A firm evaluates a number of investment projects every year. In the absence of a capital constraint, it will undertake all those projects, which have positive net present values and reject those, which have negative net present values. Further analysis may, however, indicate that some of the profitable projects may be more valuable (that is, they may have higher net present values) if undertake in the future. If may also be related that some of the unprofitable projects may yield positive net present values if they are accepted later on. These categories of investment projects may have different degrees of postponed; some of them may be postponed at the most to one or two periods, while a few may be undertaken any time in future. Those projects, while are postponed, involve two mutually exclusive alternatives: undertake investment now, or later. The firm should determine the optimum timing of investment.
The timing of investment may be a critical factor in case of those investment projects, while occur once in a while and those, while are of strategic importance to the firm. Such projects cannot be deferred for long. Postponed also creates uncertainty. For example, the net present value analysis may show that a firm should introduce a new product next year. The firm may still decide to introduce the product this year for two reasons: The firm may have a corporate strategy of remaining market leader in introducing new products. If it anticipates that its competitors will introduce the product this year if it does not, it may come up with the product this year to remain the market leader. Also for the reason of unanticipated competition from unknown quarters the firm may decide to introduce the product now.
Projects with Different Lives
The correct way of choosing between mutually exclusive projects with the same lives is to compare their net present values, and choose the project with a higher net present value. The two mutually exclusive projects being compared, however, may have different lives. The use of the net present value rule without accounting for the difference in the projects’ lives may fail to indicate correct choice. In analyzing such projects, we should answer the question: what would the firm do after the expiry of the short-lived project if it were acquired instead of the long-lived project?
Annual equivalent value method
Assume we are going to choose one machine from two alternative machines called X and Y. In a choice between machines with different lives, we assume that each machine replaced in the last year of its life. For the purpose of analysis, the replacement chains of the machines can be assumed to extend to the periods of time equal to the least common multiple of the lives of the machines.
The method for handling the choice of the mutually exclusive projects with different lives, as discussed above, can become quite cumbersome if the projects’ lives are very long. The problem fortunately can be handled by a simper method. We can calculate the annual equivalent value of cash flows of each project. We shall select the project that has lower annual equivalent cost.