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Q8-1. Can you name some industries where the payback period is unavoidably long? A8-1. Payback period is unavoidably long in industries with long-lasting projects, for example, the oil exploration industry, where it might take a long time to find acceptable oil fields and make them produce. Some agricultural products take a long time – for example starting an apple orchard would have a long payback, waiting for the trees to grow, mature and finally produce maximum produce. Q8-2. In statistics, you learn about Type I and Type II errors. A Type I error occurs when a statistical test rejects a hypothesis when the hypothesis is actually true. A Type II error occurs when a test fails to reject a hypothesis that is actually false. We can apply this type of thinking to capital budgeting. A Type I error occurs when a firm rejects an investment project that would actually enhance shareholder wealth. A Type II error occurs when a firm accepts a value-decreasing investment, an investment it should have rejected. a. Describe the features of the payback rule that could lead to Type I errors. b. Describe the features of the payback rule that could lead to Type II errors. c. Which error do you think is more likely to occur when firms use payback analysis? Does your answer depend on the length of the cutoff payback period? You can assume a “typical” project cash flow stream, meaning that most cash outflows occur in the early years of a project. A8-2. a. Payback could lead to Type 1 errors when it rejects a good project that has large cash flows after the payback period cutoff. b. Type II errors occur when payback says to accept a project that doesn't return enough to compensate for the risk taken. c. A type I error is more likely – good project with higher cash flows in later years may be rejected. Q8-3. Holding the cutoff period fixed, which method has a more severe bias against long-lived projects, payback or discounted payback? A8-3. Discounted payback has a more severe bias – discounted cash flows will be smaller, making it even harder for a project to pass the payback hurdle. Q8-4. For a firm that uses the NPV rule to make investment decisions, what consequences result if the firm misestimates shareholders’ required returns and consistently applies a discount rate that is “too high”? A8-4. If the firm consistently uses a “too high” discount rate, then it will reject good project that would add to shareholder value. Q8-5. “Cash flow projections more than a few years out are not worth the paper they’re written on. Therefore, using payback analysis, which ignores long-term cash flows, is more reasonable than making wild guesses as one has to do in the NPV approach.” Respond to this comment.
Q8-6. “Smart analysts can massage the numbers in NPV analysis to make any project’s NPV look positive. a firm’s share price will fall if it invests in projects with NPV < $0. The NPV in effect measures the dollar contribution that the given project is expected to make to the firm’s overall value. starting with Enron in late 2001. Conversely. The IRR is not well suited to ranking projects with very different scales or projects with very different cash flow timing patterns. Looking back. It is better to use a simpler approach like payback or accounting rate of return that gives analysts fewer degrees of freedom to manipulate the numbers. as long as it returns enough to compensate for the risk of the project. what kind of stock-price performance would you expect to see for this firm? b. A firm that consistently earns returns higher than its opportunity cost of capital is adding value to the firm. The CEO wants to reject the project because it would lower the firm’s average return and therefore lower the firm’s stock price. Q8-7. the IRR method enjoys widespread use because in most investment situations it generates reliable accept/reject recommendations and it is easy to interpret intuitively. a. Any method can be manipulated. A particular firm’s shareholders demand a 15 percent return on their investment. It would be hard to argue that accounting numbers can’t be manipulated after all the accounting scandals. Despite the flaws. given the firm’s risk. . What are the potential faults in using the IRR as a capital budgeting technique? Given these faults. Q8-9. How do you respond? A8-8. Q8-8. A8-6. It gives these cash flows less importance in the final answer. a. However. In what way is the NPV consistent with the principle of shareholder wealth maximization? What happens to the value of a firm if a positive-NPV project is accepted? If a negative-NPV project is accepted? A8-7. The IRR method can also yield no solution or multiple solutions that are hard to interpret. and the firm’s financial analysts estimate that the project’s return will be 18 percent. then the share price will rise. If a firm invests in a project with NPV > $0. why is this technique so popular among corporate managers? A8-9. Managers should have incentives to provide the most accurate information possible. with an average return on its portfolio of investments of 25 percent. b.” Respond to this comment. For the project returning 18%. The NPV approach is consistent with shareholder maximization because it suggests that firms should only accept projects which earn returns above the opportunity costs of the firm’s investors. it is adding value and shareholders will be happy about the decision to accept the project. The IRR suffers from several problems.A8-5. this firm has historically generated returns in excess of shareholder expectations. A new investment opportunity arises. NPV automatically adjusts for project time by using an exponentially smaller discount rate applied to later cash flows. and its stock price should increase.
Why is the NPV considered to be theoretically superior to all other capital budgeting techniques? Reconcile this result with the prevalence of the use of IRR in practice. the IRR method can yield multiple solutions. How would you respond to your CFO if she instructed you to use the IRR technique to make capital budgeting decisions on projects with cash flow streams that alternate between inflows and outflows? A8-10. and PI can lead to different decisions when they are used to rank projects or to select between mutually exclusive projects. These computers will replace outmoded equipment that will be kept on hand for emergency use. and (2) has an average accounting rate of return that exceeds the cost of capital of 15 percent. it is difficult for a firm to know whether to accept or reject a project based upon its IRR. NPV. In those cases. This equipment will be depreciated using the straight line method over four years. The NPV is the most appropriate capital budgeting method because it yields correct accept/reject situations and correct project rankings. The impact of the project on net income is derived by subtracting depreciation from cash flow each year. and PI. Solutions to End-of-Chapter Problems Accounting-Based Methods P8-1. and PI techniques provide different capital budgeting decisions? What are the underlying causes of the differences often found in the ranking of mutually exclusive projects using NPV and IRR? A8-12. Outline the differences between NPV. Q8-12. Under what circumstances will the NPV. HQ requires Kenneth to estimate the cash flows associated with the purchase of new equipment over a 4-year horizon. Nevertheless. All three methods lead to the same accept/reject decision when evaluating a single project. The profitability index is the ratio of the present value of a project’s cash flows (excluding the initial cash outflow) divided by the initial cash outflow. but IRR and PI have problems when ranking projects. IRR. The NPV method yields correct project rankings no matter what the scale of the project. NPV generally overcomes these problems.000 to buy some Macintosh computers and a laser printer to use in designing the layout of his daily paper. IRR.Q8-10. In projects with cash flow stream that switch signs. IRR and PI methods are not well suited to evaluating projects which vary in scale. The IRR is calculated by finding the discount rate which equates the NPV to zero. Q8-11. Kenneth Gould is the general manager at a small-town newspaper that is part of a national media chain. HQ accepts any project that (1) returns the initial investment within four years (on a cash flow basis). He is seeking approval from corporate headquarters (HQ) to spend $20. The NPV is calculated by discounting all of a project’s cash flows to the present. IRR. The project’s average accounting rate of return equals the average contribution to net income divided by the average book value of the investment. it is somewhat less intuitive than the IRR. The following are Kenneth’s estimates of cash flows: Year 1 Year 2 Year 3 Year 4 . What are the advantages and disadvantages of each technique? Do they agree with regard to simple accept or reject decisions? A8-11.
It does not take time value of money into account. nor does it account for cash flows received after the payback period. is the bond a bad investment? c. c.4 years. The bond is not necessarily a bad investment. A8-1. Payback Methods P8-2.100 $9. then the bond may be a good investment. It also does not consider the risk of the project and what would be an appropriate discount rate for the project's cash flows.000 + 0)/2 = $10.100 What is the average contribution to net income across all four years? What is the average book value of the investment? What is the average accounting rate of return? What is the payback period of this investment? Critique the company’s method for evaluating investment proposals. What is the discounted payback period for the bond assuming its 4 percent coupon rate is the required return? What general principle does this example illustrate regarding a project’s life. You pay $1.500 $9. depreciation will be $5. The market price of the bond is $1. nor does it look at cash flows. $7.500 + 4.100 The average net income is (2.100 -5. c. This is not an appropriate method for evaluating capital budgeting projects. is 4% a fair return? If the answer is yes. . Payback on this bond is 25 years.100 -5.37 or 37%. If the computers are depreciated on a straight-line basis. vs. a.100 Year 4 9. This shows that unless the acceptable payback period is decreased when discounted payback is used.000. e.000. The discounted payback.000. equal to its par value.700/10.100 + 4. paid semiannually. its discounted payback period. Treasury bond offers a 4 percent coupon rate.500 Year 2 9. a.000 4.100)/4 = 3. You receive $40 a year for 25 years. b. is 30 years. d. The payback period is 2.000. a. and its NPV? A8-2.Cost savings a. Contribution to net income will be: Year 1 7.000 4.000 = . The average accounting rate of return = Average net income/Average book investment = 3. Given the risk level of the bond. b.000 per year for 4 years. The average book value of the investment is (20. It is more appropriate to calculate the NPV of an investment.S.100 Year 3 9. c.500 -5.000 2.000 4.100 + 4. Payback does not take time value of money into account. Suppose that a 30-year U. using a 4% discount rate.100 -5. d. a total of $1. What is the payback period for this bond? b. With such a long payback period. e.100 $9.700 b.
5 0. You pay $7. payback of Beta = 2. You must pay out a total of .2 0.2 0. payback of Gamma = 3.5 0. Project Beta should be rejected.5 5.0 1. e.0 2. Project Beta because its payback of 2. but might be accepted if the firm uses payback analysis. If cash inflows and outflows are the same.3 0. Project Gamma is rejected under payback. The cash flows associated with three different projects are as follows: Cash Flows Initial Outflow Year 1 Year 2 Year 3 Year 4 Year 5 Alpha ($ in millions) . One of these almost certainly should be rejected. If the cutoff is 4 years.0. f. but might be rejected if the firm uses payback analysis. but even without discounting. Calculate the payback period of each investment. If the firm uses discounted payback with a 15 percent discount rate and a 4-year cutoff period. then all of the projects are acceptable. c. this is unacceptable.5 a.4 0. seems to have a high dollar return for the investment. When there is a time value to money. then Alpha will payback in about 5 years. b.5 0.4 0.2 Gamma ($ in millions) . This means only Beta is acceptable. this is likely to be an attractive investment.1.6 million and take in . P8-3.5 million and receive a total of $14 million in cash inflows. Which one? A8-3.7. If the cutoff is 3 years. Payback of Alpha = 3.1 . in other words. a. If the firm invests by choosing projects with the shortest payback period. Beta in just under 4 years and Gamma in just over 4 years.5 2.0. which projects will it accept? e. greatly lowering the value of the last $5. a positive interest rate. then projects which return money late in the life of the investment are even more disadvantaged under discounted payback than under regular payback.3 years b. If the firm uses discounted payback with a cutoff of 4 years.6 million.5 years is the shortest. Which one? f.1 0.0 3. this is a negative net present value project.5 years. Which investments does the firm accept if the cutoff payback period is three years? Four years? c. NPV is a more appropriate method to use to determine the value of an investment project. then only Beta is acceptable.5 years. which project would it invest in? d. One of these projects almost certainly should be accepted (unless the firm’s opportunity cost of capital is very high). . Unless the firm has a very high discount rate. d.3 Beta ($ in millions) .5 million cash flow.regular payback.
000 3. CFo = -$19.000 3. cash inflows are $4. Assume that the firm has an opportunity cost of 14 percent.000 3.000 . Using a 14 percent cost of capital.000 15. Project A has CFo = $-15. For each of the costs of capital listed.000 3. Comment on the acceptability of each. c. Project B has CFo = -$32. The cost of capital is 12 percent.61.000 Project B $600. a. a.000. b. b.500 per year.000 185. reject Only positive NPV projects are acceptable. A8-4.000 185.000 Cash Inflows (CFt) $18.000 Project D $760.000 185. a.000 per year. NPV at 10% = $2.000 per year for eight years. c. Michael’s Bakery is evaluating a new electronic oven.000 17.000. At a 14% discount rate.000. (2) indicate whether to accept or reject the machine.000 36.000 3. A8-5. cash inflows are $8. and 20 inflows of $8. P8-6.000 185.000 15.000 Project C $150. c.000 145.000 per year.000 12.000 3.500. This is positive NPV and an acceptable project P8-5. its NPV is $6. NPV decreases.000 185. Initial cash outlay is $15. (1) calculate the NPV.000 $ 0 0 0 25. As the discount rate increases.000 240.000 185. Project C has CFo = -$50.000 14.000/Year for 8 years.000.000 $185.296. Initial cash outlay is $50. accept c.70.000 3. Project A Initial cash outflow (CFo) Year (t) 1 2 3 4 5 6 7 8 $20.000 170.000 13.000 $3. This is positive NPV and an acceptable project.000 190. calculate the NPV for each of the projects shown in the following table and indicate whether or not each is acceptable. The oven requires an initial cash outlay of $19. and (3) explain your decision. The cost of capital is 14 percent. accept b.339.56.000 Cash flows of $4. and 20 inflows of $13.000.000. At 14%. This is negative NPV and is not acceptable.54. Calculate the net present value (NPV) for the following 20-year projects. its NPV is $5507. NPV at 12% = $870. The cost of capital is 10 percent b.000 $120. if the discount rate is high enough a previously acceptable project at lower discount rates may become unacceptable.47. At some point. NPV at 14% = -$444.100. a.000 72.000 Project E $100.000.000 and 20 inflows of $4.Net Present Value P8-4.000 185. Initial cash outlay is $32. At a 14% discount rate. its NPV is $71.000 and will generate after-tax cash inflows of $4. cash inflows are $13.000 16.70.000 220.000 0 60.
000 10.000 $20. and its cash flows are provided below. evaluate the acceptability of each tool.000 20.000 $58.000 23. followed by Project B.000 NPV -$4. The cash flows associated with each are shown in the following table.000 3.000 20.000 20.548.57 $2.000 46. There is one investment available to Erwin. c. P8-8. Three alternative replacement tools—A.424.000 17. Using NPV.000 23.9 10 A8-6.189.000 13. Erwin Enterprises has 10 million shares outstanding with a current market price of $10 per share.24 -$71. determine the impact on Erwin’s stock price and firm value if capital markets fully reflect the value of undertaking the project. and C—are under consideration.000 15.27 $17.000 Decision Reject Accept Reject Accept Accept 84. Calculate the NPV of each alternative. Rank the tools from best to worst. Project A B C D E 3. Initial cash outflow = $10.000 20.000 20.351.678.000 21.80 $8.000 20. A Initial cash outflow (CFo) Year (t) 1 2 3 4 5 6 7 8 $95.000 35.000 a. B.000 20. b.992.000 35. A8-7. using NPV.000 12.000.000 P8-7.798 $98. The firm’s cost of capital is 15 percent.95 Decision Reject Accept Accept Project C is the best. Project A is the worst project. Given this information.000 B $50. and is unacceptable.44 11.65 $67.000 23. Erwin has a cost of capital of 10 percent.000 C $150.000 Year Cash Inflow . Scotty Manufacturing is considering the replacement of one of its machine tools. Project A B C NPV -$5.000 Cash Inflows (CFt) $10.000 58.253.
742 ÷ $10.000.000.000.000 = $11.000 + $9. NPV of project = $9.972.000 $5.972.742 Current firm value = $10 × $10.000.000 $4.800.00 per share .000 $9.000.000 $6.000.000 = $100.972.000 A8-8.000.972.000 New firm value = $100.742 = $109.742 New stock price = $109.000.1 2 3 4 5 $3.
Project A B C D IRR 17.000 - Cash Inflows (CFt) $135.000 275. based on the IRR criterion. Project A Initial cash outflow (CFo ) Year (t) 1 2 3 4 5 A8-9. Assess the acceptability of each project based on the IRRs found in part (a). a. The firm’s cost of capital is 15 percent.000 165.000 24. Project B has a higher IRR.7% 17.000 Cash Inflows (CFt) $110.000 $108.000 28.000 54. c. b.000 32.000 a.4% 8.7% 27.000 55. Project A Initial cash outflow (CFo ) Year (t) 1 2 3 4 5 $550.000 7. Project A B IRR 15. The relevant cash flows for the projects are shown in the following table. Which project is preferred. calculate the internal rate of return (IRR).000 Project D $215.000 P8-10.000 7. and is preferred to Project A. based on the IRRs found in part (a)? A8-10.000 90.000 132. both projects are acceptable.000 135. . With a cost of capital of 15%.3% b.000 132.000 209.4% $72.000 $16.000 $7.2% 21.000 $154.000 77. William Industries is attempting to choose the better of two mutually exclusive projects for expanding the firm’s production capacity.000 135. c. Calculate the IRR for each of the projects.000 Project C $18.000 20.000 7.000 105. For each of the projects shown in the following table.000 7.000 Project B $358.Internal Rate of Return P8-9.000 Project B $440.000 135.000 72.
but it will not do both.000 −10.000 400.000 2. Projects that have lower initial investments and return their cash flows earlier in the life of the project tend to have higher IRRs.500. Consider a project with the following cash flows and a firm with a 15 percent cost of capital. c. Project Renovate Replace NPV $1. Rank these investments based on their NPVs. Ranking on NPV: A.000.000.P8-11. The first proposal calls for a major renovation of the company’s manufacturing facility. Ranking on IRR: B. What are the two IRRs associated with this cash flow stream? b.000 200.000 3.000.800. A c.000. should it accept or reject the project? . Rank these investments based on their IRRs. The second involves replacing just a few obsolete pieces of equipment in the facility.5% 36% The Renovate project has a higher NPV but the Replace project has a higher IRR. is considering two alternative investment proposals. B b.000 3.000 50. Why do these rankings yield mixed signals? A8-11.000 500..779 IRR 20. If the firm’s cost of capital falls between the two IRR values calculated in part (a). The rankings provide mixed signals because of the differing cash flow patterns and initial investments of the two projects.309 $433.500. Contract Manufacturing.000 a.000 −$1. The company will choose one project or the other this year. P8-12. a.000 a. as is the case with the Replace project.000 300. and the firm discounts project cash flows at 15 percent. b. The cash flows associated with each project appear below. Inc.000 3.000 2.000 600. Year 0 1 2 3 4 5 Renovate Replace −$9.128. End of Year 0 1 2 Cash Flow −$20.
56 + 4.27%.56 = 4.88 = 4.500 -80.56 0.030 a.12 0. A certain project has the following stream of cash flows: Year 0 1 2 3 4 Cash Flow $ 17.56IRR = −3. Therefore the firm can accept the project as long as its cost of capital falls between the two IRRs.000 $10.e.56 IRR 2 = 0.56 and x = = 0.A8-12.000 1 (1 + IRR ) (1 + IRR ) 2 1 (1 + IRR )1 Let x = $0 = $50.500 138.56 = -78.27% 0.44 + 0.000 $10.000 $0 = 5x − x 2 − 2 x 2 = 5x + 2 = 0 Using the quadratic formula ax2 + bx + c = 0 x= − b ± b 2 − 4ac 2a 5 ± 25 − 8 5 ± 17 5 ± 4.44 b. $0 = $50.000 x 2 − $20.56 IRR 1 = − 3.000 + $50.000 = $20. $-20.44IRR = 1 0.44 = 1 1 + IRR 4. Because the undiscounted NPV of the project is positive (i.000 x − $10. Fill in the following table: .425 -105.12 = = 2 2 2 x2 = x= 9. a.44 2 2 1 1 + IRR 0.000) the project will have a positive NPV at all discount rates between -78. P8-13.07% 4.07% and +127.455 30.56 = − 127.44IRR = 0.56IRR = 1 4.000 − − $20.
46 41.48 1 2 3 4 5 6 7 8 9 10 . A8-13. Describe the conditions under which the firm should accept this project. Project NPV 45 40 35 30 25 20 15 10 5 0 -5 Project NPV Project NPV 0 -1.35 0 .Cost of Capital (%) 0 5 10 15 20 25 30 35 50 Project NPV ______ ______ ______ ______ ______ ______ ______ ______ ______ b. c. a.56 0 -. Use the values developed in part a to draw a NPV profile for the project. What is this project’s IRR? d. Cost of Capital 0 5 10 15 20 25 30 35 50 b.672 0 3.
000 = 1. when the NPV is positive.000 Year 2 cash inflow 60. 10%. PI123 = $138. Accept both 123 and 789 because both have a PI > 1. Project Liquidate Recondition Replace Initial cash outflow -$100. then it should be accepted because it contributes the most to shareholder value.141. If these mutually exclusive projects are the only ones available and if there is sufficient capital to finance 789. but 789 is a larger scale project with a higher NPV. Profitability Index P8-14.000 = 0. e. Compare and contrast your answer to part (c) to your answer to part (d) for the mutually exclusive case.000 Year 1 cash inflow 50.436 NPV789 = $141.456. e. This project is acceptable at discount rates greater than 30%. d.564 / $500.123. A8-14.c. P8-15. Evaluate the following three projects. Explain this result. You have a $10 million capital budget and must make the decision about which investments your firm should accept for the coming year. Use the following information . Apply the NPV criterion to the projects. in this case at 0%. 20% and 30%.000 500.161 / $100. The answers do not match.000 200. Project 123 has the higher PI.000 -$1. Rank these projects by their PIs. and indicate which project you would accept if they are independent and if they are mutually exclusive. Assume a cost of capital of 15 percent. Projects 123 and 789 have positive NPVs and should be accepted. which would you accept according to the PI criterion? c. rank them according to their NPVs.000 -$500. Project 789 has the highest NPV and should be accepted.000 500.38 PI456 = $402.000. If the projects are independent.000 a.000 250.14 b. b. NPV123 = $38.161 NPV456 = -$97.000. If these projects are mutually exclusive. a.000 100.000 Year 3 cash inflow 75. The project has an IRR at every point where it crosses the discount rate axis. using the profitability index.000 500.0 c.613 NPV ranking: 789. Accept 123 because it has the highest PI d.613 / $1. which would you accept according to the PI criterion? d.81 PI789 = $1.000 = 1.
913.000 + $2. Project #3 should be accepted since it has the higher NPV and there are no other investments under consideration.12)-3 = $1.000 + $1.000 Initial cash outflow Year 1 cash inflow Year 2 cash inflow Year 3 cash inflow a.5 million mail-order processor.12)-2 + $3. Both Old Line Industries and New Tech. Which Techniques Do Firms Actually Use? P8-16.12)-2 + $5. Which project do you accept on the basis of PI? c.5 1 2 2 2 3 2 .000..637 NPV3 = -$10. New Tech has a much higher cost of capital (20%) than does Old Line (10%).000. PI1 = $4.000 2.312.12)-3 NPV1 = -$4.000.000 × (1.000 × (1.493 / $10. Project Cash Flows: Year 0 Cash Flow -$4.000.000.000 × (1.000 6. which one do you select? A8-15.000 × (1.000.26 [highest PI] PI3 = $11. × (1.000.000 3.19 c.000 5.586 / $4.312. Should Old Line invest in this processor? b. use the IRR to make investment decisions.000 Project 2 -$5.000 3.000. This machine could generate after-tax savings of $2 million per year over the next three years for both firms.637 / $5.000 + $ 4.000 × (1.586 NPV2 = -$5.000 = 1.493 [highest NPV] b.000. Given this information.12)-3 = $1.000 1.12)-1 +$ 6.000. Both firms are considering investing in a more efficient $4.000.16 PI2 = $6.913.000 × (1.000. Although Project #2 provides “more bang for the buck” as represented by its higher PI. The firm’s cost of capital is 12 percent.000 = $622. However.12)-2 + $3.000.000.000 2.000.000. If these are the only investments available.000. answer parts (a)–(c).000.000 Project 3 -$10.000 × (1. what can you infer about the acceptability of projects across firms with different costs of capital? A8-16.000.000 3.12)-1 + $3. a.000 × (1.000.000. Inc. Should New Tech invest in this processor? c. Based on your answers in parts (a) and (b). a. Which project do you accept on the basis of NPV? b.12)-1 + $2.000. due to the risky nature of its business.000.000.000 = 1.622.on three mutually exclusive projects to determine which investment your firm should accept.000.000.000 4. Project 1 -$4.000 = 1.000.
400 6 4.29. This project is acceptable by both NPV and IRR criteria. c. At Old Line's discount rate of 10%. At 10%. It has a positive NPV and its IRR is greater than its hurdle rate of 12%. The firm has a 10 percent cost of capital.400 4 4. A8-18. or unacceptable. Calculate the IRR for the proposed investment. the project NPV is -$.000 1 4. Would you recommend that the firm accept or reject the project? Explain your answer. Year 0 Cash Flow -$20.400 2 4. The firm has a 12 percent cost of capital. Determine the NPV for the project. A8-17. End of Year (t) 1 2 3 4 5 a. CF0. d. will potentially add more value for shareholders. P8-18. b.000. The IRR is 12. Determine the IRR for the project. . b. Calculate the NPV for the proposed investment. b. The cost of capital is very important to the acceptance of a project.6% or 16%.400 per year for seven years. The initial cash outflow is $20.000 $22. This project is acceptable by both NPV and IRR criteria. P8-17. c. At New Tech's 20% discount rate.500 $27.a. to New Tech. Reynolds Enterprises is attempting to evaluate the feasibility of investing $85. and negative net present value. a. Butler Products has prepared the following estimates for an investment it is considering. b.13% c. c. It has a positive NPV and its IRR is greater than its hurdle rate of 10%.000.000 Calculate the payback period for the proposed investment.400 7 4. the NPV of the project is $1.400 5 4.47 and an IRR of 15.9%. This makes the project acceptable (barely) to Old Line. Cash Inflows (CFt) $18. all other things equal.56 years NPV is $8.54 IRR is 15. b.400 a.04. The firm has estimated the cash inflows associated with the proposal as shown below.500 $36. c. a.672. A firm that has a lower cost of capital will find more projects acceptable and. d. Evaluate the acceptability of the proposed investment using NPV and IRR. in a machine having a 5-year life. this project has an NPV of $.400 3 4. and the project is expected to yield cash inflows of $4.421. What recommendation would you make relative to implementation of the project? Why? The payback period is 3.000 $31.
followed by Y and Z.94 IRR 20. The immediate program costs $5 million. P8-21.4% 14. and indicate which project you would recommend.Y. and the firm discounts cash flows at 13 percent.000 27. If the cost of capital for Wilkes is 15 percent. Project X Y Z Payback 2.57.37 years NPV $14. c. Explain why. There are two programs available to Wilkes: an all-atonce program that will be immediately funded and implemented and a gradual program that will be phased in over the next three years. . It is cheaper to implement the all at once pollution control project.75% Ranking on NPV: X. accept the project with the highest NPV. The other strategy involves a complete reformulation of the product in a way that will appeal to environmentally conscious consumers. Calculate the NPV of each project.Z Ranking on IRR: X. P8-20. Sharpe Manufacturing is attempting to select the best of three mutually exclusive projects. Calculate the IRR for each project.24 $14.48 $6. assuming that the firm has a cost of capital equal to 13 percent.000 43. so it decides that it needs to “freshen” the product. but not both.4% 17.965. whereas the phase-in program will cost $1 million today and $2 million per year for the following three years.000 a. Year 0 1 2 3 All at Once -$5 Gradual -$1 -$2 -$2 -$2 The NPV of the All at once project is -$5 million. Since they are mutually exclusive projects. is -$5.. One strategy is to maintain the current detergent formula. years (t) = 1-5 Project X $80.Z Ranking on Payback: X.000 Project Z $145. The NPV of the Gradual project.96 years 3.206.Y. Calculate the payback period for each project.240. The initial cash outflow and after-tax cash inflows associated with each project are shown in the following table.Y. Summarize the preferences dictated by each measure.000 Project Y $130. A consumer product firm finds that its brand of laundry detergent is losing market share. Project X. must invest in a pollution-control program in order to meet federal regulations to stay in business. d. which pollutioncontrol program should Wilkes select? A8-20. Wilkes.Z All measures agree that X is best. Inc.17 years 3. but to repackage the product.P8-19.000 41. Cash flows from each proposal appear below. A8-19. Cash Flows Initial cash outflow (CFo) Cash inflows (CFt). at a discount rate of 15%. The firm will pursue one strategy or the other. b.
No.000.250. b. Rank these projects based on their PIs. Repackage is better under all criteria. Which project should Lundblad choose if its cost of capital is 13. starting one year from now) in net cash inflows from leasing the property. This project would generate a quick cash payoff as the homes are sold over the next two years. Which project should Lundblad choose? f.35 A-B 0 1. IRR of Repackage is 21. Choose the higher NPV.000 3.04%.163.5 million on construction costs immediately. and the company expects to receive $350.000 10. NPV of Reformulate is $102. Rank these investments based on their PIs. d. PI of Repackage is PV of inflows divided by PV of outflows: 3. Choose the higher IRR.000. Lundblad’s cost of capital is 10 percent.50/25. c.5 1. The second proposal is to build a strip shopping mall. P8-22. Lundblad Construction Co.000 250.000 annually (for each of 50 years.Year 0 1 2 3 4 5 Repackage -$3. NPV of Repackage is $384. Construction costs for the strip mall are also about $2. Choose the higher PI. a. Draw NPV profiles for the two projects on the same set of axes and discuss these profiles.5.000 = 1.000 9. c.000. Reformulate.000.5 million.000. c. IRR of Reformulate is 13. Do these investment rankings yield mixed signals? A8-22. Lundblad estimates that it would spend $2. Rank these investments based on their IRRs. Repackage.000 1. Rank these investments based on their NPVs. The first proposal is to build 10 single-family homes on the site. Repackage.102. This project calls for Lundblad to retain ownership of the property and to lease space for retail businesses that would serve the neighborhood. Rank these projects based on their IRRs.000. d. Use this graph to explain why the NPV and IRR methods yield mixed signals in this case.5 .5 percent? 16 percent? 20 percent? A8-22.000 4.390.000 = 1.000 500. e. a.20%.000 a. the rankings do not yield mixed signals.000 7. PI of Reformulate is 25.000.000 Reformulate -$25. b. Specifically. and it would receive $1.6 B -$2.004. Draw NPV profiles for these projects on the same set of axes. Year 0 1 A -$2.390/3.163.25 . Rank these projects based on their NPVs. recently acquired 10 acres of land and is weighing two options for developing the land.6 million as cash inflows in each of the next two years.000.500.000 250. e. Do these rankings agree with those based on NPV or IRR? d. b.000 2.000.13.384.
35 . A has an NPV of $. Project A has an NPV of $.5%.5%. the project is unacceptable. IRR and NPV yield mixed signals because of differences in cash flow patterns. a pattern that generally has a higher IRR than one.A IRR 18.11 3. If the cost of capital is 13.69. is inferior to Project B. Project B has an NPV of $. -$.16% 13. At 16%. The project on top.6 .97 B.35 Project A B Rankings: NPV . The PI rankings agree with the rankings on NPV d.31.068.5 = 1. The NPV of the incremental project is -$.35 -. A.39 B.47/2. that returns cash flows over a longer period of time. 1. like B. Project A is the only acceptable project.1%. Project A is better than Project B at a discount rate of 13.15 and an IRR of 18.35 .A c.35 1. .5 = 1. When a project with nonconventional cash flows (+ inflows followed by -outflows) has an IRR greater than the hurdle rate.5%.98% A.25 -.277 . At a cost of capital of 13. f.2 3 50 a and b. At a cost of capital of 16%.16%. and its IRR is 13.777/2.088 and at 16%.B PI 2. Lundblad should choose project A. Project A returns cash sooner than B. e.
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