Proper Risk Resolution in Replacement Chain Analysis

This paper Identifies situations in which the widely recommended procedures for evaluating mutually exclusive projects with unequal lives may result in incorrect project rankings. These situations arise from the failure of conventional techniques to place alternatives on an appropriate equivalent-risk basis and may occur whether a net present value or equivalent annual annuity approach is utilized. We develop alternative discounted cash flow procedures which correctly reflect the nature of risk. In so doing, we address the following important issues: 1) the choice of the discount rate to be used in calculating the net present value of a series of replications of a project: 2) the choice of a discount rate for calculating the equivalent annual annuity for a series of replications: and 3) the selection of an appropriate common-life horizon for comparison of alternative projects