A Project That Will Provide Annual Cash Flows Of Investment Timing and Duration

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Investment Timing and Duration

A firm evaluates several investment projects each year. In the absence of capital shortages, it will undertake all projects with positive net present values ​​and reject those with negative net present values. However, further analysis may indicate that some profitable projects may be more valuable (ie have higher net present values) if undertaken in the future. Some unprofitable projects may have positive net present values ​​if they are accepted later. These categories of investment projects may have varying degrees of deferral; Some of them may be postponed for a period or two, while others may be undertaken at any time in the future. When those projects are postponed, two mutually exclusive options are involved: invest now or later. The company should determine the optimal timing of the investment.

The timing of investment can be an important factor in the case of those investment projects, when they occur sometime and are of strategic importance to the firm. Such projects cannot be postponed for long. Postponement also creates uncertainty. For example, net present value analysis may indicate that the firm should introduce a new product next year. A firm may still decide to introduce a product this year for two reasons: The firm may have a corporate strategy to introduce new products. If its competitors are expected to introduce the product this year, if not, it can come out with the product this year to be the market leader. Also a firm may decide to introduce a product now because of unexpected competition from an unknown class.

Projects with different lives

The correct way to choose between mutually exclusive projects with equal lives is to compare their net present values ​​and choose the project with the higher net present value. Two mutually exclusive projects are being compared, however, their lives may be different. Application of the net present value rule without accounting for the difference in the life of the projects may fail to indicate the correct choice. When analyzing such projects, we must answer the question: What will the company do after the short-term project expires if it is acquired instead of a long-term project?

Annual Equivalent Value Method

Assume that we are going to choose a machine from two alternative machines named X and Y. In choosing between machines with different lives, we will assume that each machine is replaced in the last year of its life. For analysis purposes, machine replacement chains can be extended to a period equal to at least a common multiple of the machine life.

As discussed above, the method of handling the selection of mutually exclusive projects with different lives can become quite difficult if the projects have very long lives. Fortunately, the problem can be dealt with in a simple way. We can calculate the annual equivalent value of each project’s cash flows. We will choose the project with lower annual equivalent cost.

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