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In computing the differential cash flows, the project with the larger initial investment becomes the project against which the comparison is made. In practical terms, this means that the Cash FlowB-A is computed if B has a higher initial investment than A, and the Cash FlowA-B is computed if A has a higher initial investment than B. If we compare more than two projects, we still compare one pair at a time, and the less attractive project is dropped at each stage.

The differential cash flows can be used to compute the net present value and the decision rule can be summarized as follows:

If NPVb-a > 0 : Project B is better than project A NPVB-A< 0 : Project A is better than project B Notice two points about the differential net present value. The first is that it provides the same result as would have been obtained if the business had computed net present values of the individual projects and then taken the difference between them.

The second is that this approach works only when the two projects being compared have the same risk level and discount rates, since only one discount rate can be used on the differential cash flows. By contrast, computing project-specific net present allows for the use of different discount rates on each project.

The differential cash flows can also be used to compute an internal rate of return, which can guide us to select the better project.

If IRRb-a > Discount Rate : Project B is better than project A IRRb-a< Discount Rate : Project A is better than project B Again, this approach works only if the projects are of equivalent risk.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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