Question

Your client is unsure why can’t company compare mutually exclusive projects with unequal-life using the Net Present Values (NPVs)? Which method should company use instead? Explain in details and give examples

Answer 1

Net present value cannot be used for evaluation of projects which are mutually exclusive in nature having unequal lives because both the project are used in alternate with each other and Net present value will just be discounting their cash flows in respect to present value and finding out which one is having the highest positivecash flows but it is not efficient in order to select those products because they are having unequal lives and selection based on the net present value can be misleading at times because it will be selecting bad projects and is skipping the better project so this is just comparing on the basis of discounting the present value and it is an inefficient method.

Equivalent annual annuity method would be considering both the project which are having unequal life and who are mutually exclusive in nature and it will be discounting them according to their annuity and then selecting the better project out of them.

So equivalent annual annuity method is used for selection of the project which are having un equal life and mutually exclusive in nature.