Comparative Comparative Investment ProblemsInvestment Problems

©Dr. Bradley C. Paul 2002 revisions 2009©Dr. Bradley C. Paul 2002 revisions 2009

Note – The concepts covered in these slides can be found in most Note – The concepts covered in these slides can be found in most Engineering Economics and discounted cash flow texts no one of which Engineering Economics and discounted cash flow texts no one of which was specifically referenced for this material. The material in these slides was specifically referenced for this material. The material in these slides is regarded by the author to be common knowledge to those with is regarded by the author to be common knowledge to those with expertise in the field.expertise in the field.

Types of Engineering Types of Engineering Econ ProblemsEcon Problems

Invest and EarnInvest and Earn Evaluates one cash flow or project at a timeEvaluates one cash flow or project at a time Objective is to determine whether the Objective is to determine whether the

investment achieves the desired returninvestment achieves the desired return Usually money pot is located at time zeroUsually money pot is located at time zero Sweep the cash flow into the pot and get an NPVSweep the cash flow into the pot and get an NPV Trying to determine whether project achieved Trying to determine whether project achieved

desired rate of returndesired rate of return If it did NPV will be 0 or positiveIf it did NPV will be 0 or positive

Invest and Earn VariationInvest and Earn Variation

Concern is for a future event or monetary Concern is for a future event or monetary needneed Money sweeps to the future to determine Money sweeps to the future to determine

whether you accumulate the money needed whether you accumulate the money needed for a future eventfor a future event

May take the form of a NFV (Net Future May take the form of a NFV (Net Future Value)Value)

Success criteria is normally whether you Success criteria is normally whether you have the right amount of money for the have the right amount of money for the future eventfuture event

Backwards SolutionsBackwards Solutions

You may want to know what series of You may want to know what series of payments will repay an investor at a desired payments will repay an investor at a desired rate of return for an initial investmentrate of return for an initial investment Initial investment * A/PInitial investment * A/P

You may want to know what series of savings You may want to know what series of savings will guarantee a future sum of money at a given will guarantee a future sum of money at a given rate of returnrate of return Final amount * A/FFinal amount * A/F

Many times we want to Many times we want to compare projects or compare projects or investmentsinvestments

Invest and Earn Techniques are not designed Invest and Earn Techniques are not designed for comparing – they determine whether a for comparing – they determine whether a project meets a required returnproject meets a required return

All Cost Alternatives ProblemAll Cost Alternatives Problem Comparing things that cost money but the fact that Comparing things that cost money but the fact that

you must do something has been decidedyou must do something has been decided NPVs will be negativeNPVs will be negative

Walking away is usually not an option because decision to Walking away is usually not an option because decision to do something has been madedo something has been made

Objective is to perform required task in the most Objective is to perform required task in the most cost effective mannercost effective manner

Solving All Cost Solving All Cost AlternativesAlternatives

Two major techniquesTwo major techniques Do NPVs and select the one that looses the least Do NPVs and select the one that looses the least

amount of moneyamount of money Can be very unpalatableCan be very unpalatable NPVs are vulnerable to project scale – can lead you into NPVs are vulnerable to project scale – can lead you into

mistakesmistakes

Pick your favorite alternative – subtract the other Pick your favorite alternative – subtract the other from it and get a new cash flowfrom it and get a new cash flow Treat the new cash flow as an invest and earn problemTreat the new cash flow as an invest and earn problem If you made the right choice NPV will be zero or betterIf you made the right choice NPV will be zero or better

Problems with Problems with Subtraction TechniqueSubtraction Technique

If you have a large number of alternatives to If you have a large number of alternatives to comparecompare Subtraction technique does two at a timeSubtraction technique does two at a time

Response to problemResponse to problem Easy one – Do an NPV to screen for the most Easy one – Do an NPV to screen for the most

competitive choicescompetitive choices Then use the subtraction technique on the best choicesThen use the subtraction technique on the best choices

Set up a single elimination tournament like an NCAA Set up a single elimination tournament like an NCAA Basket Ball TournamentBasket Ball Tournament May be enough work to give new meaning to March May be enough work to give new meaning to March

MadnessMadness

The Competing The Competing Investments ProblemInvestments Problem

Many companies evaluate more projects than Many companies evaluate more projects than they actually have money forthey actually have money for Your boss asks you to do a design for something - Your boss asks you to do a design for something -

you bring it to your boss - he smiles thanks you says you bring it to your boss - he smiles thanks you says it looks good - and then doesn’t put it in the budgetit looks good - and then doesn’t put it in the budget

Companies may not consider opportunities that Companies may not consider opportunities that don’t make required returndon’t make required return All alternatives that make return are not guaranteed All alternatives that make return are not guaranteed

investmentsinvestments

More Competing More Competing InvestmentsInvestments

Some investments are mutually exclusiveSome investments are mutually exclusive if you build your new Zebra24 auto plant in if you build your new Zebra24 auto plant in

DeSoto, you may not be able to build it in DeSoto, you may not be able to build it in NashvilleNashville

What do you do when you have a bunch What do you do when you have a bunch of invest and earn problems competing of invest and earn problems competing for the same space?for the same space?

IdeasIdeas

Need to recognize that Discounted Cash Need to recognize that Discounted Cash Flow Analysis may be a requirement to Flow Analysis may be a requirement to be a competing alternative - it isn’t be a competing alternative - it isn’t necessarily the final saynecessarily the final say

New Issues AppearNew Issues Appear

With types of problems done so far there is With types of problems done so far there is a right answera right answer Investment is or is not goodInvestment is or is not good Alternative A is or is not more cost effective Alternative A is or is not more cost effective

than alternative Bthan alternative B

The nasty with Comparative Investments is The nasty with Comparative Investments is that what it means to maximize wealth is that what it means to maximize wealth is not always as simple as counting moneynot always as simple as counting money

Three Schools of ThoughtThree Schools of Thought

You become wealthiest by picking the projects You become wealthiest by picking the projects that make the most moneythat make the most money Make as much money as possible on X number of Make as much money as possible on X number of

investmentsinvestments You become wealthiest by picking the projects You become wealthiest by picking the projects

that give you the most in return for the dollars that give you the most in return for the dollars you invest.you invest.

You become wealthiest by having the most You become wealthiest by having the most dollars by the time you get to the target point in dollars by the time you get to the target point in the future.the future.

No they are not all the same thing.No they are not all the same thing.

Comparative Investments Comparative Investments Technique #1Technique #1

Do an NPV on the cash flow and pick the one Do an NPV on the cash flow and pick the one with the best NPVwith the best NPV Problem is NPV is project scale sensitiveProblem is NPV is project scale sensitive

Is a project needing a 10 million dollar investment and Is a project needing a 10 million dollar investment and having an NPV of 2 million a better investment thanhaving an NPV of 2 million a better investment than

A project needing a $50,000 investment and having an NPV A project needing a $50,000 investment and having an NPV of 1 million dollarsof 1 million dollars

Unless your firm is very sensitive to the number of Unless your firm is very sensitive to the number of projects picking the biggest projects with good NPV is projects picking the biggest projects with good NPV is not necessarily the best choicenot necessarily the best choice

Subtraction technique that worked for all cost Subtraction technique that worked for all cost alternatives has same scale problemalternatives has same scale problem

What If You Are Bang for What If You Are Bang for the Buck Investing?the Buck Investing?

Obviously NPV is scale sensitive and won’t Obviously NPV is scale sensitive and won’t work.work.

IRR measures the rate of return on money IRR measures the rate of return on money investedinvested

PVR measures the dollars of return for PVR measures the dollars of return for dollars invested dollars invested

Both measures indicate monetary efficiencyBoth measures indicate monetary efficiency Possible SolutionPossible Solution

Do IRRs or PVRs on the cash flows and pick the most Do IRRs or PVRs on the cash flows and pick the most monetarily efficient projectsmonetarily efficient projects

Last School of ThoughtLast School of Thought

Put the series of investment events and Put the series of investment events and earnings down from now until the some earnings down from now until the some future date of interestfuture date of interest Then do a NFVThen do a NFV

NoteNote

People who said pick me projects that make the most People who said pick me projects that make the most money did NPVmoney did NPV

People who said pick me projects that give the most People who said pick me projects that give the most bang for the buck did IRR and PVRbang for the buck did IRR and PVR

People who said make sure you are the richest when People who said make sure you are the richest when the fat lady sings did NFVthe fat lady sings did NFV

If you have one good project and a bunch of dogsIf you have one good project and a bunch of dogs You will normally get the same answer no matter what you doYou will normally get the same answer no matter what you do

If you are picking between good projects then different If you are picking between good projects then different measures will give different answers (and actually measures will give different answers (and actually respond to differences in what exactly you mean by respond to differences in what exactly you mean by make me the richest)make me the richest)

Now Its Your TurnNow Its Your Turn

Do Homework #10Do Homework #10 Manager of a large electric utility Manager of a large electric utility

company that is deciding what type of company that is deciding what type of power plant to buildpower plant to build You will need to consider which of the 3 You will need to consider which of the 3

strategies best suits the companystrategies best suits the company Then compare the investments and make a Then compare the investments and make a

pick.pick.