Comparative Investment Problems ©Dr. Bradley C. Paul 2002

Types of Engineering Econ Problems Invest and Earn –Evaluates one cash flow or project at a time –Objective is to determine whether the investment achieves the desired return Usually money pot is located at time zero Sweep the cash flow into the pot and get an NPV Trying to determine whether project achieved desired rate of return –If it did NPV will be 0 or positive

Invest and Earn Variation Concern is for a future event or monetary need –Money sweeps to the future to determine whether you accumulate the money needed for a future event –May take the form of a NFV (Net Future Value) –Success criteria is normally whether you have the right amount of money for the future event

Many times we want to compare projects or investments Invest and Earn Techniques are not designed for comparing – they determine whether a project meets a required return All Cost Alternatives Problem –Comparing things that cost money but the fact that you must do something has been decided –NPVs will be negative Walking away is usually not an option because decision to do something has been made –Objective is to perform required task in the most cost effective manner

Solving All Cost Alternatives Two major techniques –Do NPVs and select the one that looses the least amount of money Can be very unpalatable NPVs are vulnerable to project scale – can lead you into mistakes –Pick your favorite alternative – subtract the other from it and get a new cash flow Treat the new cash flow as an invest and earn problem If you made the right choice NPV will be zero or better

Problems with Subtraction Technique If you have a large number of alternatives to compare –Subtraction technique does two at a time Response to problem –Easy one – Do an NPV to screen for the most competitive choices Then use the subtraction technique on the best choices –Set up a single elimination tournament like an NCAA Basket Ball Tournament May be enough work to give new meaning to March Madness

The Competing Investments Problem Many companies evaluate more projects than they actually have money for –Your boss asks you to do a design for something - you bring it to your boss - he smiles thanks you says it looks good - and then doesn’t put it in the budget Companies may not consider opportunities that don’t make required return –All alternatives that make return are not guaranteed investments

More Competing Investments Some investments are mutually exclusive –if you build your new Zebra24 auto plant in DeSoto, you may not be able to build it in Nashville What do you do when you have a bunch of invest and earn problems competing for the same space?

Ideas Need to recognize that Discounted Cash Flow Analysis may be a requirement to be a competing alternative - it isn’t necessarily the final say

New Issues Appear With types of problems done so far there is a right answer –Investment is or is not good –Alternative A is or is not more cost effective than alternative B The nasty with Comparative Investments is that what it means to maximize wealth is not always as simple as counting money

Comparative Investments Technique #1 Do an NPV on the cash flow and pick the one with the best NPV –Problem is NPV is project scale sensitive Is a project needing a 10 million dollar investment and having an NPV of 2 million a better investment than A project needing a $50,000 investment and having an NPV of 1 million dollars –Unless your firm is very sensitive to the number of projects picking the biggest projects with good NPV is not necessarily the best choice Subtraction technique that worked for all cost alternatives has same scale problem

The Value of Different Measures IRR measures the rate of return on money invested PVR measures the dollars of return for dollars invested Both measures indicate monetary efficiency Possible Solution –Do IRRs or PVRs on the cash flows and pick the most monetarily efficient projects