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One proposed asset gives cash flows for four years and a rival gives cash flows for six years. How are the two made comparable?
AThe longer asset is treated as sold at residual value
BThe shorter asset is extended by two more cash flows
CThe longer asset has its later cash flows discounted
DThe shorter asset is charged two extra years of cost
Answer & Solution
Correct answer: A. The longer asset is treated as sold at residual value
1. A differential analysis can only compare two proposals over the same number of years.
2. The asset with the longer run of cash flows is cut back to the shorter horizon.
3. It is assumed to be sold for its residual value in the final year of that shorter horizon.
4. Year four then carries two inflows for that asset: the operating cash flow and the residual proceeds.
5. Cash flows in years five and six are dropped from the comparison.
6. Inventing extra cash flows for the shorter asset would put figures into the analysis that nobody has forecast.
_Source: Jonick, Principles of Managerial Accounting (UNG Press, CC BY-SA 4.0), section 9.8 Capital Investment Analysis_
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