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Choosing between Two Projects

It has been several years since your office last upgraded its office networking software. Two competing systems have been proposed. Both have an expected useful life of 3 years, at which point it will be time for another upgrade. One proposal is for an expensive cutting-edge system, which will cost $800,000 and increase firm cash flows by $350,000 a year through increased productivity. The other proposal is for a cheaper, somewhat slower system. This system would cost only $700,000 but would increase cash flows by only $300,000 a year. If the cost of capital is 7 percent, which is the better option?

The following table summarizes the cash flows and the NPVs of the two proposals:

Cash Flows, Thousands of Dollars

System C0 C1 C2 C3 NPV at 7%

Faster 800 +350 +350 +350 +118.5

Slower 700 +300 +300 +300 + 87.3

In both cases, the software systems are worth more than they cost, but the faster system would make the greater contribution to value and therefore should be your preferred choice.

Mutually exclusive projects, such as our two proposals to update the networking system, involve a project interaction, since taking one project forecloses the other. Unfortunately, not every project interaction is so simple to evaluate as the choice between the two networking projects, but we will explain how to tackle three important decisions:

The investment timing decision. Should you buy a computer now or wait and think again next year? (Here today s investment is competing with possible future investments.)

The choice between long- and short-lived equipment. Should the company save money today by installing cheaper machinery that will not last as long? (Here today s decision would accelerate a later investment in machine replacement.)

The replacement decision. When should existing machinery be replaced? (Using it another year could delay investment in machine replacement.)

INVESTMENT TIMING

Let us return to Example 1, where Obsolete Technologies was contemplating the purchase of a new computer system. The proposed investment has a net present value of almost $20,000, so it appears that the cost savings would easily justify the expense of the system. However, the financial manager is not persuaded. She reasons that the price of computers is continually falling and therefore proposes postponing the purchase, arguing that the NPV of the system will be even higher if the firm waits until the following year. Unfortunately, she has been making the same argument for 10 years and the company is steadily losing business to competitors with more efficient systems. Is there a flaw in her reasoning?

This is a problem in investment timing. When is it best to commit to a positive-NPV investment? Investment timing problems all involve choices among mutually exclusive investments. You can either proceed with the project now, or you can do so later. You can t do both.

Table 4.2 lays out the basic data for Obsolete. You can see that the cost of the computer is expected to decline from $50,000 today to $45,000 next year, and so on. The new computer system is expected to last for 4 years from the time it is installed. The present value of the savings at the time of installation is expected to be $70,000. Thus if Obsolete invests today, it achieves an NPV of $70,000 $50,000 = $20,000; if it invests next year, it will have an NPV of $70,000 $45,000 = $25,000. Isn t a gain of $25,000 better than one of $20,000? Well, not necessarily you may prefer to be $20,000 richer today rather than $25,000 richer next year. The better choice depends on the cost of capital. The fourth column of Table 4.2 shows the value today (Year 0) of those net present values at a 10 percent cost of capital. For example, you can see that the discounted value of that $25,000 gain is $25,000/1.10 = $22,700. The financial manager has a point. It is worth postponing investment in the computer, but it should not be postponed indefinitely. You maximize net present value today by buying the computer in Year 3.

Notice that you are involved in a trade-off. The sooner you can capture the $70,000 savings the better, but if it costs you less to realize those savings by postponing the investment, it may pay you to do so. If you postpone purchase by 1 year, the gain from buying a computer rises from $20,000 to $25,000, an increase of 25 percent. Since the cost of capital is only 10 percent, it pays to postpone at least until Year 1. If you postpone from Year 3 to Year 4, the gain rises from $34,000 to $37,000, a rise of just under 9 percent. Since this is less than the cost of capital, it is not worth waiting any longer.

The decision rule for investment timing is to choose the investment date that results in the highest net present value today.