When appraising mutually exclusive investments in plant and

When appraising mutually exclusive investments in plant and equipment, financial managers calculate the investments’ equivalent annual costs and rank the investments on this basis. Why is this necessary? Why not just compare the investments’ NPVs? Explain.

Solution

Sometimes the projects have unequal lives. It may so happen that high NPV is applicable for smaller life projects and lower NPV is for higher life projects. If we rank just based on NPV in this case, we may choose a project which lasts for small life. So for a like to like comparison, one needs to calculate equivalent annual cost.