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AOL Signs Internet Browser Deals With Both Netscape And Microsoft’s Explorer

Question

These two Internet browsers seem be substitutes. Thus, the purchase of a browser is like deciding between two mutually exclusive projects. In capital budgeting decisions, we tell you to choose the project with the highest NPV. So why is America Online (AOL) accepting two mutually exclusive projects?

Answer

One way to answer the question is by making the decision criterion slightly more complicated. The textbook-rule of undertaking the project with the highest NPV ignores the uncertainty of the project’s cash flows.

In real world situations, you need to estimate/forecast these cash flows. However, in a number of circumstances, they are almost impossible to estimate with any reasonable accuracy, especially when dealing with new technologies. Thus, in these situations, firms might decide initially to adopt both technologies until one of them emerges as a dominant or a standard design. By following this strategy, firms eliminate the possibility of complete ruin if they were to end up choosing the wrong alternative.

Thus, what might seem contradictory to the NPV rule for mutually exclusive projects is actually rational. Moreover, the textbook rule is correct when there are no such uncertainties with regard to the magnitude of cash flows.