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Page 36
36
Mutually exclusive projects
•
These are situa8ons when only one project can
be done because:
–
any one project will do the job
–
you can only have one project done
–
the resul8ng projects, if both (all) were installed
would all do the same thing
•
Cau8on: preferred alterna8ve is not necessarily
the one with the highest IRR, the INCREMENTAL
METHOD is required
•
Projects must have or be transformable to have
equal lives
Page 37
37
Incremental Analysis
•
This evaluates the diﬀerence, or the “increment” between
two or more mutually exclusive alterna8ves
•
This approach is required to correctly apply IRR (or B/C
ra8o) measures to mutually exclusive alterna8ves.
•
The steps in incremental analysis are:
1. Order alterna8ves in increasing order of FCs to insure that the
increments have cash ﬂow pa\erns corresponding to
investments
2. Calculate the economic value of the “do nothing“ alterna8ve or
the leastexpensive if donothing is not available
3. One by one evaluate each alterna8ve (challenger) against the
best alterna8ve (defender) found so far.
•
The IRRs >= MARR and the B/C >= 1 represent investments
that should be made.
Page 38
38
Incremental Analysis the Concept
•
Key principle MARR is always the default
investment
•
Goal is to make as much money as possible
Example where MARR = 8% and all lives are 10 y:
Page 39
39
Incremental Investment
•
Which investment is preferred, MARR = 70%?
•
$1 ﬁrst cost today and 2$ return in one year
•
$1000 ﬁrst cost today and $1900 return in one year
First project: 1 + 2 (P/F,i,1) = 0
(P/F,i,1) = 0.5
→
i= 100%
Second project : 1000 + 1900 (P/F,i,1) =0
(P/F,i,1) = 0.5263
→
i= 90%
Incremental investment: (10001) + (19002) (P/F,i,1) = 0
i=89.9%
IRR (incremental investment) > MARR
→
second project
should be chosen
Page 40
40
PW, AW and IRR
•
PW, AW, AC and B/C have the same reinvestment
assump8ons (we can invest at MARR any8me) and
i*
is
used as the investment rate – this is DO NOTHING
op8on
•
MARR is also the reinvestment assump8on when IRR is
used, but note that IRR is not the reinvestment rate
•
IRR uses the same interest rate as other approaches.
In PW, AW, AC and B/C
i*
appears as the interest rate.
But, for IRR calcula8ons
i*
is used as the standard for
comparison!
•
For loans, a good IRR<
i*
and for an investment IRR>
i*
•
They all use the same assump8on, and when applied
correctly, they make the same recommenda8ons
Page 41
41
More on Comparison Methods
•
Constrained Project Selec8ons
–
i.e. ranking of projects, project selec8on under
constrained budgets
–
ranking by IRR is the best method if the implied
assump8on is repeated lives
–
ranking by PW or AW only acceptable for projects with the
same life
and similar cash ﬂow structures
•
Don’t use this method, s8ck to IRR if repeated life assump8on is
valid
•
Comparing alterna8ves (assuming projects can be
repeated)
–
Easiest way is to use PW (over a common 8me horizon) if
lives are diﬀerent, use EAW or EAC
–
Can also examine IRR of increments
•
some ques8ons will have to be done with incremental analysis
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