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Principles of Finance

16.5 Choosing between Projects

Principles of Finance16.5 Choosing between Projects

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Choose between mutually exclusive projects.
  • Compare projects with different lives.
  • Compare projects of different scales.
  • Rank projects when resources are limited.

So far, we have considered methods for deciding to accept or to reject a single stand-alone project. Sometimes, managers must make decisions regarding which of two projects to accept, or a company might be faced with a number of good, acceptable projects and have to decide which of those projects to take on during the current year.

Choosing between Mutually Exclusive Projects

Earlier in this chapter, we saw that the embroidery machine that Sam’s Sporting Goods was considering had a positive NPV, making it a project that Sam’s should accept. However, another, more expensive embroidery machine may be available that is able to make more stitches per minute. Although the initial cost of this heavy-duty machine is higher, it would allow Sam’s to embroider and sell more items each year, generating more revenue. The two embroidery machines are mutually exclusive projects. Mutually exclusive projects compete with one another; purchasing one embroidery machine excludes Sam’s from purchasing the other embroidery machine.

Table 16.11 shows the cash outflow and inflows expected from the original embroidery machine considered as well as the heavy-duty machine. The heavy-duty machine costs $25,000, but it will generate more cash inflows in years 3 through 6. Both machines have a positive NPV, leading to decisions to accept the projects. Also, both machines have an IRR exceeding the company’s 9% cost of raising capital, also leading to decisions to accept the projects.

When considered by themselves, each of the machines is a good project for Sam’s to pursue. The question the managers face is which is the better of the two projects. When faced with this type of decision, the rule is to take the project with the highest NPV. Remember that the goal is to choose projects that add value to the company. Because the NPV of a project is the estimate of how much value it will create, choosing the project with the higher NPV is choosing the project that will create the greater value.

Year 0 1 2 3 4 5 6 NPV IRR
Regular Machine ($) (16,000) 2,000 4,000 5,000 5,000 5,000 5,000 2,835.62 14.10%
Heavy-Duty Machine ($) (25,000) 2,000 4,000 8,000 9,000 9,000 9,000 3,970.67 13.20%
Table 16.11

Choosing between Projects with Different Lives

Suppose you are considering starting an ice-cream truck business. You find that you can purchase a used truck for $50,000. You estimate that the truck will last for three years, and you will be able to sell enough ice cream treats to generate a cash inflow of $40,000 during each of those years. Your cost of capital is 10%. The positive NPV of $49,474 for the project makes this an acceptable project.

Another ice-cream truck is also for sale for $50,000. This truck is smaller and will not be able to hold as many frozen treats. However, the truck is newer, with lower mileage, and you estimate that you can use it for six years. This newer truck will allow you to generate a cash inflow of $30,000 each year for the next six years. The NPV of the newer truck is $80,658.

Because both trucks are acceptable projects but you can only drive one truck at a time, you must choose which truck to purchase. At first, it may be tempting to purchase the newer, lower-mileage truck because of its higher NPV. Unfortunately, when comparing two projects that have different lives, a decision cannot be made simply by comparing the NPVs. Although the ice-cream truck with the six-year life span has a much higher NPV than the larger truck, it consumes your resources for a long time.

There are two methods for comparing projects with different lives. Both assume that when the short-life project concludes, another, similar project will be available.

Replacement Chain Approach

With the replacement chain approach, as many short-life projects as necessary are strung together to equal the life of the long-life project. You can purchase the newer, lower-mileage ice-cream truck and run your business for six years. To make a comparison, you assume that if you purchase the larger truck that will last for three years, you will be able to repeat the same project, purchasing another larger truck that will last for the next three years. In essence, you are comparing a six-year project with two consecutive three-year projects so that both options will generate cash inflows for six years. Your timeline for the projects (comparing an older, larger truck with a newer, lower-mileage truck) will look like Table 16.12:

Year 0 1 2 3 4 5 6
Older Truck ($) ($50,000) 40,000 40,000 40,000 40,000 40,000 40,000
Older Truck ($)       (50,000)      
               
Newer Truck ($) (50,000) 30,000 30,000 30,000 30,000 30,000 30,000
Table 16.12

The present values of all of the cash inflows and outflows from purchasing two of the older, larger trucks consecutively are added together to find the NPV of that alternative. The NPV of this alternative is $86,645, which is higher than the NPV of $80,658 of the newer truck, as shown in Table 16.13:

Year 0 1 2 3 4 5 6
Older Truck ($)   40,000 40,000 40,000 40,000 40,000 40,000
Older Truck ($)       (50,000)      
Net Present Value (50,000) 36,363.64 33,057.85 (7,513.15) 27,320.54 24,836.85 22,578.96

 

NPV=$86,644.69NPV=$86,644.69
Table 16.13

When using the replacement chain approach, the short-term project is repeated any number of times to equal the length of the longer-term project. If one project is 5 years and another is 20 years, the short one is repeated four times. This method can become tedious when the length of the longer project is not a multiple of the shorter project. For example, when choosing between a five-year project and a seven-year project, the short one would have to be duplicated seven times and the long project would have to be repeated five times to get to a common length of 35 years for the two projects.

Equal Annuity Approach

The equal annuity approach assumes that both the short-term and the long-term projects can be repeated forever. This approach involves the following steps:

Step 1: Find the NPV of each of the projects.

  • The NPV of the larger, older ice-cream truck is $49,474.
  • The NPV of the smaller, newer ice-cream truck is $80,658.

Step 2: Find the annuity that has the same present value as the NPV and the same number of periods as the project.

  • For the larger, older ice-cream truck, we want to find the three-year annuity that would have a present value of $49,474 when using a 10% discount rate. This is $19,894.
  • For the smaller, newer ice-cream truck, we want to find the six-year annuity that would have a present value of $80,658 when using a 10% discount rate. This is $18,520.

Step 3: Assume that these projects, or similar projects, can be repeated over and over and that these annuities will continue forever. Calculate the present value of these annuities continuing forever using the perpetuity formula.

PVLargerTruck = $19,8940.10=$198,940PVSmallerTruck = $18,5200.10=$185,200PVLargerTruck = $19,8940.10=$198,940PVSmallerTruck = $18,5200.10=$185,200

We again find that the older, larger truck is preferred to the newer, smaller truck.

These methods correct for unequal lives, but managers need to be aware that some unavoidable issues come up when these adjustments are made. Both the replacement chain and equal annuity approaches assume that projects can be replicated with identical projects in the future. It is important to note that this is not always a reasonable assumption; these replacement projects may not exist. Estimating cash flows from potential projects is prone to errors, as we will discuss in Financial Forecasting these errors are compounded and become more significant as projects are expected to be repeated. Inflation and changing market conditions are likely to result in cash flows varying in the future from our predictions, and as we go further into the future, these changes are potentially greater.

Choosing Projects When Resources Are Limited

Choosing positive NPV projects adds value to a company. Although we often assume that the company will choose to pursue all positive NPV projects, in reality, managers often face a budget that restricts the amount of capital that they may invest in a given time period. Thus, managers are forced to choose among several positive NPV projects. The goal is to maximize the total NPV of the firm’s projects while remaining within budget constraints.

For example, suppose Southwest Manufacturing is considering the seven projects displayed in Table 16.14. Each of the projects has a positive NPV and would add value to the company. The firm has a budget of $200 million to put toward new projects in the upcoming year. Doing all seven of the projects would require initial investments totaling $430 million. Thus, although all of the projects are good projects, Southwest Manufacturing cannot fund them all in the upcoming year and must choose among these projects. Southwest Manufacturing could choose the combination of Projects A and D; the combination of Projects B, C, and E; or several other combinations of projects and exhaust its $200 million investment budget.

Project NPV ($Millions) Initial Investment ($Millions) Profitability Index Cumulative Investment Required ($Millions)
A 60 150 1.40 150
B 25 100 1.25 250
C 10 70 1.14 320
D 15 50 1.30 370
E 11 30 1.37 400
F 7 20 1.35 420
G 2 10 1.20 430
Table 16.14 Projects Being Considered by Southwest Manufacturing

To decide which combination results in the largest added NPV for the company, rank the projects based on their profitability index, as is done in Table 16.15. Projects A, E, and F should be chosen, as they have the highest profitability indexes. Because those three projects require a cumulative investment of $200 million, none of the remaining projects can be undertaken at the present time. Doing those three projects will add $78 million in NPV to the firm. Out of this set of choices, there is no combination of projects that is affordable given Southwest Manufacturing’s budget that would add more than $78 million in NPV.

Project NPV ($Millions) Initial Investment ($Millions) Profitability Index Cumulative Investment Required ($Millions)
A 60 150 1.40 150
E 11 30 1.37 180
F 7 20 1.35 200
D 15 50 1.30 250
B 25 100 1.25 350
G 2 10 1.20 360
C 10 70 1.14 430
Table 16.15 Projects Ranked by Profitability Index

Notice that when choices must be made among projects, the decision cannot be made by simply ranking the projects from highest to lowest NPV. Project D has an NPV of $15 million, which is higher than both the $11 million of Project E and the $7 million of Project F. However, Project D requires $50 million for an initial investment. For the same $50 million of investment funds, Southwest Manufacturer can accept both Projects E and F for a total NPV of $18 million. Investment capital is a scare resource for this company. By ranking projects based on their profitability index, the company is able to determine the best way to allocate its scarce capital for the largest potential increase in NPV.

Concepts In Practice

Capital Budgeting Challenges

Although the basic techniques of project evaluation are straightforward, real-world capital budgeting decisions are complex and multifaceted. The goal of capital budgeting is to choose the projects that will bring the most value to the shareholders of the company. The NPV rule provides a clear, concise criterion for which projects will bring value to the shareholders. It is important to remember, however, that all of the project valuation calculations are based on projected cash flows. These projected cash flows are estimates, based on the best educated guesses that a company makes about its business opportunities over the next few years. Because no company has a crystal ball that can predict the future, its calculation of NPV is an estimate of what it expects.

Think, for example, of an oil company deciding whether to drill for oil. The project will require expenditures on equipment, land, and other items. The cash inflows will depend on the likelihood of oil being found, the quantity of oil produced by the well, and the price at which the oil can be sold. If a company estimates that oil will sell for $100 per barrel during the next few years, the project will have a much higher NPV than if the company estimates that oil will sell for only $50 per barrel.

A project that has a positive NPV and is accepted when a company is planning how to allocate its capital toward investments may end up being a bad project that the company wishes it had avoided if the future is much different from what it projected. Managers must stay attuned to economic developments and reevaluate capital budgeting decisions when significant changes occur. In spring 2020, managers around the globe were faced with a dramatically changing economic environment amid a pandemic. Oil companies, for example, saw oil prices drop from over $50 per barrel at the beginning of March to under $15 per barrel by the end of April.

Footnotes

  • 2David Filipov. “Russia Spent $50 Billion on the Sochi Olympics. It Might Actually Have Been Worth It.” Washington Post, November 15, 2017. https://www.washingtonpost.com/world/europe/that-sochi-olympic-boondoggle-russians-say-all-the-investment-is-paying-off/2017/11/13/65014bd0-b82c-11e7-9b93-b97043e57a22_story.html
  • 3Tom Brinded, Zak Cutler, Erikhans Kok, and Prakash Parbhoo. “Resetting Capital Spending in the Wake of COVID-19.” McKinsey & Company. June 25, 2020. https://www.mckinsey.com/business-functions/operations/our-insights/resetting-capital-spending-in-the-wake-of-covid-19
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