Chapter 7 -- Ranking Mutually Exclusive Investments

1. Chapter 7 -- Ranking 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

2. 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.

3. 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

4. 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

5. 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

6. 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