5.3 Analysis Period and Project Lives
Earlier in this chapter, we used NPV and AEV analysis to evaluate and compare several projects. However, the projects we considered were reasonably straightforward – the project durations were specified, and projects being compared had equal durations. That is, if a company needed equipment for 5 years, we would compare alternatives with 5-year project durations. But what happens when this is not the case?
For example, suppose that a custom 3D-printing company needs to choose the model of 3D printers it will use to fill customer orders. The company wants to plan for the next 10 years, but the two printers they are considering have useful lives of 4 years and 6 years. Even if we know the purchase prices and maintenance costs of the two printer models, how could we evaluate them appropriately? This section will discuss how we can adapt evaluation methods like AEV and NPV to these situations.
But first, here are two key definitions:
- Analysis period (also called the planning horizon or study period) is the length of time over which the project will occur, and over which we must analyze the project’s cash flows to make an economic evaluation. In the 3D-printing example the analysis period is 10 years because that is the length of time over which the company wishes to plan its finances.
- Project life (or project duration) is how long the project will last. In the 3D-printing example there are two projects to choose from: one with a project life of 4 years, and another with a project life of 6 years. After the project life has ended, the equipment is no longer useful to the company and must be either replaced or sold. The dollar amount the equipment can be sold for is the salvage value.
If alternatives have:
- unequal project lives, or
- project lives that are different than the analysis period
These differences need to be accounted for in our analysis. That is, we cannot simply evaluate the alternatives using NPV, AEV, or IRR analysis. We must adjust our methods depending on the situation. To properly analyze these problems, we must first be able to recognize the type of situation we are facing.
There are two important questions to consider for any case we analyze.
- Do our alternatives have equivalent project lives?
- Are the project lives equal to our chosen analysis period?
Figure 5.6 below shows the cases we might face depending on our answers to those two questions, and the suggested method of evaluation for each case. These cases and their solutions will each be discussed in greater detail.
Equivalent Project Lives
5.3.1 A1: Project Lives = Analysis Period
The simplest analysis problems are those in which all project lives are equal to each other and equal to the analysis period. You are already familiar with this type of problem, as the majority of Chapter 5 has exclusively dealt with this scenario. These problems can be solved directly with NPV, AEV, or IRR analysis, and require no special treatment of t