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Chapter 9

1. Payback Period Given the cash flows of the four projects, A, B, C, and D, and using

the Payback Period decision model, which projects do you accept and which projects do

you reject with a three year cut-off period for recapturing the initial cash outflow?

Assume that the cash flows are equally distributed over the year for Payback Period

calculations.

Projects

Cost

Cash Flow Year One

Cash Flow Year Two

Cash Flow Year Three

Cash Flow Year Four

Cash Flow year Five

Cash Flow Year Six

A

$10,000

$4,000

$4,000

$4,000

$4,000

$4,000

$4,000

B

$25,000

$2,000

$8,000

$14,000

$20,000

$26,000

$32,000

C

$45,000

$10,000

$15,000

$20,000

$20,000

$15,000

$10,000

D

$100,000

$40,000

$30,000

$20,000

$10,000

$0

$0

Solution

Project A:

Year Two: -$6,000 + $4,000 = $2,000 left to recover

Year Three: -$2,000 + $4,000 = fully recovered

Year Three: $2,000 / $4,000 = year needed for recovery

Payback Period for Project A: 2 and years, ACCEPT!

Project B:

Year Two: -$23,000 + $8,000 = $15,000 left to recover

Year Three: -$15,000 + $14,000 = $1,000 left to recover

Year Four: -$1,000 + $20,000 = fully recovered

Year Four: $1,000 / $20,000 = 1/20 year needed for recovery

Payback Period for Project B: 3 and 1/20 years, REJECT!

1

Project C:

Year Two: -$35,000 + $15,000 = $20,000 left to recover

Year Three: -$20,000 + $20,000 = fully recovered

Year Three: $20,000 / $20,000 = full year needed

Payback Period for Project B: 3 years, ACCEPT!

Project D:

Year Two: -$60,000 + $30,000 = $30,000 left to recover

Year Three: -$30,000 + $20,000 = $10,000 left to recover

Year Four: -$10,000 + $10,000 = fully recovered

Year Four: $10,000 / $10,000 = full year needed

Payback Period for Project B: 4 years, REJECT!

2. Payback Period What are the Payback Periods of Projects E, F, G and H? Assume

all cash flows are evenly spread throughout the year. If the cut-off period is three years,

which projects do you accept?

Projects

Cost

Cash Flow Year One

Cash Flow Year Two

Cash Flow Year Three

Cash Flow Year Four

Cash Flow year Five

Cash Flow Year Six

E

$40,000

$10,000

$10,000

$10,000

$10,000

$10,000

$10,000

F

$250,000

$40,000

$120,000

$200,000

$200,000

$200,000

$200,000

G

$75,000

$20,000

$35,000

$40,000

$40,000

$35,000

$20,000

H

$100,000

$30,000

$30,000

$30,000

$20,000

$10,000

$0

Solution

Project E:

Year Two: -$30,000 + $10,000 = $20,000 left to recover

Year Three: -$20,000 + $10,000 = $10,000 left to recover

Year Four: $10,000 / $10,000 = full year needed

Payback Period for Project A: 4 years

Project F:

Year Two: -$210,000 + $120,000 = $90,000 left to recover

Year Three: -$90,000 + $200,000 = fully recovered

Year Three: $90,000 / $200,000 = 0.45 year needed

Payback Period for Project B: 2.45 years

Project G:

Year Two: -$55,000 + $35,000 = $20,000 left to recover

Year Three: -$20,000 + $40,000 = fully recovered

Year Three: $20,000 / $40,000 = 0.5 year needed

Payback Period for Project B: 2.5 years

Project H:

Year Two: -$70,000 + $30,000 = $40,000 left to recover

Year Three: -$40,000 + $30,000 = $10,000 left to recover

Year Four: -$10,000 + $20,000 = fully recovered

Year Four: $10,000 / $20,000 = 0.5 year needed

Payback Period for Project B: 3.5 years

3. Discounted Payback Period Given the following four projects and their cash flows,

calculate the discounted payback period with a 5% discount rate, 10% discount rate, and

20% discount rate. What do you notice about the payback period as the discount rate

rises? Explain this relationship.

Projects

Cost

Cash Flow Year One

Cash Flow Year Two

Cash Flow Year Three

Cash Flow Year Four

Cash Flow year Five

Cash Flow Year Six

A

$10,000

$4,000

$4,000

$4,000

$4,000

$4,000

$4,000

B

$25,000

$2,000

$8,000

$14,000

$20,000

$26,000

$32,000

C

$45,000

$10,000

$15,000

$20,000

$20,000

$15,000

$10,000

D

$100,000

$40,000

$30,000

$20,000

$10,000

$10,000

$0

Project A:

PV Cash flow year two -- $4,000 / 1.052 = $3,628.12

PV Cash flow year three -- $4,000 / 1.053 = $3,455.35

PV Cash flow year four -- $4,000 / 1.054 = $3,290.81

PV Cash flow year five -- $4,000 / 1.055 = $3,134.10

PV Cash flow year six -- $4,000 / 1.056 = $2,984.86

and fully recovered

Discounted Payback Period is 3 years.

Project B:

PV Cash flow year two -- $8,000 / 1.052 = $7,256.24

PV Cash flow year three -- $14,000 / 1.053 = $12,093.73

PV Cash flow year four -- $20,000 / 1.054 = $16,454.05

PV Cash flow year five -- $26,000 / 1.055 = $20,371.68

PV Cash flow year six -- $32,000 / 1.056 = $23,878.89

$16,454.05 = $12,708.78 and fully recovered

Discounted Payback Period is 4 years.

Project C:

PV Cash flow year two -- $15,000 / 1.052 = $13,605.44

PV Cash flow year three -- $20,000 / 1.053 = $17,276.75

PV Cash flow year four -- $20,000 / 1.054 = $16,454.05

PV Cash flow year five -- $15,000 / 1.055 = $11,752.89

PV Cash flow year six -- $10,000 / 1.056 = $7,462.15

$16,454.05 = $11,860.05 and fully recovered

Discounted Payback Period is 4 years.

Project D:

PV Cash flow year two -- $35,000 / 1.052 = $31,746.03

PV Cash flow year three -- $20,000 / 1.053 = $17,276.75

PV Cash flow year four -- $10,000 / 1.054 = $8,227.02

PV Cash flow year five -- $10,000 / 1.055 = $7,835.26

PV Cash flow year six -- $0 / 1.056 = $0

$8,227.02 + $7,835.26 = $3,180.30 and fully recovered.

Discounted Payback Period is 5 years.

Project A:

PV Cash flow year two -- $4,000 / 1.102 = $3,307.79

PV Cash flow year three -- $4,000 / 1.103 = $3,005.26

PV Cash flow year four -- $4,000 / 1.104 = $2,732.05

PV Cash flow year five -- $4,000 / 1.105 = $2,483.69

PV Cash flow year six -- $4,000 / 1.106 = $2,257.90

= $2,681.46 and fully recovered

Discounted Payback Period is 4 years.

Project B:

PV Cash flow year two -- $8,000 / 1.102 = $6,611.57

PV Cash flow year three -- $14,000 / 1.103 = $10,518.41

PV Cash flow year four -- $20,000 / 1.104 = $13,660.27

PV Cash flow year five -- $26,000 / 1.105 = $16,143.95

PV Cash flow year six -- $32,000 / 1.106 = $18,063.17

$13,660.27 = $7,608.43 and fully recovered

Discounted Payback Period is 4 years.

Project C:

PV Cash flow year two -- $15,000 / 1.102 = $12,396.69

PV Cash flow year three -- $20,000 / 1.103 = $15,026.30

PV Cash flow year four -- $20,000 / 1.104 = $13,660.27

PV Cash flow year six -- $10,000 / 1.106 = $5,644.74

Discounted Payback Period: -$45,000 + $9,090.91 + $12,396.69 + $15,026.20 +

$13,660.27 = $5174.07 and fully recovered

Discounted Payback Period is 4 years.

Project D:

PV Cash flow year two -- $35,000 / 1.102 = $28,925.62

PV Cash flow year three -- $20,000 / 1.103 = $15,026.30

PV Cash flow year four -- $10,000 / 1.104 = $6,830.13

PV Cash flow year five -- $10,000 / 1.105 = $6,209.21

PV Cash flow year six -- $0 / 1.106 = $0

$6,830.13 + $6,209.21 = -$6,645.10 and never recovered.

Initial cash outflow is never recovered.

Solution at 20% discount rate

Project A:

PV Cash flow year two -- $4,000 / 1.202 = $2,777.78

PV Cash flow year three -- $4,000 / 1.203 = $2,314.81

PV Cash flow year four -- $4,000 / 1.204 = $1,929.01

PV Cash flow year five -- $4,000 / 1.205 = $1,6075.10

PV Cash flow year six -- $4,000 / 1.206 = $1,339.59

$354.93 and fully recovered

Project B:

PV Cash flow year two -- $8,000 / 1.202 = $5,555.56

PV Cash flow year three -- $14,000 / 1.203 = $8,101.85

PV Cash flow year four -- $20,000 / 1.204 = $9,645.06

PV Cash flow year five -- $26,000 / 1.205 = $10,448.82

PV Cash flow year six -- $32,000 / 1.206 = $10,716.74

+ $10,448.82 = $10,417.96 and fully recovered

Discounted Payback Period is 5 years.

Project C:

PV Cash flow year two -- $15,000 / 1.202 = $10,416.67

PV Cash flow year three -- $20,000 / 1.203 = $11,574.07

PV Cash flow year four -- $20,000 / 1.204 = $9,645.06

PV Cash flow year five -- $15,000 / 1.205 = $6,028.16

PV Cash flow year six -- $10,000 / 1.206 = $3,348.97

$9,645.06 + $6,028.16 = $997.29 and fully recovered

Discounted Payback Period is 5 years.

Project D:

PV Cash flow year two -- $35,000 / 1.202 = $24,305.56

PV Cash flow year three -- $20,000 / 1.203 = $11,574.07

PV Cash flow year four -- $10,000 / 1.204 = $4,822.53

PV Cash flow year six -- $0 / 1.206 = $0

Discounted Payback Period: -$100,000 + $33,333.33 + $24,305.56 + $11,574.07 +

$4,822.53 + $4,018.78 = -$21,945.73 and initial cost is never recovered.

Discounted Payback Period is infinity.

As the discount rate increases, the Discounted Payback Period also increases. The reason

is that the future dollars are worth less in present value as the discount rate increases

requiring more future dollars to recover the present value of the outlay.

for projects under $25,000 and has a cut off period of 4 years for these small value

projects. Two projects, R and S are under consideration. The anticipated cash flows for

these two projects are listed below. If Graham Incorporated uses an 8% discount rate on

these projects are they accepted or rejected? If they use 12% discount rate? If they use a

16% discount rate? Why is it necessary to only look at the first four years of the projects

cash flows?

Cash Flows

Initial Cost

Cash flow year one

Cash flow year two

Cash flow year three

Cash flow year four

Project R

$24,000

$6,000

$8,000

$10,000

$12,000

Solution at 8%

Project R:

Project S

$18,000

$9,000

$6,000

$6,000

$3,000

PV Cash flow year three -- $10,000 / 1.083 = $7,938.32

PV Cash flow year four -- $12,000 / 1.084 = $8,820.36

= $5,172.95 and initial cost is in first four years, project accepted.

Project S:

PV Cash flow year two -- $6,000 / 1.082 = $5,144.03

PV Cash flow year three -- $6,000 / 1.083 = $4,762.99

PV Cash flow year four -- $3,000 / 1.084 = $2,205.09

= $2,445.44 and initial cost is in first four years, project accepted.

Solution at 12%

Project R:

PV Cash flow year two -- $8,000 / 1.122 = $6,377.55

PV Cash flow year three -- $10,000 / 1.123 = $8,541.36

PV Cash flow year four -- $12,000 / 1.124 = $7,626.22

= $3,902.27 and initial cost is in first four years, project accepted.

Project S:

10

PV Cash flow year three -- $6,000 / 1.123 = $4,270.68

PV Cash flow year four -- $3,000 / 1.124 = $1,906.55

= $996.10 and initial cost is in first four years, project accepted.

Solution at 16%

Project R:

PV Cash flow year two -- $8,000 / 1.162 = $5,945.30

PV Cash flow year three -- $10,000 / 1.163 = $6,406.58

PV Cash flow year four -- $12,000 / 1.164 = $6,627.49

= $151.78 and initial cost is in first four years, project accepted.

Project S:

PV Cash flow year two -- $6,000 / 1.162 = $4,458.98

PV Cash flow year three -- $6,000 / 1.163 = $3,843.95

PV Cash flow year four -- $3,000 / 1.164 = $1,656.87

= -$251.58 and initial cost is not recovered in first four years, project rejected.

11

Because Graham Incorporated is using a four year cut-off period, only the first four years

of cash flow matter. If the first four years of anticipated cash flows are insufficient to

cover the initial outlay of cash, the project is rejected regardless of the cash flows in years

five and forward.

is debating using Payback Period versus Discounted Payback Period for small dollar

projects. The Information Officer has submitted a new computer project of $15,000 cost.

The cash flows will be $5,000 each year for the next five years. The cut-off period used

by Mathew Incorporated is three years. The Information Officer states it doesnt matter

what model the company uses for the decision, it is clearly an acceptable project.

Demonstrate for the IO that the selection of the model does matter!

Solution

Calculate the Payback Period for the project:

Payback Period = -$15,000 + $5,000 + $5,000 + $5,000 = 0 so the

payback period is 3 years and the project is a go!

Calculate the Discounted Payback Period for the project at any positive discount

rate, say 1%...

Present Value of cash flow year one = $5,000 / 1.01 = $4,950.50

Present Value of cash flow year two = $5,000 / 1.012 = $4,901.48

Present Value of cash flow year three = $5,000 / 1.013 = $4,852.95

Discounted Payback Period = -$15,000 + $4,950.50 + $4,901.48 +

$4,852.95 = -$295.04 so the payback period is over 3 years and the project is a no-go!

12

switching from Payback Period to Discounted Payback Period for small dollar projects.

The cut-off period will remain at 3 years. Given the following four projects cash flows

and using a 10% discount rate, which projects that would have been accepted under

Payback Period will now be rejected under Discounted Payback Period?

Cash Flows

Initial cost

Year One

Year Two

Year Three

Project One

$10,000

$4,000

$4,000

$4,000

Project Two

$15,000

$7,000

$5,500

$4,000

Project

Three

$8,000

$3,000

$3,500

$4,000

Project Four

$18,000

$10,000

$11,000

$0

Solution

Calculate the Discounted Payback Periods of each project at 10% discount rate:

Project One

Present Value of cash flow year one = $4,000 / 1.10 = $3,636.36

Present Value of cash flow year two = $4,000 / 1.102 = $3,305.78

Present Value of cash flow year three = $4,000 / 1.103 = $3,005.26

Discounted Payback Period = -$10,000 + $3,636.36 + $3,305.78 +

$3,005.26 = -$52.60 so the discount payback period is over 3 years and the project is

a no-go!

Project Two

Present Value of cash flow year one = $7,000 / 1.10 = $6,930.69

Present Value of cash flow year two = $5,500 / 1.102 = $5,391.63

13

Discounted Payback Period = -$15,000 + $6,930.69 + $5,391.63 +

$3,005.26 = $327.58 so the discount payback period is 3 years and the project is a go!

Project Three

Present Value of cash flow year one = $2,500 / 1.10 = $2,272.73

Present Value of cash flow year two = $3,000 / 1.102 = $2,479.34

Present Value of cash flow year three = $3,500 / 1.103 = $2,629.60

Discounted Payback Period = -$8,000 + $2,272.73+ $2,479.34 +

$2,629.20 = -$618.33 so the discount payback period is over 3 years and the project is

a no-go!

Project Four

Present Value of cash flow year one = $10,000 / 1.10 = $9,090.91

Present Value of cash flow year two = $11,000 / 1.102 = $9,090.91

Present Value of cash flow year three = $0 / 1.103 = $0

Discounted Payback Period = -$18,000 + $9,090.91 + $9,090.91 + $0 = $181.82

so the discount payback period is 3 years and the project is a go!

Projects one and three will now be rejected using discounted payback period with

a discount rate of 10%.

7. Net Present Value Swanson Industries has a project with the following projected

cash flows:

Initial Cost, Year 0: $240,000

Cash flow year one: $25,000

14

Cash flow year three: $150,000

Cash flow year four: $150,000

a. Using a 10% discount rate for this project and the NPV model should this

project be accepted or rejected?

b. Using a 15% discount rate?

c. Using a 20% discount rate?

Solution

a. NPV = -$240,000 + $25,000/1.10 + $75,000/1.102 + $150,000/1.103 +

$150,000/1.104

NPV = -$240,000 + $22,727.27 + $61,983.47 + $112,697.22 + $102,452.02

NPV = $59,859.98 and accept the project.

b. NPV = -$240,000 + $25,000/1.15 + $75,000/1.152 + $150,000/1.153 +

$150,000/1.154

NPV = -$240,000 + $21,739.13 + $56,710.76 + $98,627.43 + $85,762.99

NPV = $22,840.31 and accept the project.

c. NPV = -$240,000 + $25,000/1.20 + $75,000/1.202 + $150,000/1.203 +

$150,000/1.204

NPV = -$240,000 + $20,833.33 + $52,083.33 + $86,805.56 + $72,337.96

NPV = -$7,939.82 and reject the project.

8. Net Present Value Campbell Industries has a project with the following projected

cash flows:

15

Cash flow year one: $135,000

Cash flow year two: $240,000

Cash flow year three: $185,000

Cash flow year four: $135,000

a. Using an 8% discount rate for this project and the NPV model should this

project be accepted or rejected?

b. Using a 14% discount rate?

c. Using a 20% discount rate?

Solution

a. NPV = -$468,000 + $135,000/1.08 + $240,000/1.082 + $185,000/1.083 +

$135,000/1.084

NPV = -$468,000 + $125,000.00 + $205,761.32 + $146,858.96 + $99,229.03

NPV = $108,849.31 and accept the project.

b. NPV = -$468,000 + $135,000/1.14 + $240,000/1.142 + $185,000/1.143 +

$135,000/1.144

NPV = -$468,000 + $118,421.05 + $184,672.21 + $124,869.73 + $79,930.84

NPV = $39,893.83 and accept the project.

c. NPV = -$468,000 + $135,000/1.20 + $240,000/1.202 + $185,000/1.203 +

$135,000/1.204

NPV = -$468,000 + $112,500.00 + $166,666.67 + $107,060.19 + $65,104.17

NPV = -$16,668.97 and reject the project.

16

9. Net Present Value Swanson Industries has four potential projects all with an initial

cost of $2,000,000. The capital budget for the year will only allow Swanson industries to

accept one of the four projects. Given the discount rates and the future cash flows of each

project, which project should they accept?

Cash Flows

Year one

Year two

Year three

Year four

Year five

Discount Rate

Project M

$500,000

$500,000

$500,000

$500,000

$500,000

6%

Project N

$600,000

$600,000

$600,000

$600,000

$600,000

9%

Project O

$1,000,000

$800,000

$600,000

$400,000

$200,000

15%

Project P

$300,000

$500,000

$700,000

$900,000

$1,100,000

22%

Solution, find the NPV of each project and compare the NPVs.

Project Ms NPV = -$2,000,000 + $500,000/1.05 + $500,000/1.052 +

$500,000/1.053 + $500,000/1.054 + $500,000/1.055

Project Ms NPV = -$2,000,000 + $476,190.48 + $453,514.74 + $431,918.80

+ $411,351.24 + $391,763.08

Project Ns NPV = $164,738.34

Project Ns NPV = -$2,000,000 + $600,000/1.09 + $600,000/1.092 +

$600,000/1.093 + $600,000/1.094 + $600,000/1.095

Project Ns NPV = -$2,000,000 + $550,458.72 + $505,008.00 + $463,331.09

+ $425,055.13 + $389,958.83

Project Ns NPV = $333,790.77

Project Os NPV = -$2,000,000 + $1,000,000/1.15 + $800,000/1.152 +

$600,000/1.153 + $400,000/1.154 + $200,000/1.155

Project Os NPV = -$2,000,000 + $869,565.22 + $604,914.93 + $394,509.74

+ $228,701.30 + $99,435.34

17

Project Ps NPV = -$2,000,000 + $300,000/1.22 + $500,000/1.222 +

$700,000/1.223 + $900,000/1.224 + $1,100,000/1.225

Project Ps NPV = -$2,000,000 + $245,901.64 + $335,931.20 + $385,494.82

+ $406,259.18 + $406,999.18

Project Ps NPV =-$219,413.98 (would reject project regardless of budget)

And the ranking order based on NPVs is,

Project N NPV of $333,790.77

Project O NPV of $197,126.53

Project M NPV of $164,738.34

Project P NPV of -$219,413.98

Swanson Industries should pick Project N.

10. Net Present Value Campbell Industries has four potential projects all with an initial

cost of $1,500,000. The capital budget for the year will only allow Swanson industries to

accept one of the four projects. Given the discount rates and the future cash flows of each

project, which project should they accept?

Cash Flows

Year one

Year two

Year three

Year four

Year five

Discount Rate

Project Q

$350,000

$350,000

$350,000

$350,000

$350,000

4%

Project R

$400,000

$400,000

$400,000

$400,000

$400,000

8%

Project S

$700,000

$600,000

$500,000

$400,000

$300,000

13%

Project T

$200,000

$400,000

$600,000

$800,000

$1,000,000

18%

Solution, find the NPV of each project and compare the NPVs.

Project Qs NPV = -$1,500,000 + $350,000/1.04 + $350,000/1.042 +

$350,000/1.043 + $350,000/1.044 + $350,000/1.045

18

+ $299,181.47 + $287,674.49

Project Qs NPV = $58,137.84

Project Rs NPV = -$1,500,000 + $400,000/1.08 + $400,000/1.082 +

$400,000/1.083 + $400,000/1.084 + $400,000/1.085

Project Rs NPV = -$2,000,000 + $370,370.37 + $342,935.53 + $317,532.90

+ $294,011.94 + $272,233.28

Project Rs NPV = $97,084.02

Project Ss NPV = -$1,500,000 + $700,000/1.13 + $600,000/1.132 +

$500,000/1.133 + $400,000/1.134 + $300,000/1.135

Project Ss NPV = -$1,500,000 + $619,469.03 + $469,888.01 + $346,525.08

+ $245,327.49 + $162,827.98

Project Ss NPV = $344,037.59

Project Ts NPV = -$1,500,000 + $200,000/1.18 + $400,000/1.182 +

$600,000/1.183 + $800,000/1.184 + $1,000,000/1.185

Project Ts NPV = -$1,500,000 + $169,491.53 + $287,273.77 + $365,178.52

+ $412,631.10 + $437,109.22

Project Ts NPV = $171,684.14

And the ranking order based on NPVs is,

Project S NPV of $344,037.59

Project T NPV of $171,684.14

Project R NPV of $97,084.02

Project Q NPV of $58,137.84

19

11. Internal Rate of Return What are the IRRs of the four projects for Swanson

Industries in problem #9?

Solution, this is an iterative process but can be solved quickly on a calculator or

spreadsheet.

Enter the keys noted for each project in the CF of a Texas BA II Plus calculator

Cash Flows

CFO

CO1, F1

CO2, F2

Year three

Year four

Year five

CPT IRR

Project M

-$2,000,000

$500,000, 1

$500,000, 1

$500,000, 1

$500,000, 1

$500,000, 1

7.93%

Project N

-$2,000,000

$600,000, 1

$600,000, 1

$600,000, 1

$600,000, 1

$600,000, 1

15.24%

Project O

-$2,000,000

$1,000,000, 1

$800,000, 1

$600,000, 1

$400,000, 1

$200,000, 1

20.27%

Project P

-$2,000,000

$300,000, 1

$500,000, 1

$700,000, 1

$900,000, 1

$1,100,000, 1

17.72%

12. Internal Rate of Return -- Internal Rate of Return What are the IRRs of the four

projects for Campbell Industries in problem #10?

Solution, this is an iterative process but can be solved quickly on a calculator or

spreadsheet.

Enter the keys noted for each project in the CF of a Texas BA II Plus calculator

Cash Flows

CFO

CO1, F1

CO2, F2

Year three

Year four

Year five

CPT IRR

Project Q

-$1,500,000

$350,000, 1

$350,000, 1

$350,000, 1

$350,000, 1

$350,000, 1

5.37%

Project R

-$1,500,000

$400,000, 1

$400,000, 1

$400,000, 1

$400,000, 1

$400,000, 1

10.42%

20

Project S

-$1,500,000

$700,000, 1

$600,000, 1

$500,000,1

$400,000, 1

$300,000, 1

23.57%

Project T

-$1,500,000

$200,000, 1

$400,000, 1

$600,000, 1

$800,000, 1

$1,000,000, 1

21.86%

13. Comparing NPV and IRR Chandler and Joey were having a discussion about which

financial model to use for their new business. Chandler supports NPV and Joey supports

IRR. The discussion starts to get heated when Ross steps in and states, gentlemen, it

doesnt matter which method we choose, they give the same answer on all projects. Is

Ross right? Under what conditions will IRR and NPV be consistent when accepting or

rejecting projects?

Solution: Ross is partially right as NPV and IRR both reject or both accept the

same projects under the following conditions:

The hurdle rate for IRR is the same as the discount rate for NPV

made on another project (projects are not mutually exclusive)

14. Comparing NPR and IRR Monica and Rachel are having a discussion about IRR

and NPV as a decision model for Monicas new restaurant. Monica wants to use IRR

because it gives a very simple and intuitive answer. Rachel states that there can be errors

made with IRR that are not made with NPV. Is Rachel right? Show one type of error can

be made with IRR and not with NPV?

Solution: The most typical example here is with two mutually exclusive

projects where the IRR of one project is higher than the IRR of the other

project but the NPV of the second project is higher than the NPV of the first

21

project. When comparing two projects using only IRR this method fails to

account for the level of risk of the project cash flows. When the discount rate

is below the cross-over rate one project is better under NPV while the other

project is better if the discount rate is above the cross-over rate and still below

the IRR.

15. Profitability Index -- Given the discount rates and the future cash flows of each

project, which projects should they accept using profitability index?

Cash Flows

Year zero

Year one

Year two

Year three

Year four

Year five

Discount Rate

Project U

-$2,000,000

$500,000

$500,000

$500,000

$500,000

$500,000

6%

Project V

-$2,500,000

$600,000

$600,000

$600,000

$600,000

$600,000

9%

Project W

-$2,400,000

$1,000,000

$800,000

$600,000

$400,000

$200,000

15%

Project X

-$1,750,000

$300,000

$500,000

$700,000

$900,000

$1,100,000

22%

Solution, find the present value of benefits and divide by the present value of the

costs for each project.

Project Us PV Benefits = $500,000/1.05 + $500,000/1.052 + $500,000/1.053

+ $500,000/1.054 + $500,000/1.055

Project Us PV Benefits = $476,190.48 + $453,514.74 + $431,918.80 +

$411,351.24 + $391,763.08 = $2,164,738.34

Project Us PV Costs = $2,000,000

Project Us PI = $2,164,738.34 / $2,000,000 = $1.0824 accept project.

Project Vs PV Benefits = $600,000/1.09 + $600,000/1.092 + $600,000/1.093

+ $600,000/1.094 + $600,000/1.095

22

$463,331.09 + $425,055.13 + $389,958.83 = $2,333,790.77

Project Vs PV Costs = $2,500,000

Project Vs PI = $2,333,790.77 / $ 2,500,000 = 0.9335 and reject project.

Project Ws PV Benefits = $1,000,000/1.15 + $800,000/1.152 +

$600,000/1.153 + $400,000/1.154 + $200,000/1.155

Project Ws PV Benefits = $869,565.22 + $604,914.93 + $394,509.74 +

$228,701.30 + $99,435.34 = $2,197,126.53

Project Ws PV Costs = $2,400,000

Project Ws PI = $2,197,126.53 / $2,400,000 = 0.9155 and reject project.

Project Xs PV Benefits= -$2,000,000 + $300,000/1.22 + $500,000/1.222 +

$700,000/1.223 + $900,000/1.224 + $1,100,000/1.225

Project Xs PV Benefits= -$2,000,000 + $245,901.64 + $335,931.20 +

$385,494.82 + $406,259.18 + $406,999.18 = $1,780,586.02

Project Xs PV Cost = $1,750,000

Project Xs PI = $1,780,586.02 / $1,750,000 = 1.0175 and accept project.

16. Profitability Index -- Given the discount rates and the future cash flows of each

project, which projects should they accept using profitability index?

Cash Flows

Year zero

Year one

Year two

Year three

Year four

Year five

Discount Rate

Project A

-$1,500,000

$350,000

$350,000

$350,000

$350,000

$350,000

4%

Project B

-$1,500,000

$400,000

$400,000

$400,000

$400,000

$400,000

8%

23

Project C

-$2,000,000

$700,000

$600,000

$500,000

$400,000

$300,000

13%

Project D

-$2,000,000

$200,000

$400,000

$600,000

$800,000

$1,000,000

18%

Solution, find the present value of benefits and divide by the present value of the

costs for each project.

Project As PV Benefits = $350,000/1.04 + $350,000/1.042 + $350,000/1.043

+ $350,000/1.044 + $350,000/1.045

Project As PV Benefits = $336,538.46 + $323,594.67 + $311,148.73 +

$299,181.47 + $287,674.49 = $1,558,137.84

Project As PV Costs = $1,500,000

Project As PI = $1,558,137.84 / $1,500,000 = 1.0388 and accept project.

Project Bs PV Benefits = $400,000/1.08 + $400,000/1.082 + $400,000/1.083

+ $400,000/1.084 + $400,000/1.085

Project Bs NPV = -$2,000,000 + $370,370.37 + $342,935.53 + $317,532.90

+ $294,011.94 + $272,233.28 = $1,597,084.02

Project Bs PV Costs = $1,500,000

Project Bs PI = $1,597,084.02 / $1,500,000 = 1.0647 and accept project.

Project Cs PV Benefits = $700,000/1.13 + $600,000/1.132 + $500,000/1.133

+ $400,000/1.134 + $300,000/1.135

Project Cs PV Benefits = $619,469.03 + $469,888.01 + $346,525.08 +

$245,327.49 + $162,827.98 = $1,844,037.59

Project Cs PV Costs = $2,000,000

Project Cs PI = $1,844,037.59 / $2,000,000 = 0.9220 and reject project.

Project Ds PV Benefits = $200,000/1.18 + $400,000/1.182 + $600,000/1.183

+ $800,000/1.184 + $1,000,000/1.185

24

$412,631.10 + $437,109.22 = $1,671,684.14

Project Ds PV Costs = $2,000,000

Project Ds PI = $1,671,684.14 / $2,000,000 = 0.8358 and reject project.

17. Comparing All Methods -- Given the following After Tax Cash Flows for Tylers

Tinkering Toys on a new toy find the Payback Period, NPV, and Profitability Index of

this project. The appropriate discount rate for the project is 12%. If the cut-off period is

six years for major projects, determine if the project is accepted or rejected under the four

different decision models.

Year 0 cash outflow: $10,400,000

Years 1 to 4 cash inflow: $2,600,000 each year

Year 5 cash outflow: $1,200,000

Years 6 8 cash inflow: $750,000 each year

Solution:

Payback Period: -$10,400,000 + $2,600,000 + $2,600,000 + $2,600,000 +

$2,600,000 = $0 (Four years but year five is also an outflow so we need to

continue) -$1,200,000 + $7,500,000 + $7,500,000 = $300,000 so we only need

part of year seven, $4,500,000 / $7,500,000 = 0.6 so total Payback is 7.6 years

and project is rejected with six year cut-off.

25

$2,600,000/1.123 + $2,600,000/1.124 - $1,200,000/1.125 + $7,500,000/1.126 +

$7,500,000/1.127 + $750,000/1.128

NPV = -$10,400,000 + $2,321,428.57 + $2,072,704.08 + $1,850,628.64 +

$1,652,347.00 - $680,912.23 + $379,973.34 + $339,261.91 + $302,912.42

NPV = -$2,161,656.25 and reject project under NPV rules.

$2,600,000/1.123 + $2,600,000/1.124 - + $7,500,000/1.126 + $7,500,000/1.127 +

$750,000/1.128 = $2,321,428.57 + $2,072,704.08 + $1,850,628.64 +

$1,652,347.00 + $379,973.34 + $339,261.91 + $302,912.42 = $8,919,255.73

$680,912.23 = $11,080,912.23

18. Comparing All Methods -- Toms Risky Business is looking at a project with the

estimated cash flows as follows:

Cash Flow at end of Year 1: $500,000

Cash Flow at end of Years 2 through 6: $625,000 each year

Cash Flow at end of Year 7 through 9: $530,000 each year

26

Risky Business wants to know the Payback Period, NPV, and Profitability Index

of this project. The appropriate discount rate for the project is 14%. If the cut-off

period is six years for major projects, determine if the project is accepted or

rejected under the four different decision models.

Solution:

Payback Period = -$3,600,000 + $500,000 + $625,000 + $625,000 + $625,000 +

$625,000 + $625,000 = $ 25,000 and we only need part of year 6 so,

$600,000 / $625,000 = 0.96 and Payback Period is 5.96 years and project is

accepted.

NPV = -$3,600,000 + $500,000 / 1.14 + $625,000/1.142 + $625,000/1.143 +

$625,000/1.144 + $625,000/1.145 + $625,000/1.146 + $530,000/1.147

+ $530,000 /1.148 + $530,000/1.149 + $385,000/1.1410

NPV = -$3,600,000 + $438,596.49 + $480,917.21 + $421,857.20 + $370,050.17

+ $324,605.42 + $284,741.59 + $211,807.78 + $185,796.30 + $162,979.21

+ $103,851.37 = -$614,797.27 and project is rejected using NPV rules.

$625,000/1.144 + $625,000/1.145 + $625,000/1.146 + $530,000/1.147

+ $530,000 /1.148 + $530,000/1.149 + $385,000/1.1410

27

$370,050.17 + $324,605.42 + $284,741.59 + $211,807.78 + $185,796.30 +

$162,979.21+ $103,851.37 = $2,985,202.73

Profitability Index = $2,985,202.73 / $3,600,000 = 0.8292 and reject.

28

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