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• W55593100 abstract "This paper introduces an alternative approach known as capitalized cost method mentioned by Knox, Zima and Brown (1993) for a firm to evaluate investment projects. We employ this method to select mutually exclusive projects with unequal lives and operating costs. The capitalized cost of an asset is the total present values of its full net costs that an asset spends over its life. We show the total present value of equivalent annual costs (EAC) equals the capitalized cost of an asset that could be replaced for infinite periods. The capitalized cost method is simpler and easier than the EAC method, and seems to be preferable for selecting projects with unequal economic lives. I. Introduction We usually set up a capital budgeting scenario where a firm must select between two or more machines, or pieces of equipment, with different lives, and these alternative investments that are mutually exclusive. All candidate machines have identical functions, that is, they can do exactly the same job, but they are designed differently, have distinct operating costs and will last for different time periods. Simply applying NPV rule that suggests that a firm should select the project having the lowest present value of costs and would be an incorrect choice, because the lowest-cost machine may need to be replaced earlier than the other ones. In other words, the timing of a future investment decision is contingent on the choice made today. The selection between alternative projects affects future replacement decisions if they will be replaced at different future dates. Future decisions have to be taken into account for accurately evaluating the alternative investment projects that a firm faces, (see Brealey and Myers, 2003) Thus, the correct method for evaluating these projects should be based on an equal-life basis. Conventional approaches are based on the assumption of replacement chains. With regard to this assumption, there are two methods extensively recommended: one is matching cycle (common life) approach, and the other equivalent annual annuity or equivalent annual cost (EAA or EAC) procedure.1 Both of these two methods are appropriate for evaluating regular like-for-like replacement decisions where each replication of a project leads to identical cash flows that do not consider technological change or the possibility of early abandonment, (see Pilotte, 2000) This objective of this paper is to introduce an alternative approach mentioned by Knox, Zima and Brown (1993), which is the capitalized cost method, and to compare it with the equivalent annual cost approach.2 Although Knox et al. did not state definitely this method could be used on projects with unequal lives and required returns, we will demonstrate that this procedure is not only identical to the equivalent annual annuity/ cost approach,3 but also simpler and easier, and so, appears to be the preferred alternative for evaluating investment projects with unequal economic lives. The remainder of this paper is organized as follows: Section II describes the capitalized cost method. Section III compares the capitalized cost method with equivalent annual cost method and demonstrates the consistency between these two methods. Section IV provides an example where a firm chooses between two machines with similar capacities but different lives using both EAC and CCM to document the consistency between these two methods. Section V presents concluding remarks. II. Capitalized Cost Method (CCM) With the EAC procedure being indistinguishable, our criterion for choosing between assets with distinct economic horizons is, therefore, to opt for the asset with the lowest equivalent annual cost when the assets to be selected have the same risks. However, if the risks between candidate assets are not identical, we must compare directly the K's values to make the correct decision so that this procedure is identical to the correct EAC approach. III. …" @default.
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• W55593100 date "2005-06-01" @default.
• W55593100 modified "2023-09-23" @default.
• W55593100 title "An Empirical Comparison of the Capitalized Cost and Equivalent Annual Cost Methods for Evaluating Mutually Exclusive Projects" @default.
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