Chapter 7 -- Ranking Mutually Exclusive Investments

Goals

for this Chapter:

Understand

the reasons for mutually exclusive investments Know why NPV is better than IRR Understand when you would use an NPV versus an equivalent annuity when faced with unequal lives Understand the peculiarities associated with a repair versus replace decisions Be able to calculate: The best alternative when facing mutually exclusive projects an optimal abandonment

Mutually Exclusive Investments

Reasons

for mutually exclusive investments: Differences in the lives of projects Differences in the use of other scarce resources Floor space, Skilled personnel Management talent, Franchise

NPV Is Better Than IRR

Net

present value measures the wealth created today from an investment today. This is the goal of management. IRR does not account for the size of the project. If money cost 10%, it is better to earn 12% on a million dollar project than 12% on a $1,000 project. IRR ignores the length of time the money is invested. Using the example above, it may be better to earn 12% for 5 years than 14% for one year.

When to Use NPV Versus Equivalent Annuity for Projects With Unequal Lives
If

you cannot reuse the constrained resource, then maximize NPV very rare situation industrial park location or a lease If you can reuse the constrained resource, then maximize the equivalent annuity most situations in reality

Repair or Replace Decisions

In

most situations a new asset will have a longer life than an existing asset, in these cases you must use the equivalent annuity method (if the asset can be replaced) You should not net the salvage value of the old into the cost of the new, it alters the equivalent annuity -- they must be kept separate

Optimal Abandonment Decisions

Do

not ignore the salvage value in predicting cash flows Salvage value typically decreases with age When using the computer it is easier to start with the longest life first

Optimal Abandonment Decisions

If

abandonment frees up a constrained resource and replacement with a like resource is possible, then use the equivalent annuity method If you cannot replace the constrained resource with a like resource, then maximize the net present value considering future salvage values