A company evaluates a number of investment projects each year. In the absence of a capital constraint, it will proceed with all projects with positive NPVs and reject projects with negative NPVs. However, further analysis may indicate that some of the profitable projects could be more valuable (ie have a higher NPV) if implemented in the future. It may also be related to the fact that some of the unprofitable projects may have positive net present values upon subsequent acceptance. These categories of investment projects can be shifted to different extents; some of them can be postponed to a period or two at most, while some can be done at any time in the future. While these projects are being postponed, they involve two mutually exclusive alternatives: invest now or invest later. The company should determine the optimal timing of the investment.
The timing of the investment can be a critical factor in the case of investment projects that occur occasionally and are of strategic importance to the company. Such projects cannot be postponed for long. Procrastination also creates uncertainty. For example, NPV analysis may show that a company should launch a new product in the next year. The company may still choose to launch the product this year for two reasons: The company may have a corporate strategy of remaining the leader in new product launches. If it assumes that its competitors will launch the product this year, when they don’t, it can come up with the product this year to remain the market leader. Also, due to unforeseen competition from unknown sources, the company may decide to launch the product now.
Projects with different lives
The correct way to choose between mutually exclusive projects with the same lifetime is to compare their NPVs and choose the project with a higher NPV. However, the two mutually exclusive projects being compared may have different lives. Applying the NPV rule without considering the difference in project lifetimes may not indicate the right choice. In analyzing such projects, we should answer the question: What would the company do after the short-lived project expired if it were acquired instead of the long-lived project?
Annual equivalent value method
Suppose we choose one machine from two alternative machines named X and Y. When choosing between machines with different lifetimes, we assume that each machine will be replaced in the last year of its lifetime. For analysis purposes, it can be assumed that the machines’ spare chains extend over time periods equal to the least common multiple of the machines’ lifetime.
The procedure for handling the choice of mutually exclusive projects with different lifetimes, as discussed above, can become quite cumbersome when the lifetime of the projects is very long. Fortunately, the problem can be dealt with by a simpler method. We can calculate the annual equivalent of each project’s cash flows. We select the project with the lower annual equivalent cost.