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Why NPV is inefficient to indicate optimum replacement period and then we go for equivalent annual cost?
It is not that NPV is inefficient – equivalent annual cost is still using an NPV approach.
It is simply that usually we look at a project as a one off decision lasting (say) 4 years.
However, if we need the machine effectively for ever, then it is not just for (say) 4 years – we are going to have to keep replacing the machine and the problem is shall we replace it every two year or every three years or whatever.
To be able to decide we first look at the PV of the first machine. But that is not enough – since we are going to have to keep buying a new one, the PV is going to keep being repeated every year or every 2 years or every 3 years or whatever,
To be able to compare, we then calculate the equivalent annual cost. Then we can say that whatever replacement policy give the cheapest equivalent annual cost is the best.
It is still an NPV approach.
Have you watched the lecture on this?
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