Capital investment appraisal - part 2

　　by Samuel O Idowu

　　01 Sep 2000

　　In Capital Investment Appraisal 1, a second article, was promised which would look at projects with unequal lives, taxation and the impact of inflation. Students at this stage of their studies should be aware that questions in this area would not always be straightforward.

　　This second article intends to focus on some of these complications which may be introduced into capital investment appraisal questions. It is hoped that by working through the author?s approach in the following example, students will learn the techniques required in tackling questions of this sort and be able to apply them in an examination environment.

　　Before looking at the example, let us say a word or two about them.

　　Unequal life projects

　　When considering possible investment projects, it is often the case that competing projects are not of the same life span. For example, an organisation may have to choose between two projects in which project A might have a useful life of, say, five years whilst another competing project, B may have a useful life of seven years. To simply compare the net present values of the two projects without looking at the unequal life span will not be comparing like with like. Under normal circumstances project B will have a higher net present value, as it has the opportunity of generating cash for two additional years. To recommend undertaking project B solely, on the basis of the higher net present value may not be based on a sound reason. This is because there is a possibility that the net cash inflow generated from project A at the end of its five-year life could be reinvested elsewhere for the two equivalent additional years generating additional NPV which may total more than project B?s NPV. This fact is often ignored as only the net present values of projects at the end of their respective lives are compared.

　　What needs to be done is to express the two projects in equal terms. If two or more unequal life projects being considered had the same level of risk, then it will be appropriate to use the Equivalent Annual Cost Approach also known as Annual Equivalent Annuity Method to compare net present values of costs on an annualised basis. If the projects had different levels of risk then the appropriate approach will be to assume Infinite Re-investment for each project and calculate their net present values to infinity.

　　These two approaches will now be examined in detail.