In view o fthese problems, no experienced financial analyst would be too concerned
about comparing mutually exclusive projects with lives of, say, eight years and ten
years. Given all the uncertainties in the estimation process, such projects would, for all
practical purposes, be assumed to have the same life. Still, it is important to recognize
that a problem exists if mutually exclusive projects have substantially different lives.
When we encounter such problems in practice, we use a computer spreadsheet and
build expected inflation and/or possible efficiency gains directly into the cash flow esti-
mates, and then use the replacement chain approach. The cash flow estimation is a bit
more complicated, but the concepts involved are exactly the same as in our example.Economic Life versus Physical Life
Projects are normally analyzed under the assumption that the firm will operate the as-
set over its full physical life. However, this may not be the best course of action—it
may be best to terminate a project before the end of its potential life, and this possi-
bility can materially affect the project’s estimated profitability. The situation in Table
7-1 can be used to illustrate this concept and its effects on capital budgeting. The sal-
vage values listed in the third column are after taxes, and they have been estimated for
each year of Project A’s life.
Using a 10 percent cost of capital, the expected NPV based on three years of oper-
ating cash flows and the zero abandonment (salvage) value is $14.12:(^0) 10% 123
($4,800) $2,000 $2,000 $1,750
0
Thus, Project A would not be accepted if we assume that it will be operated over its
full three-year life. However, what would its NPV be if the project were terminated
after two years? In this case, we would receive operating cash flows in Years 1 and 2,
plus the salvage value at the end of Year 2, and the project’s NPV would be $34.71:
(^0) 10% 12
($4,800) $2,000 $2,000
1,650
Thus, Project A would be profitable if we operate it for two years and then dispose of
it. To complete the analysis, note that if the project were terminated after one year, its
NPV would be $254.55. Thus, the optimal life for this project is two years.
$34.71.
NPV$4,800$2,000/(1.10)^1 $2,000/(1.10)^2 $1,650/(1.10)^2
$14.12.
NPV$4,800$2,000/(1.10)^1 $2,000/(1.10)^2 $1,750/(1.10)^3
Special Applications of Cash Flow Evaluation 283
TABLE 7-1 Project A: Investment, Operating, and Salvage Cash Flows
Year Initial (Year 0) Investment and After-tax Net Salvage Value
(t) Operating Cash Flows at End of Year t
0 ($4,800) $4,800
1 2,000 3,000
2 2,000 1,650
3 1,750 0