Question

Question: The stock of “Orion S.A.” is trading €100 per share Part B Discuss upon the usage of the net present value rule in order to analyze mutually exclusive projects in the cases of: a) Postponing the investment expenditure, b) How to choose between projects with unequal lives, c) When to replace equipment? (<250 words)

Answer 1

Companies often use net present value as a capital budgeting method because it's perhaps the most insightful and useful method to evaluate whether to invest in a new capital project. It is more refined from both a mathematical and time-value-of-money point of view than either the payback period or discounted payback period methods. It is also more insightful in certain ways than the ​profitability index or internal rate of return calculations.​​

Net Present Value Decision Rules

Every capital budgeting method has a set of decision rules. For example, the payback period method's decision rule is that you accept the project if it pays back its initial investment within a given period of time. The same decision rule holds true for the discounted payback period method.

Net present value also has its own decision rules, which include the following:

• Independent projects: If NPV is greater than $0, accept the project.
• Mutually exclusive projects: If the NPV of one project is greater than the NPV of the other project, accept the project with the higher NPV. If both projects have a negative NPV, reject both projects.

a and b

In case of postponing of capital expenditure and unequal cash flow the  NPV can sometimes lead to conflicting results in the analysis of mutually exclusive projects. One reason for this potential problem is the timing of the cash flows of the mutually exclusive projects. As a result, we need to adjust for the timing issue in order to correct this problem.

There are two methods used to make the adjustments:

1. Replacement-chain method

2. Equivalent annual annuity