NPV Part 2 - with extra slides_1

# NPV Part 2 - with extra slides_1 - Lecture 7 Project...

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Lecture 7 Project Evaluation: Competing Projects IRR Method

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2 Evaluation of Competing Projects Through NPV Comparing projects with different lives Optimal replacement decisions
3 Comparing Projects with Different Lives (Annual equivalent or per year NPV) After you graduate from UQ, you find yourself in charge of the financial management at Werribee Safari Park The trustees ask you to make a recommendation on the purchase of a safari minibus, which will be replaced indefinitely

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4 Comparing Projects with Different Lives You are considering two vehicles: Vehicle A has an NPV of \$3,500 over a 5-year period Vehicle B has an NPV of \$5,000 over a 7-year period What are you going to recommend to the trustees? Assume a required rate of return of 6% p.a.
5 Comparing Projects with Different Lives Must compare projects over the same time frame So, we compare the annual equivalent (AE), or the annual annuity with the same NPV ( 29 89 . 830 06 . 06 . 1 1 500 , 3 = - = - 5 A AE Annuity formula! This just computes the 5 year annuity payment equivalent to \$3,500 now.

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Comparing Projects with Different Lives ( 29 68 . 895 06 . 06 . 1 1 000 , 5 = - = - 7 B AE Therefore, recommend Vehicle B. 5000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 895.68 3500 0 1 2 3 4 5 6 7 8 9 10 830.89 Project A’s – cash flows Project B’s – cash flows
7 Comparing Projects with Different Lives Principle: When evaluating competing machines that will be replaced indefinitely, choose the machine with the highest positive annual equivalent Annual equivalent is computed as the annual annuity payment over the life of the project with the same NPV as the project

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8 A Decision Tree for Evaluation of Competing Projects that are on a continuing cycle Are projects  independent? Do projects have  equal lives? Select project with  highest + NPV Yes Select all projects  with + NPV Yes Mutually exclusive No Select project with  highest NPV annual  equivalent No
9 Optimal Replacement Decisions (cost minimising replacement) You are considering replacing your business vehicle at the end of year 3, 4 or 5 You require a return of 6% p.a. on the vehicle

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10 Optimal Replacement Decisions The net cash flows associated with the running of the vehicle and salvage values are shown in the table on the next slide What is the optimal replacement decision that will minimise the cost of the vehicle to your business?
11 Optimal Replacement Decisions Year 0 1 2 3 4 5 NCF -20,000 -1,500 -3,000 -3,500 -3,700 -4,000 Salvage - 17,000 15,500 14,000 13,000 10,000 Principle : when determining the optimal replacement policy for a piece of equipment, choose the option with the lowest annual equivalent cost

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## This note was uploaded on 03/13/2010 for the course ECON econ1010 taught by Professor Margretfinch during the Three '08 term at Griffith.

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NPV Part 2 - with extra slides_1 - Lecture 7 Project...

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