Intelligent Semiconductor, a diversified technology company, is considering two mutually-exclusive projects. Assume the following information:
Project A -
Initial cash outlay: ($500,000)
t1: $125,000
t2: $125,000
t3: $155,000
t4: $285,000
Cost of capital 11.35%
Project B -
Initial cash outlay ($395,000)
t1: $170,000
t2: $160,000
t3: $175,000
Cost of capital 11.35%
Assuming no taxes, a $0.00 salvage value at the end of each projects' life, and the ability for each project to be replicated identically, identify the superior project according to the Replacement Chain approach. Additionally, what is the NPV and IRR of the superior project over the common life?
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A. B. C. D. E. F.Explanation
The Replacement Chain, or "Common Life" approach, is a useful analysis method which allows two or more projects with unequal lives to be examined. In the
Replacement Chain approach, the lifespans of each project being examined are multiplied in such a way that the resulting projects share a "common life." In this example, Project A has a lifespan of 4 periods, whereas Project B has a lifespan of 3. The common multiple of both is 12, and to transform each project into one which has a twelve period lifespan, multiply project A by 3 and Project B by 4. Doing so will result in the following series of cash flows for Project A:
Project A -
t0 ($500,000)
t1: $125,000
t2: $125,000
t3: $155,000
t4: [$285,000 + ($500,000)]=($215,000)
t5: $125,000
t6: $125,000
t7: $155,000
t8: [$285,000 + ($500,000)]=($215,000)
t9: $125,000
t10 $125,000
t11: $155,000
t12: $285,000
Multiplying project B by 4 will result in the following cash flows: t0 ($395,000) t1: $170,000 t2: $160,000 t3: [$175,000 + ($395,000)]=($220,000) t4: $170,000 t5: $160,000 t6: [$175,000 + ($395,000)]=($220,000) t7: $170,000 t8: $160,000 t9: [$175,000 + ($395,000)]=($220,000) t10: $170,000 t11: $160,000 t12 $175,000
Solving for NPV and IRR will determine that Project B is superior on both figures, with an NPV of $35,417.16, and an IRR of 13.301%. Project A has a NPV of
$22,256.14 and an IRR of 12.22%.