CP

What is done in the post-audit?

Identify several purposes of the post-audit.

Special Applications of Cash Flow Evaluation

Misapplication of the NPV method can lead to errors when two mutually exclusive

projects have unequal lives. There are also situations in which an asset should not be

operated for its full life. The following sections explain how to evaluate cash flows in

these situations.

Comparing Projects with Unequal Lives

Note that a replacement decision involves comparing two mutually exclusive projects:

retaining the old asset versus buying a new one. When choosing between two mutu-

ally exclusive alternatives with significantly different lives, an adjustment is necessary.

We now discuss two procedures—(1) the replacement chain method and (2) the

equivalent annual annuity method—to illustrate the problem and to show how to deal

with it.

Suppose a company is planning to modernize its production facilities, and it is con-

sidering either a conveyor system (Project C) or some forklift trucks (Project F) for

moving materials. Figure 7-6 shows both the expected net cash flows and the NPVs

for these two mutually exclusive alternatives. We see that Project C, when discounted

at the firm’s 11.5 percent cost of capital, has the higher NPV and thus appears to be

the better project.

Although the NPV shown in Figure 7-6 suggests that Project C should be se-

lected, this analysis is incomplete, and the decision to choose Project C is actually in-

correct. If we choose Project F, we will have an opportunity to make a similar invest-

ment in three years, and if cost and revenue conditions continue at the Figure 7-6

levels, this second investment will also be profitable. However, if we choose Project C,

we cannot make this second investment. Two different approaches can be used to

correctly compare Projects C and F. The first is the equivalent annual annuity

Special Applications of Cash Flow Evaluation 281

FIGURE 7-6 Expected Net Cash Flows for Projects C and F

Project C:

(^0) 11.5% 123456

40,000 8,000 14,000 13,000 12,000 11,000 10,000
NPVCat 11.5% $7,165; IRR 17.5%.
Project F:
(^0) 11.5% 12 3

20,000 7,000 13,000 12,000
NPVFat 11.5% $5,391; IRR 25.2%.

The Basics of Capital Budgeting: Evaluating Cash Flows 279