Chapter 13, Solutions

Cornett, Adair, and Nofsinger

CHAPTER 13 - WEIGHING NET PRESENT VALUE AND OTHER CAPITAL BUDGETING CRITERIA Questions LG1 1. Is the set of cash flows depicted below normal or non-normal? Explain. 0 1 2 3 4 5 Time Cash Flow -$100 -$50 $80 $0 $100 $100 They’re normal: there is only one change in cash flows from negative to positive. LG1 2. Derive an accept/reject rule for IRR similar to 13-8 that would make the correct decision on cash flows that are non-normal, but which always have one large positive cash flow at time zero followed by a series of negative cash flows: 0 1 2 3 4 5 Time Cash Flow Sign + - - - - With one positive at the beginning and all future cash flows negative, this type of project would be worth more if rates were higher, implying that the NPV profile would be upward-sloping. So the appropriate accept/reject decision rule would look like Accept Project if IRR ≤ Cost of Capital Reject Project if IRR > Cost of Capital LG1 3. Is it possible for a company to initiate two products that target the same market and are not mutually exclusive? Sure, as long as the market has room for both products. LG2 4. Suppose that your company used “APV”, or “All-the-Present Value-Except-CF0”, to analyze capital budgeting projects. What would this rule’s benchmark value be? Accept Project if APV ≥ -CF0 Reject Project if APV < -CF0 LG3 5. Under what circumstances could Payback and Discounted Payback be equal? They would be equal if i = 0. LG5 6. Could a project’s MIRR ever exceed its IRR?

13-1

Chapter 13, Solutions

Cornett, Adair, and Nofsinger

MIRR would be greater than IRR if a project with normal cash flows had a negative NPV. LG6 7. If you had two mutually exclusive, normal-cash-flow projects whose NPV profiles crossed at all points, for which range of interest rates would IRR give the right accept/reject answer? At all rates, because we would be indifferent between the two projects at any rate. LG7 8. Suppose a company wanted to double their firm’s value with the next round of capital budgeting project decisions. To what would they set the PI benchmark to make this goal? They would set it equal to 1. LG5 9. Suppose a company faced different borrowing and lending rates: How would this range change the way that you would compute the MIRR statistic? We would want to use the borrowing rate to move the negative cash flows to time 0, and the lending rate to move the positive cash flows to the end of the project.

Problems Basic Problems LG2 13-1 Compute the NPV for Project M and accept or reject the project with the cash flows shown below if the appropriate cost of capital is 8 percent. Project M 0 1 2 3 4 5 Time Cash Flow -$1,000 $350 $480 $520 $300 $100 Using equation 13-2:
NPV $1, 000 $436.96 $350 1.08
1

$480 1.08
2

$520 1.08
3

$300 1.08
4

$100 1.08
5

The project should be accepted.

13-2

Chapter 13, Solutions

Cornett, Adair, and Nofsinger

LG2

13-3

Compute the NPV statistic for Project U and recommend whether the firm should accept or reject the project with the cash flows shown below if the appropriate cost of capital is 10 percent. Project U 0 1 2 3 4 5 Time Cash Flow -$1,000 $350 $1,480 -$520 $300 -$100 Using equation 13-2:
NPV $1, 000 $293.45 $350 1.10
1

$1, 480 1.10
2

$520 1.10
3

$300 1.10
4

$100 1.10
5

The project should be accepted. LG3 13-5 Compute the Payback statistic for Project B and decide whether the firm should accept or reject the project with the cash flows shown below if the appropriate cost of capital is 12 percent and the maximum allowable payback is 3 years. Project B 0 1 2 3 4 5 Time Cash Flow -$11,000 $3,350 $4,180 $1,520 $0 $1,000 Solving equation 13-3 for N: Year Cash Flow Cumulative Cash Flow 0 -$11,000 -$11,000 1 $3,350 -$7,650 2 $4,180 -$3,470 3 $1,520 -$1,950 4 $0 -$1,950 5 $1,000 -$950

This project will never achieve payback, and should be rejected. LG3 13-6 Compute the Discounted Payback statistic for Project C and recommend whether the firm should accept or reject the project with the cash flows shown below if the appropriate cost of capital is 8 percent and the maximum allowable discounted payback is 3 years. Project C 0 1 2 3 4 5 Time -$1,000 $350 $480 $520 $300 $100 Cash Flow

13-3

Chapter 13, Solutions

Cornett, Adair, and Nofsinger

Solving equation 13-5 for N, cumulative PV of cash flow will switch from negative and positive between years 2 and 3:

Year Cash Flow Cash Flow PV Cum. Cash Flow PV Specifically, D PB LG5 13-9

0 -$1,000 -$1,000 -$1,000
2

1 $350
$350 1.08
1

2 $480
$480 1.08
2

3 $520
$520 1.08
3

4 $300

5 $100

$324.07

$411.52

$412.79

-$675.93

-$264.41

$148.38

$264.41 $412.79

2.64 years and this project should be accepted.

Compute the IRR statistic for project F and note whether the firm should accept or reject the project with the cash flows shown below if the appropriate cost of capital is 12 percent. Project F 0 1 2 3 4 Time Cash Flow -$11,000 $3,350 $4,180 $1,520 $2,000 The IRR for this project will be the solution to equation 13-7:
0 IR R $11, 000 1 IR R
0

$3, 350 1 IR R
1

$4,180 1 IR R
2

$1, 520 1 IR R
3

$2, 000 1 IR R
4

.2068, or 20.68%

Since IRR > i, this project should be accepted. LG5 13-11 Compute the MIRR statistic for Project H and note whether to accept or reject the project with the cash flows shown below if the appropriate cost of capital is 8 percent. Project H 0 1 2 3 4 5 Time -$1,000 $350 $480 $520 $300 $100 Cash Flow

13-4

Chapter 13, Solutions

Cornett, Adair, and Nofsinger

Cash flows will be moved as shown below: Year Cash Flow Future Value (If Positive) Sum of FV Modified CFs -$1,000 With this new set of modified cash flows, the MIRR is:
0 1 IR R $1, 000 IR R
0

0 -$1,000

1 $350
$350 1.08
4

2 $480
$480 1.08
3

3 $520
$520 1.08
2

4 $300
$300 $324 1.08
1

5 $100 $100 $2,111.36 $2,111.36

$476.17

$604.66

$606.53

$2,111.36 1 IR R
5

.1612, or 16.12%

Since our MIRR decision statistic exceeds the 8 percent cost of capital, we would accept the project under the MIRR method. . LG5 13-13 Compute the MIRR statistic for Project J and advise whether to accept or reject the project with the cash flows shown below if the appropriate cost of capital is 10 percent. Project J 0 1 2 3 4 5 Time Cash Flow -$1,000 $350 $1,480 -$520 $300 -$100 Cash flows will be moved as shown below: Year Cash Flow Present Value (If Negative) 0 -$1,000 -$1,000 1 $350 2 $1,480 3 -$520
$520 1.10
3

4 $300

5 -$100
$100 1 .1 0
5

$390.68
4 3
1

$ 6 2 .0 9

Sum of PV -$1,452.78 Future Value (If Positive) Sum of FV

$350

1.10

$1, 480

1.10

$300 $330

1.10

$512.44

$1, 969.88

$2,812.32

13-5

Chapter 13, Solutions

Cornett, Adair, and Nofsinger

Modified -$1,452.78 CFs With this new set of modified cash flows, the MIRR is:
0 IR R $1, 452.78 1 IR R
0

$2,812.32

$2, 812.32 1 IR R
5

.1412, or 14.12%

Since our MIRR decision statistic is greater than the 10 percent cost of capital, we would accept the project under the MIRR method. LG5 13-15 Compute the PI statistic for Project Q and tell whether you would accept or reject the project with the cash flows shown below if the appropriate cost of capital is 12 percent. Project Q 0 1 2 3 4 Time Cash Flow -$11,000 $3,350 $4,180 $1,520 $2,000 Using equation 13-9:
NPV $11, 000 $2, 323.72 PI $2, 323.72 $11, 000 .2112, or -21.12% $3, 350 1.12
1

$4, 180 1.12
2

$1, 520 1.12
3

$2, 000 1.12
4

Since PI < 0, the project should be rejected. LG1 13-18 How many possible IRRs could you find for the following set of cash flows? 0 1 2 3 4 Time Cash Flow -$211,000 -$39,350 $440,180 $217,520 -$2,000 Since there are 2 changes in sign, there could potentially be as many as 2 IRRs.

Intermediate Problems

13-6

Chapter 13, Solutions

Cornett, Adair, and Nofsinger

***Use this information to answer the next 6 questions. If a particular decision method should not be used, indicate why.*** Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 8 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively. 0 Time Cash -$5,000 Flow LG3 1 $1,200 2 $1,400 3 $1,600 4 $1,600 5 $1,400 6 $1,200

13-19 Use the payback decision rule to evaluate this project; should it be accepted or rejected? Cumulative cash flow will switch from negative and positive between years 3 and 4: 0 Year Cash Flow -$5,000 Cumulative Cash -$5,000 Flow Specifically, P B
3

1 $1,200 -3,800

2 $1,400 -2,400

3 4 5 6 $1,600 $1,600 $1,400 $1,200 -800 800

$800 $1, 600

3.5 years , which is equal to the maximum

allowable payback, so this project should be accepted. LG3 13-20 Use the discounted payback decision rule to evaluate this project; should it be accepted or rejected? Cumulative PV of cash flow will switch from negative and positive between years 4 and 5: Year Cash Flow Cash Flow PV Cum. Cash Flow PV 0 -$5,000 -$5,000 -$5,000 1 $1,200 $1,111 -$3,889 2 $1,400 $1,200 -$2,689 3 $1,600 $1,270 -$1,418 4 5 6 $1,600 $1,400 $1,200 $1,176 $953 $756 -$242 $710

Specifically, D PB

4

$242 $953

4.25 years , which is less than the maximum

allowable payback of 4.5 years, so this project should be accepted. LG5 13-21 Use the IRR decision rule to evaluate this project; should it be accepted or rejected? The IRR for this project will be the solution to:

13-7

Chapter 13, Solutions

Cornett, Adair, and Nofsinger

0 1 IR R

$5, 000 IR R
0

$1, 200 1 IR R
1

$1, 400 1 IR R
2

$1, 600 1 IR R
3

$1, 600 1 IR R
4

$1, 400 1 IR R
5

$1, 2 00 1 IR R
6

.1706, or 17.06%

Since IRR > i, this project should be accepted. LG5 13-22 Use the MIRR decision rule to evaluate this project; should it be accepted or rejected? Cash flows will be moved as shown below: Year Cash Flow Future Value (If Positive) Sum of FV Modified CFs 0 -$5,000 1 $1,200
$1, 200 1.08
5

2 $1,400
$1, 400 1.08
4

3 $1,600
$1, 600 1.08
3

4 $1,600
$1, 600 1.08
2

5 $1,400
$1, 400 $1, 512 1.08
1

6 $1,200
$1, 200

$1, 763.19

$1, 904.68

$2, 015.54

$1, 866.24

$10,261.66 -$5,000 With this new set of modified cash flows, the MIRR is:
0 1 IR R $5, 000 IR R
0

$10,261.66

$10, 261.66 1 IR R
6

.1273, or 12.73%

Since our MIRR decision statistic is greater than the 8 percent cost of capital, we would accept the project under the MIRR method. LG2 13-23 Use the NPV decision rule to evaluate this project; should it be accepted or rejected?
NPV $5, 000 $1, 466.58 $1, 200 1.08
1

$1, 400 1.08
2

$1, 600 1.08
3

$1, 600 1.08
4

$1, 400 1.08
5

$1, 200 1.08
6

The project should be accepted. LG7 13-24 Use the PI decision rule to evaluate this project; should it be accepted or rejected?

13-8

Chapter 13, Solutions

Cornett, Adair, and Nofsinger

NPV

$5, 000 $1, 466.58

$1, 200 1.08
1

$1, 400 1.08
2

$1, 600 1.08
3

$1, 600 1.08
4

$1, 400 1.08
5

$1, 200 1.08
6

PI

$1, 466.58 $5, 000

.2933, or 29.33%

Since PI > 0, the project should be accepted.

13-9

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