Project A

Finance theory says to accept all positive NPV projects. Two problems if not enough internally cash to fund all these projects: Increasing Marginal Cost of Capital Capital Rationing

Flotation costs with externally raised capital increases the cost of capital Large capital projects seen as risky, which drives up the cost of capital If external funds needed, then the NPV should be estimated using this higher marginal cost of capital

Capital Rationing: Company cannot fund all positive NPV projects Possible Reasons: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Companies don’t have enough staff to implement all positive NPV projects.

FIN 614: Financial Management Larry Schrenk, Instructor