Net Present Value Method  Comparing Competing Investment Projects:
Learning Objectives:
 Compare the competing investment
projects using net present value (NPV) method.
Our examples on
net
present value (NPV) method page have involved only a single investment
alternative. We will now expand the net present value method to include two
alternatives. In addition, we will integrate the concept of the relevant
costs into the discounted cash flow analysis.
The net present value method can be used to
compare competing investment projects in two ways. One is the total cost
approach, and the other is the incremental cost approach. Each
approach is illustrated below: Total Cost Approach:
The total cost approach is the most
flexible method for comparing competing investment projects. To illustrate
the mechanics of the approach, consider the following example:
Example 1:
Harper Ferry Company provides a ferry
service across the Mississippi River. One of its small ferryboats is in poor
condition. This ferry can be renovated at an immediate cost of $200,000.
Further repairs and an overhaul of the motor will be needed five years from
now at a cost of $80,000. In all, the ferry right now is $70,000. It will
cost $300,000 each year to operate the ferry, and revenue will total
$400,000 annually. As an alternative,
Harper Ferry Company can purchase a new ferryboat at a cost of $360,000. The
new ferry will have a life of 10 years, but it will require some repairs at
the end of five years. It is estimated that these repairs will amount to
$30,000. T the end of 10 years, it is estimated that the ferry will have a
scrap value of $60,000. It will cost $210,000 each year to operate the
ferry, and revenues will total $400,000 annually. Harper Ferry Company
requires a return of at least 14% before taxes on all investment projects.
Should the company purchase the new ferry or
renovate the old ferry? Following is the solution using the total cost
approach:

New Ferry 
Old Ferry 
Annual revenues 
$400,000 
$400,000 
Annual cash operating costs 
210,000 
300,000 



Net annual cash inflows 
$190,000 
$100,000 



Item 
Year(s) 
Amount of Cash Flows 
14% Factor* 
Present Value of Cash Flows 
Buy the new
ferry: 




Initial
investment 
Now 
$(360,000) 
1.000 
$(360,000) 
Repairs
in five years 
5 
(30,000) 
0.519 
(15,570) 
Net
annual cash inflows 
1  10 
190,000 
5.216 
991,040 
Salvage
of the old ferry 
Now 
70,000 
1.000 
70,000 
Salvage
of the new ferry 
10 
60,000 
0.270 
16,200 





Net present
value 



701,670 





Keep the old ferry: 




Initial
repairs 
Now 
$(200,000) 
1.000 
(200,000) 
Repairs
in five years 
5 
(80,000) 
0.519 
(41,520) 
Net
annual cash inflows 
1  10 
100,000 
5.216 
521,600 
Salvage
of the old ferry 
10 
60,000 
0.270 
16,200 





Net present
value 



$296,280 





Net present
value in favor of buying the new ferry 



$405,390 










* All present value factors are from
Future Value and Present
Value Tables page  Table 3 and Table 4. 
Two points should be noted from the above
solution. First, observe that all cash inflows and all cash outflows are
included in the solution under each alternative. No effort has been made to
isolate those cash flows that are relevant to the decision and those that
are not relevant. The inclusion of all cash flows associated with each
alternative gives the approach its name  the total cost approach.
Second, notice that a net present value is
computed for each of the two alternatives. This is a distinct advantage of
the total cost approach in that an unlimited number of alternatives can be
compared side by side to determine the best action. or example, an other
alternative for Harper Ferry Company would be to get out of the ferry
business entirely. If management desired, the net present value of this
alternative could be computed to compare with the alternatives shown in the
solution. Still other alternatives might be open to the company. Once
management has determined the net present value of each alternative that it
wishes to consider, it can select the course of action that promises to be
the most profitable. In the case at hand, given only the two alternatives,
the data indicate that the most profitable course is to purchase the new
ferry.
The alternative with the highest net present
value is not always the best choice, although this is the best choice in
this case.
[For further
discussion about this point see
ranking investment projects page]. Incremental Cost Approach:
When only two alternatives are being
considered, the incremental cost approach offers a simpler and more direct
route to decision. Unlike the total cost approach, it focuses only on
differential costs. Technically, the
incremental cost approach is misnamed, since it focuses on differential
costs (that is, on both cost increases and cost decreases) rather than on
just on incremental costs. As used here, the term incremental costs
should be interpreted broadly to include both increases and cost decreases. The procedure is to include in the discounted cash flow
analysis only those costs and revenues that differ between the two
alternatives being considered. Example 2:
To illustrate, refer again to the data in
example 1 relating to Harper Ferry Company. The solution using only
differential costs is presented below:
Item 
Year(s) 
Amount of Cash Flows 
14% Factor* 
Present Value of Cash Flows 
Incremental
investment to buy the new ferry 
Now 
$(160,000) 
1.000 
$(160,000) 
Difference in repairs in five years 
5 
50,000 
0.519 
(25,950) 
Increase
in net
annual cash inflows 
1  10 
90,000 
5.216 
469,440 
Salvage
of the old ferry now 
Now 
70,000 
1.000 
70,000 
Difference in salvage value in ten years 
10 
0 
0.270 
0 





Net present
value in favor of buying the new ferry 



$405,390 





* All present value factors are from
Future Value and Present
Value Tables page  Table 3 and Table 4. 
Two things should be noted from the above
solution. First, notice that the net present value in favor of buying the
new ferry of $405,390 shown in the solution. agrees with the net present
value shown under the total cost approach in example 1. This agreement
should be expected, since the two approaches are just different roads to the
same destination. Second, notice that
the costs used in incremental cost approach are just differences between the
costs shown for the two alternatives in the prior example. For example the
$160,000 incremental investment required to purchase the new ferry in
example 2 in the difference between $360,000 cost of the new ferry and
$2,00,000 cost required to renovate the old ferry from example 1. The other
figures in the example 2 have been computed in the same way.
In Business

Does It Really Need to Be New?
Tom Copland, the director of Corporate
Finance Practice at the consulting firm Monitor Group. Observers: "If
they could afford it, most people would like to drive a new car.
Managers are no different . . . [I]n my experience. . . [managers]
routinely spend millions of dollars on new machines years earlier than
they need to. In most cases, the overall cost (including the cost of
breakdowns) is 30% to 40% lower if a company continues servicing an
existing machine for five more years instead of buying a new one. In
order to fight impulsive acquisition of new machinery, companies should
require unit managers to run the numbers on all alternative investment
options open to them  including maintaining the existing assets or
buying used ones."
Source: Tom Copland, "Cutting Costs
Without Drawing Blood." Harvard Business Review, September 
October 2000, pp. 37. 
