Paper P1 Performance Operations: When You're Conducting Investment Appraisals or Making Capital Budgeting Decisions, the Annualised Equivalent Method Will Allow You to Make a Proper Comparison of Assets with Unequal Lifespans

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Question 4 of the November 2011 Performance Operations paper presented a scenario in which a company needed to decide between two replacement computer systems that had different lifespans. Many candidates calculated the net present values (NPVs) of both systems, but didn't seem to appreciate that these weren't directly comparable, because the first system had a lifespan of three years while the second would last for five years.

The second system's NPV ($671,000) worked out as significantly higher than that of the first one ($350,000). But if the company were to choose system one, it would be able to invest in another after three years. The systems' NPVs needed to be adjusted so that they could be compared on a like-for-like basis. One way of doing this is known as the annualised equivalent method - indeed, the question directed candidates to take this approach.

A similar situation occurs when a company needs to determine how long to keep an asset before replacing it. A good example of this type of decision concerns the replacement of vehicles - a problem faced by both companies and individuals. The following example demonstrates how the annualised equivalent method applies …