Investments of Unequal Lives The Equivalent Annual Cost Method

Suppose a firm must choose between two machines of unequal lives. Both machines can do the same job, but they have different operating costs and will last for different time periods. A simple application of the NPV rule suggests that we should take the machine whose costs have the lower present value. This could lead to the wrong decision, though, because the lower-cost machine may need to be replaced before the other one. If we are choosing between two mutually exclusive projects that have different lives, the projects must be evaluated on an equal-life basis. In other words, we must devise a method that takes into account all future replacement decisions. We first discuss the classic replacement-chain problem. Next, a more difficult replacement decision is examined.

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