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How to compare projects with unequal economic lives?
August 16, 2017
To answer this question let’s take a look at the example described below. Suppose we are planning to buy a new machine for our production - we are choosing between two options: Machine A and Machine B (See table 1).
Table 1. NPV comparison.
Machine A has a useful life of 3 years and Machine B has a useful life of 4 years. If we calculate NPVs of these two projects we will see that Machine B generates higher NPV than Machine A. However, we need to remember that NPVs of mutually exclusive projects with unequal economic lives are not directly comparable!
We need to restate the NPVs in a way that will allow direct comparison. In this case, a monthly annuity payment of NPV can be used as the basis for comparison. NPV as a monthly annuity payment is calculated as follows:
Where:
When the monthly annuity payment of NPV is calculated, we can see that Machine A is a more attractive investment than Machine B (See Table 2).
Table 2. Comparison of NPV as a monthly annuity.
In Invest for Excel®, the monthly annuity payment of NPV is calculated automatically, while another software feature, the Comparison Table, allows you to see and compare all profitability indicators side by side and easily evaluate the attractiveness of investment projects under consideration (See illustration below):
