Week 10 - Firm Financial Decisions - Investment Decisions 2 Flashcards
(2 cards)
Choose between mutually exclusive alternatives
When choosing among mutually exclusive investment opportunities, pick the opportunity with the highest NPV. Do not use IRR to choose among mutually exclusive projects
→ When choosing any one project excludes us from taking the other projects we are facing mutually exclusive projects
→ Using NPV, the choice is to simply take the project which generates the highest NPV
→ Because the IRR is a measure of the expected return of investing in the project, you might be tempted to extend the IRR investment rule to the case of mutually exclusive projects by picking the project with the highest IRR. Unfortunately, picking one project over another simply because it has a larger IRR can lead to mistakes. Problems arise when the mutually exclusive investments have differences in scale (require different initial investments) and when they have different cash flow patterns
→ Even when projects have the same scale, the IRR may lead you to rank them incorrectly due to differences in the timing of cash flows. The reason for this is that the IRR is expressed as a return, but the dollar value of earning a given return - and therefore NPV - depends on how long the return is earned.
→ Consider a high-IRR project with cash flows paid back quickly. It may have a lower NPV than a project with a lower IRR who cash flows are paid back over a longer period. This sensitivity to timing is another reason why you cannot use the IRR to choose between mutually exclusive investments
Evaluate projects with different lives
When choosing among projects with different lives, you need a standard basis of comparison. First, compute an annuity with an equivalent present value to the NPV of each project. The projects can then be compared on their cost or value created per year.
