Project A should be preferred to project B because or its NPV. If we had compared the two projects without incorporating the consequences of replacing the machine at the end of year 2 the decision would have been the revers, because the net present value of project A then would be Rs 3,054 (Rs 7.272 + Rs 5.782 – Rs 10,000).
The implicit assumption of this approach is that the investment which is being replaced will produce cash flows of a similar pattern in future as it has done in the past.
We have taken a very simple situation where the project’s life was only 2 years. But in actual practice the competing alternatives may have much longer lives say 10 year and 20 years. In such circumstances, it would probably not be possible to apply strictly the criterion mentioned above, that is, replacing the investment of the shorter-period project 4 times and longer-period project 3 times, in all having a 60 year life. It will obviously not be possible to make correct estimates for these project A for such a distant future.
The equivalent cost method obviates these difficulties. According to this method annual value/cost of all mutual, exclusive investment projects under consideration is determined. The equivalent annual set present value (EANPV) is determined dividing the NPV of cash flows of the annuity factor corresponding to the life of the project at the given cost of capital. The decision, in the case of revenue-expanding proposals. is the maximization d EANPV and minimalism of equivalent annual cost (EAC) in the case of cost-reduction proposals.