Problem Set on Ch.

10
Crossover rate and missing cash flow
1. Athey Airlines is considering two mutually exclusive projects, Project A and Project B. The
projects have the following cash flows (in millions of dollars!
Project A Project B
"ear #ash $low #ash $low
% &'(.% )
1 *.% 1.+
* ,.% ,.*
, -.% -..
The crossover rate of the two projects/ 0P1 profiles is 2 percent. #onse3uently, when the
4A## is 2 percent the projects have the same 0P1. 4hat is the cash flow for Project B at t 5
%)
NPV profiles
*. Two projects 6eing considered are mutually exclusive and have the following projected cash
flows!
Project A Project B
"ear #ash $low #ash $low
% &'-%,%%% &' -%,%%%
1 1-,22% %
* 1-,22% %
, 1-,22% %
( 1-,22% %
- 1-,22% 1%%,-7%
At what rate (approximately do the 0P1 profiles of Projects A and B cross)
NPV
,. 8eturns on the mar9et and #ompany "/s stoc9 during the last , years are shown 6elow!
"ear :ar9et #ompany "
1 &*(; &**;
* 1% 1,
, ** ,7
The ris9&free rate is - percent, and the re3uired return on the mar9et is 11 percent. "ou are
considering a low&ris9 project whose mar9et 6eta is %.- less than the company/s overall
1
corporate 6eta. "ou finance only with e3uity, all of which comes from retained earnings. The
project has a cost of '-%% million, and it is expected to provide cash flows of '1%% million per
year at the end of "ears 1 through - and then '-% million per year at the end of "ears 7
through 1%. 4hat is the project/s 0P1 (in millions of dollars)
NPV profiles
(. As the director of capital 6udgeting for 8aleigh<=urham #ompany, you are evaluating two
mutually exclusive projects with the following net cash flows!
Project > Project ?
"ear #ash $low #ash $low
% &'1%% &'1%%
1 -% 1%
* (% ,%
, ,% (%
( 1% 7%
@s there a crossover point in the relevant part of the 0P1 profile graph (the northeast, or upper
right, 3uadrant)
MIRR
-. Taylor Technologies has a target capital structure which is (% percent de6t and 7% percent
e3uity. The e3uity will 6e financed with retained earnings. The company/s 6onds have a
yield to maturity of 1% percent. The company/s stoc9 has a 6eta 5 1.1. The ris9&free rate is 7
percent, the mar9et ris9 premium is - percent, and the tax rate is ,% percent. The company is
considering a project with the following cash flows!
Project A
"ear #ash $low
% &'-%,%%%
1 ,-,%%%
* (,,%%%
, 7%,%%%
( &(%,%%%
4hat is the project/s modified internal rate of return (:@88)
2
Solttions
. Crossover rate and missing cash flow
Atep 1! =etermine the 0P1 of Project A at the crossover rate!
0P1A 5 &'( B '*<1.%2 B ',<(1.%2
*
B '-<(1.%2
,
5 &'( B '1..,(.7 B '*.-*-%( B ',..7%2*
5 '(.**%.* million.
Atep *! =etermine the P1 of cash inflows for Project B at the crossover rate!
0P1B 5 #$% B '1.+<1.%2 B ',.*<(1.%2
*
B '-..<(1.%2
,
5 #$% B '1.--27, B '*.72,,. B '(.(+.77
5 #$% B '..+,17+ million.
Atep ,! =etermine the cash outflow at t 5 % for Project B!
At the crossover rate, 0P1A 5 0P1BC 0P1A & 0P1B 5 %.
0P1A 5 '(.**%.* millionC 0P1B 5 #$% B '..+,17+ million.
'(.**%.* & #$% & '..+,17+ 5 %
&#$% 5 '..+,17+ & '(.**%.*
#$% 5 &'(.-1%.- million.
Financial calculator solution:
Atep 1! =etermine the 0P1 of Project A at the crossover rate!
Dsing a financial calculator, enter the following inputs!
#$% 5 &(, #$1 5 *, #$* 5 ,, #$, 5 -, @ 5 2, and then solve for 0P1A 5 '(.**%.*
million.
Atep *! =etermine the P1 of cash inflows for Project B at the crossover rate!
Dsing a financial calculator, enter the following inputs!
#$% 5 %, #$1 5 1.+, #$* 5 ,.*, #$, 5 -.., @ 5 2, and then solve for 0P1 5
'..+,17+ million.
(8emem6er, this isn/t the 0P1B 6ecause at the crossover rate 0P1B 5 0P1A 5
'(.**%.* million.
Atep ,! =etermine the cash outflow at t 5 % for Project B!
At the crossover rate, 0P1A 5 0P1BC 0P1A & 0P1B 5 %.
0P1A 5 '(.**%.* millionC 0P1B 5 #$% B '..+,17+ million.
'(.**%.* & #$% & '..+,17+ 5 %
&#$% 5 '..+,17+ & '(.**%.*
#$% 5 &'(.-1%.- million.
3
2. NPV profiles
Net Present Value
[$]
11.5
50,560
29,950
Project Bs NPV profile
rosso!er rate " 11.5#
Project $s NPV profile
ost of apital %#&
'((
$
" 1)#
'((
B
" 15#
Time line:



IRR
A
= ?


0
IRR
B
= ?
1 2 3 4 5 Years


CF
A
-50,000 15,990 15,990 15,990 15,990 15,990
CF
B
-50,000 0 0 0 0 100,560
CF
A-B
0 15,990 15,990 15,990 15,990 -84,50
Finan!ial !al!"la#$r s$l"#i$n:
Solve for IRR
A
In%"#s: CF
0
= -50,000& CF
1
= 15,990& '
(
= 5) *"#%"#: IRR =
18)0+
Solve for IRR
B
In%"#s: CF
0
= -50,000& CF
1
= 0& '
(
= 4& CF
2
= 100,560) *"#%"#:
IRR

=

15)0+
Solve for crossover rate using the differential project CFs,
CF
A-B
In%"#s: CF
0
= 0& CF
1
= 15,990& '
(
= 4& CF
2
= -84,50)
*"#%"#: IRR = 11)49+) T,e !r$ss$-er ra#e is 11)49+)
Ta."lar s$l"#i$n:
Solve for numerical PVIFA and PVIF and obtain corresponding
interest rates from table.
/r$(e!# A: 50,000 = 15,9900/1IFA
IRRA,5
2
3)12695 = /1IFA
IRRA,5
IRR
A
18+
/r$(e!# B: 50,000 = 100,5600/1IF
IRRB,5
2
0)4922 = /1IF
IRRB,5
IRR
B
15+
3$l-in4 5$r #,e !r$ss$-er ra#e $5 11)49+ re6"ires
in#er%$la#i$n, 7,i!, is n$# !$-ere8 in #,e #e9#) :$7e-er, .;
"sin4 #rial an8 err$r an8 an '/1 %r$5ile 8ra7in4, #,e s#"8en#
!an sele!# #,e !$rre!# m"l#i%le !,$i!e ans7er, 11)5+) <ra7in4
an '/1 %r$5ile 8ra7in4 "sin4 #,e !al!"la#e8 IRRs, an8 #,e '/1s
a# = = 0+, s,$7s #,a# #,ere is a !r$ss$-er ra#e) *5 #,e
res%$nses lis#e8 in #,e %r$.lem, 16)5+ an8 20)0+ are !learl;
#$$ ,i4,, sin!e #,e IRR
B
is 15+) A# = = 6)5+ #,e '/1s are n$#
e6"al, #,"s 11)5+ m"s# .e #,e !$rre!# res%$nse)
3. NPV
4
Atep 1! 8un a regression to find the corporate 6eta. :ar9et returns are the >&input values,
while "/s returns are the "&input values. Beta is 1.*1%*.
Atep *! $ind the project/s estimated 6eta 6y su6tracting %.- from the corporate 6eta. The
project 6eta is thus 1.*1%* & %.- 5 %.+1%*.
Atep ,! $ind the company/s cost of e3uity, which is its 4A## 6ecause it uses no de6t!
9s 5 4A## 5 -; B (11; & -;%.+1%* 5 2.*7;.
Atep (! 0ow find the project/s 0P1 (inputs are in millions!
#$% 5 &-%%C #$1&- 5 1%%C #$7&1% 5 -%C @ 5 2.*7;C and then solve for 0P1 5
'1%.(* million.
4. NPV profiles
Time line:



A IRR
= ?


0
B IRR
= ? 1 2 3 4 Years



CF
>
-100 50 40 30 10
CF
Y
-100 10 30 40 60
CF
> - Y
0 40 10 -10 -50
Finan!ial !al!"la#$r s$l"#i$n:
/r$(e!# >: In%"#s: CF
0
= -100& CF
1
= 50& CF
2
= 40& CF
3
= 30& CF
4
= 10)
*"#%"#: IRR = 14)489+ 14)49+)
/r$(e!# Y: In%"#s: CF
0
= -100& CF
1
= 10& CF
2
= 30& CF
3
= 40& CF
4
= 60)
*"#%"#: IRR = 11)9+)
Calculate the PVs of the projects at ! " # discount rate.
'/1
>,= = 0+
= -100 ? 50? 40 ? 30 ? 10 = 30)
'/1
Y,= = 0+
= -100 ? 10 ? 30 ? 40 ? 60 = 40)
Calculate the IRR of the differential project, that is,
Project
> - Y
IRR
> - Y
In%"#s: CF
0
= 0& CF
1
= 40& CF
2
= 10& CF
3
= -10& CF
4
= -50)
*"#%"#: IRR = )16 )1+)
3$lel; "sin4 #,e !al!"la#$r 7e !an 8e#ermine #,a# #,ere is a
!r$ss$-er %$in# in #,e rele-an# %ar# $5 an '/1 %r$5ile 4ra%,)
/r$(e!# > ,as #,e ,i4,er IRR) /r$(e!# Y ,as #,e ,i4,er '/1 a# =
= 0) T,e !r$ss$-er ra#e is )1+ an8 $!!"rs in #,e "%%er ri4,#
6"a8ran#)
5. MIRR
5
First, find the companys weighted average cost of capital:
4e/re given the 6efore&tax cost of de6t, 9d 5 1%;. 4e can find the cost of e3uity as follows!
9s 5 %.%7 B %.%-(1.1 5 %.11- or 11.-;.
Thus, the 4A## is! 9 5 %.((%.1%(1 & %., B %.7(%.11- 5 %.%2+ or 2.+;.
Second, the PV of all cash outflows can be calculated as follows:
P1 of #$(! 0 5 (C @ 5 2.+C P:T 5 %C $1 5 (%,%%%C and then solve for P1 5 &'*+,7*%.7*. Total
P1#osts 5 &'-%,%%% & '*+,7*%.7* 5 &'++,7*%.7*.
Third, find the terminal value of the project at t !:
$1 of #$1 at t 5 ( is calculated as follows! 0 5 ,C @ 5 2.+C P1 5
&,-,%%%C P:T 5 %C and then solve for $1 5 '(7,*%(,.2. Aimilarly, the $1s of #$* and #$, are
found to 6e '-1,+(7.-2 and '7-,.*%, respectively. Aumming these $1s gives a terminal value
of '(7,*%(..2 B '-1,+(7.-2 B '7-,.*%.%% 5 '17,,++1.(..
Finall;, #,e @IRR !an .e !al!"la#e8 as ' = 4& /1 = -,620)62&
/@T = 0& F1 = 163,1)48& an8 #,en s$l-e 5$r I = @IRR = 20)52+)
6