1. Comparing two projects of different life spans
What happens if you were to compare the NPV of two projects with different life spans?
Since the NPV calculation is simply a sum of discounted cash flows, a longer project will have a higher value than a similar but shorter project, and you can't really compare the two values directly. Luckily, there are a few methodologies to deal with this problem.
2. Different NPVs and IRRs
For example, imagine two different project proposals. Project 1 requires an initial 100 dollar investment, but generates 200 dollars in year 2 and 300 in year 3.
Project 2 requires a 125 dollar initial investment, but generates 100 dollars per year every year for 7 more years.
Now, in this example, project 2 has a higher net present value simply because of the length of the project. But look at project 1! The project paid itself off entirely after the first year, and quickly generates a great return, with an IRR of 200%.
It's fair to compare IRRs between the two projects, whereas the NPV is misleading. However, the IRR doesn't give you a sense of the size of the project in terms of total profitability. This is where another methodology comes into play.
3. Equivalent Annual Annuity
The equivalent annual annuity (EAA) approach is a method that we can use to compare the two projects of different lifespans in present value terms.
In this approach, you essentially assume that each project is a loan that pays out a certain amount each year, totaling the NPV of the project at the end of the period. You can then compare the value of these payments to determine which project results in the higher NPV relative to the lifespan of the project.
4. Let's practice!
Now it's your turn!