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Real options and capital budgeting analysis

Real options and capital budgeting analysis - Capital...

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Click to edit Master subtitle style 10/2/11 Capital budgeting analysis: practical issues 11
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10/2/11 Applying the NPV to projects with unequal lives It is incorrect to compare projects with unequal lives using the NPV method. One popular remedy is to adjust the CFs of each project until they are of equal length. Example: Consider the following two projects (r = 10%) Project A Years 0 1 2 NPV CFs -1,000 750 500 95.04 Project B Years 0 1 2 3 4 NPV CFs -1,000 350 350 350 350 109.45 22
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10/2/11 Applying the NPV to projects with unequal lives Choice I: invest in project A, then invest in project A again at the end of two years Choice II: invest in project B Years 0 1 2 3 4 I invest in A -1000 750 500 Invest in A -1000 750 500 Total CFs -1000 750 -500 750 500 Invest in B CFs -1,000 350 350 350 350 33
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10/2/11 Equivalent annuity (EA)/equivalent NPV The EA is the level of annuity over the investment’s life that has a present value equal to the investment’s NPV. The investment with the highest EA will have the highest NPV of total CFs if all competing projects are repeated to infinitely or to a comparable time horizon at which the lives of all competing investments end.
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