End of Chapter Exercises: Solutions Chapter 3

1. (a) What is meant by the term mutually exclusive projects ? (b) Explain why the I !ecision rule coul! "ive the wron" result when comparin" mutually exclusive projects.

Answer: (a) Projects are said to be mutually exclusive when the selection of one automatically eliminates the need for any of the alternatives; eg. choosing among a number of alternative road designs between the same two oints. (b) !t is ossible that the ran"ing of rojects using their #P$s changes when the discount rate changes (switching). !n this case one roject will not be unambiguously su erior to another as a ran"ing by !%% would suggest.

#.

$he %ollowin" net cash %lows relate to two projects& 'E$ ()*+ ,-.W* (I' / 10111) 2E) 3 .4E($ ) 3 .4E($ 5 1 671 68# 1 #1 9: # #1 ## ; #1 #1 9 #1 1; : #1 1; 7 #1 1;

(i) (ii) (iii) (iv)

(alculate the '3<s %or each project0 assumin" 11= cost o% capital. )ssumin" that the two projects are in!epen!ent0 woul! you accept them i% the cost o% capital is 1:=? What is the I o% each project? Which o% the two projects woul! you pre%er i% they are mutually exclusive0 "iven a 1:= !iscount rate?

Answer: (i) #P$A(&'() ) *+.&&; #P$,(&'() ) *-..& (ii) /es. #P$A(&0())&0.-1;#P$,(&0())&-..2 (iii) !%%(A))*.(; !%%(,))*-( (iv) Prefer , 3 higher #P$(&0() ;. >sin" a sprea!sheet "enerate your own set o% ?iscount an! )nnuity $ables %or0 say0 all !iscount rates between 1= an! #1= (at 1 percenta"e point intervals) an! %or time perio!s 1 to ;1 (at one time perio! intervals)0 as well as time perio!s :1 an! 111. 2ou shoul! "enerate these tables by insertin" the numbers %or the time perio!s in the %irst column o% each row an! the !iscount rates in the %irst row o% each column0 an! then insertin" the appropriate %ormula into one cell o% the table @ year 1 at 1= 6 an! then copyin" it to all other cells in the matrix. (+int& ?o not %or"et to anchor the re%erences to perio!s an! !iscount rates usin" the / symbol.)

Answer: 4rite the discount formula into s readsheet as shown below and then co y across *' columns (headed &( through *'() and down 0' rows (headed & to 0').

Column B Row 2 1 2 3 1% A1B(1C5/#)D/)# 1.EF1 1.E81 2% 1.EF1 1.E71 1.E9# 3% 1.E81 1.E9; 1.E1:

9.

) %irm has a capital bu!"et o% /111 which must be spent on one o% two projects0 each reGuirin" a present outlay o% /111. 3roject ) yiel!s a return o% /1#1 a%ter one year0 whereas 3roject 5 yiel!s /#11.19 a%ter : years. (alculate& (i) the '3< o% each project usin" a !iscount rate o% 11=H (ii) the I o% each project. What are the project ranIin"s on the basis o% these two investment !ecision rules? *uppose that you are tol! that the %irmJs reinvestment rate is 1#=0 which project shoul! the %irm choose?

Answer: (i)#P$(A) ) 1.'1; #P$(,) ) *..516 ,7A (ii) !%%(A) ) *'(; !%%(,) ) &0(6 A7, 8sing a reinvestment rate of &*( the terminal values are 9$(A) ) &55.5*; 9$(,) ) *'&.&.6 hence ,7A. Alternatively calculate the !%% of (,:A): !%%(,:A) ) &2.+5( 7 &*(6 hence underta"e the e;tra roject (,:A) ie. underta"e ,. :. ) %irm has a capital bu!"et o% /111 which must be spent on one o% two projects0 with any unspent balance bein" place! in a banI !eposit earnin" 1:=. 3roject ) involves a present outlay o% /111 an! yiel!s /;#1.87 a%ter : years. 3roject 5 involves a present outlay o% /91 an! yiel!s /E# a%ter one year. (alculate& (i) the I o% each projectH (ii) the 5B( ratio o% each project0 usin" a 1:= !iscount rate. What are the project ranIin"s on the basis o% these investment !ecision rules? *uppose that i% 3roject 5 is un!ertaIen its bene%it can be reinveste! at 18=H what project shoul! the %irm choose? *how your calculations (sprea!sheet printout is acceptable as lon" as entries are clearly labelle!). Answer: (i)!%%(A) ) *-.2(; !%%(,) ) &2'(6 ,7A (ii),<%(A) ) &.-; ,<%(,) ) *6 ,7A 8sing a reinvestment rate of &+( the terminal values are: 9$(A))2*&.+-; 9$(,))*12.'56 hence A7,. Alternatively calculate the !%% of (A:,): !%%(A: ,))&5.0&(7&+(6 hence underta"e the e;tra roject (A:,)6 ie. underta"e A.

7.

) %irm has a capital bu!"et o% /;10111 an! is consi!erin" three possible in!epen!ent projects. 3roject ) has a present outlay o% /1#0111 an! yiel!s /90 #F1 per annum %or : years. 3roject 5 has a present outlay o% /110111 an! yiel!s /901F9 per annum %or : years. 3roject ( has a present outlay o% /180111 an! yiel!s /:0F1# per annum %or 11 years. ,un!s which are not allocate! to one o% the projects can be place! in a banI !eposit where they will earn 1:=. (a) I!enti%y six combinations o% project investments an! a banI !eposit which exhaust the bu!"et. (b) Which o% the above combinations shoul! the %irm choose& (i) when the reinvestment rate is 1:=? (ii) when the reinvestment rate is #1=? Explain your answer an! show your calculations (sprea!sheet printout is acceptable as lon" as entries are clearly labelle!).

Answer: 9o answer these =uestions it is robably best to com are future values after &' years6 bearing in mind that rojects with a 0:year life will have terminal value after 0 years which needs to com ounded forward at the reinvestment rate (&0( and *'() to year &'6 and the residual de osited in the ban" is always com ounded over &' years at a &0( interest rate. >uture values are as follows: A?@&56''' in ban" ,? @*'6''' in ban" <?@&26''' in ban" A?,?@56''' in ban" ,?<?@26''' in ban" A?<?@&6''' in ban". &0( @&2'65+@&2+6-0* @&+'621. @&.+6&-& @&5-6-+1 @&+161'. *'( @&0*6'1* @&05625+ @*'26*'0 @&516&&* @*.'6**. @*2261*1

At a reinvestment rate of &0( or *'( the combination of rojects ,?< would be referred. 8. ) public !ecision6maIer has a bu!"et o% /111 which must be spent in the current year. $hree projects are propose!0 each o% which is in!ivisible (it is not possible to un!ertaIe less than the whole project) an! non6repro!ucible (it is not possible to construct two versions o% the same project). $he !iscount rate is 11= per annum. $he project bene%its an! costs are summariKe! in the %ollowin" $able& 3roject (ost (/) 2ear 1 ) 5 ( ;1 ;1 81 2ear 1 91 1 1 5ene%its (/) 2ear # 1 :1 111

(i) (ii) (iii)

WorI out the 'et 3resent <alue ('3<)0 Internal an! 5ene%itB(ost atio (5B() %or each projectH anI the projects accor!in" to the '3<0 I criteriaH

ate o%

eturn (I

an! 5B( investment

Which projects shoul! be un!ertaIen to spen! the bu!"et& (a) (b) i% the reinvestment rate is ##= per annumH i% the reinvestment rate is #F= per annum?

Answer: (!n answering this =uestion the student should assume that the full amount of the budget must be e;hausted on some combination of the three rojects; ie. it cannot be assumed that some art of the initial budget is invested at the reinvestment rate. !t should also be assumed that end of year * is the terminal year.) (i) ) 5 ( (ii) '3< /7.;7 /11.;# /1#.79 I ;;= #E= #1= 5( 1.#1 1.;F 1.1F

ran" by: #P$ <6 ,6 A !%% A6 ,6 < ,<% ,6A6<

(iii) Anly roject A is affected by the reinvestment rate. (a) At **( the future value of @.' at end of year * is @.5.5.9herefore select rojects , and < to ma;imiBe return on @&'' investment. (b) At *5( the future value of @.' at end of year * is @0&.*. 9herefore select rojects A and < to ma;imiBe return on @&'' investment.