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Home Capital Budgeting Decisions Net Present Value Method - Comparing Competing Investment Projects


Net Present Value Method - Comparing Competing Investment Projects:

Learning Objectives:

  1. 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. 3-7.

You may also be interested in other articles from "capital budgeting decisions" chapter:

  1. Capital Budgeting - Definition and Explanation
  2. Typical Capital Budgeting Decisions
  3. Time Value of Money
  4. Screening and Preference Decisions
  5. Present Value and Future Value - Explanation of the Concept
  6. Net Present Value (NPV) Method in Capital Budgeting Decisions
  7. Internal Rate of Return (IRR) Method - Definition and Explanation
  8. Net Present Value (NPV) Method Vs Internal Rate of Return (IRR) Method
  9. Net Present Value (NPV) Method - Comparing the Competing Investment Projects
  10. Least Cost Decisions
  11. Capital Budgeting Decisions With Uncertain Cash Flows
  12. Ranking Investment Projects
  13. Payback Period Method for Capital Budgeting Decisions
  14. Simple rate of Return Method
  15. Post Audit of Investment Projects

  16. Inflation and Capital Budgeting Analysis
  17. Income Taxes in Capital Budgeting Decisions
  18. Review Problem 1: Basic Present Value Computations
  19. Review Problem 2: Comparison of Capital Budgeting Methods
  20. Future Value and Present Value Tables


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