Final answer:
When comparing projects with different life spans in capital budgeting, one should opt for the project with the lowest equivalent annual cost to ensure cost-effectiveness over the life of the project.
Step-by-step explanation:
When comparing projects with different lives, one should choose the project with the lowest equivalent annual cost. This concept is a part of capital budgeting, a crucial aspect of financial management that deals with the appraisal and selection of investment projects. The equivalent annual cost (EAC) method is used to compare the cost-effectiveness of projects with differing lifespans by converting their costs into an annualized value.
For example, if a company is considering three different investments with costs of $200,000, $600,000, and $400,000 respectively, and if the EAC is calculated to be the lowest for the third investment, it would be chosen over the others assuming risk and return factors are comparable. The goal is to minimize costs while achieving the desired level of benefits or outputs. Therefore, the selection of a project is not necessarily based on the total cost but rather on the cost spread over its effective life.