April 2024

Assume you have two mutually exclusive investing opportunities with differing cash flows, Net Present Values (NPVs) and Rates of Return (ROR).  Project A offers a 25% ROR and Project B offers a 15% ROR.   Your job is to choose which project is the best investment for your company.  While a higher ROR seems like a simple justification for choosing one project opportunity over the other, a cash flow model is invaluable to make a fully informed decision.

 

The following cash flow models lay out the individual cash flows for each project.  Assume a minimum ROR of 10%.

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Choosing projects based on ROR is common industry practice; given our minimum ROR of 10%, it seems obvious that a higher ROR of 25% is a clear winner!  However, if you make decisions based on NPV, you would choose Project B with the higher NPV at $4,583.  The two most common economic criterion are not in agreement, so which one should you rely on to make an economic decision?

 

The short answer is you can use both, but only if an incremental model is made.  An incremental model should be structured to evaluate the economic value of the additional money invested in a more capital-intensive alternative.  The incremental analysis forces you to ask where the $25,000 ($35,000-$10,000) might be invested if you don’t go with Project B.  If you go with the smaller investment associated with Project A, the baseline assumption is the extra $25,000 will go into other projects earning a 10% minimum ROR and a zero NPV.   What if the extra $25,000 was put into the larger capital investment  Project B?

 

 

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By taking the difference between the two options, you can see that the extra $25,000 should be invested in Project B and not in other investment opportunities at 10%.  Additionally, by investing in Project B, you are creating $488 dollars of value, even though it has a smaller ROR of 15%.

 

Let me address two rebuttals that we often get in response to the above scenario.  You might be thinking that undertaking three versions of Project A would be most beneficial to your company for the money you have to invest.  However, the projects would no longer be considered mutually exclusive.  They would fall under the Non-Mutually Exclusive Rules for project evaluation where more than one project can be selected.  You may also be considering an option to find a project to invest the extra money at, say, 20%.  Economic models are only as good as our assumptions going into them.  The motto “garbage in, garbage out” comes to mind.   The minimum ROR should reflect the other opportunities you have now and in the future.  If 20% is your minimum ROR, then it is necessary to re-evaluate these mutually exclusive alternatives at 20%.   For the assumed higher minimum ROR of 20%, Project B is undesirable with only a 15% ROR, leaving Project A as the desired opportunity.  

 

In the end, it’s important to remember that we should never compare two project ROR’s head-to-head to make a mutually exclusive decision.  When properly developed, an incremental evaluation will cause all criterion, including ROR, NPV, and ratios, to reach the same economic conclusion. 

 

Economic evaluations such as this one are vital to the success of your business and financial well-being. If you haven’t already taken our course, Economic Evaluation & Investment Decision Methods,  and would like to learn more, view our course description here on our website or contact us for more information. 

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