Yesterday, we covered the proper methodology for selecting the best option among mutually exclusive projects. Today, we’ll discuss the ideal approach for non-mutually exclusive projects (also known as independent projects).
Let’s say you have assembled a list of ten promising energy-efficiency measures; however, your prospect can’t afford to pursue all ten. Your job is to help your prospect choose the ones that are the most capital-efficient. There are four rules that you should apply in this scenario:
- Only consider lowest life-cycle-cost alternatives. If replacing the boiler is a potential project, the boiler on your list should have already been determined to be the boiler with the lowest life-cycle cost.
- Eliminate any project that has a negative net present value (NPV). A project with a negative net present value is one in which the sum of cash inflows is actually less than the sum of cash outflows when all inflows and outflows are reduced to their respective present values.
- Calculate each project’s modified internal rate of return (MIRR) or savings-to-investment ratio (SIR). These metrics will inform which projects will be most promising to pursue (see Step 4 below).
- Fund the potential projects in the order of highest to lowest modified internal rate of return or savings-to-investment ratio. Doing so will allocate the prospect’s capital in a manner that delivers “the most bang for the buck.”
There are two mitigating circumstances to keep in mind when using the above-referenced four rules:
- If you have a piece of equipment that is likely to fail soon, you’ll want to prioritize its replacement. It does you little good to allocate your dollars in an attempt to maximize your capital efficiency only to find out that right after your capital is fully deployed, something needs to be fixed and there’s no money left to fix it.
- If you see a situation where two things should logically be paired and done at the same time, bundle those projects before doing your ranking exercise.
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