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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 . NPV Is Better Than IRR.
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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
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