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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