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Chap6

Chap6

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CHAPTER 6
PROJECT INTERACTIONS, SIDE COSTS AND SIDE BENEFITS

In much of our discussion so far, we have assessed projects independently of other projects that the firm already has or might have in the future. Disney, for instance, was able to look at the theme park investment and analyze whether it was a good or bad investment. In reality, projects at most firms have interdependencies with and consequences for other projects. Disney may be able to increase both movie and merchandise revenues because of the new theme park in Bangkok and may face higher advertising expenditures because of its Asia expansion.

In this chapter, we examine a number of scenarios in which the consideration of one project affects other projects. We start with the most extreme case, where investing in one project leads to the rejection of one or more other projects; this is the case when firms have to choose between mutually exclusive investments. We then consider a less extreme scenario, where a firm with constraints on how much capital it can raise considers a new project. Accepting this project reduces the capital available for other projects that the firm considers later in the period and thus can affect their acceptance; this is the case of capital rationing.

Projects can create costs for existing investments by using shared resources or excess capacity, and we consider these side costs next. Projects sometimes generate benefits for other projects, and we analyze how to bring these benefits into the analysis. In the final part of the chapter, we introduce the notion that projects often have options embedded in them, and that ignoring these options can result in poor project decisions.

Mutually Exclusive Projects

Projects are mutually exclusive when only one of the set of projects can be accepted by a firm. Projects may be mutually exclusive for different reasons. They may each provide a way of getting a needed service, but any one of them is sufficient for the service. The owner of a commercial building may be choosing among a number of different air-conditioning or heating systems for a building. Or, projects may provide alternative approaches to the future of a firm; a firm that has to choose between a \u201chigh-

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margin, low volume\u201d strategy and a \u201clow-margin, high-volume\u201d strategy for a product
can choose only one of the two.

In choosing among mutually exclusive projects, we continue to use the same rules we developed for analyzing independent projects. The firm should choose the project that adds the most to its value. While this concept is relatively straightforward when the projects are expected to generate cash flows for the same number of periods (have the same project life), as you will see, it can become more complicated when the projects have different lives.

Projects with Equal Lives

When comparing projects with the same lives, a business can make its decision in one of two ways. It can compute the net present value of each project and choose the one with the highest positive net present value (if the projects generate revenue) or the one with the lowest negative net present value (if the projects minimize costs). Alternatively, it can compute the differential cash flow between two projects and base its decision on the net present value or the internal rate of return of the differential cash flow.

Comparing Net Present Values

The simplest way of choosing among mutually exclusive projects with equal lives is to compute the net present values of the projects and choose the one with the highest net present value. This decision rule is consistent with firm value maximization.

Illustration 6.1: Mutually Exclusive Cost Minimizing Projects with equal lives

Bookscape is choosing between alternative vendors who are offering phone systems. Both systems have 5-year lives, and the appropriate cost of capital is 10% for both projects. Figure 6.1 summarizes the expected cash outflows on the two investments:

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Figure 6.1: Cash Flows on Phone Systems
-$ 8000
-$ 8000
-$ 8000
-$ 8000
-$ 8000
-$20,000
-$ 3000
-$ 3000
-$ 3000
-$ 3000
$ 3000
-$30,000
Vendor 1: Less Expensive System
Vendor 2: More Expensive System
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5
0
1
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The more expensive system is also more efficient, resulting in lower annual costs. The
net present values of these two systems can be estimated as follows \u2013
Net Present Value of Less Expensive System = - $20,000 - $8,000 [PV(A,10%,5 years)]
= - $50,326
Net Present Value of More Expensive System = - $30,000 - $3,000 [PV(A,10%,5 years)]
= - $41,372
The net present value of all costs is much lower with the second system making it the
better choice.
Differential Cash Flows

An alternative approach for choosing between two mutually exclusive projects is to compute the difference in cash flows each period between the two investments being compared. Thus, if A and B are mutually exclusive projects with estimated cash flows over the same life time (n), the differential cash flows can be computed as shown in Figure 6.2.

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