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Capital Budgeting Solutions Manual Ch10 PDF
Capital Budgeting Solutions Manual Ch10 PDF
Why are capital investments considered the most important decisions made by a firms
management?
Capital investments are the most important decisions made by a firms management,
because they usually involve large cash outflows and once made are not easily reversed.
These are usually long-term projects that will define the firms line of business and
significantly contribute to the total revenue figure for years to come.
2.
What are the differences between capital projects that are independent, mutually
exclusive, and contingent?
A project is independent if the decision to accept or reject it does not affect the decision
to accept or reject another project. On the other hand, projects are mutually exclusive if
the acceptance of one implies rejection of the other. Contingent projects are those in
which the acceptance of one project is dependent on another project.
Section 10.2
1.
2.
If a firm accepts a project with a $10,000 NPV, what is the effect on the value of the
firm?
If a firm accepts a project with a $10,000 NPV, it will increase its value by $10,000.
3.
Section 10.3
1.
2.
Why does the payback period provide a measure of a projects liquidity risk?
The payback period determines how quickly you recover your investment in a project.
Thus, it serves as a good measure of the projects liquidity.
3.
Section 10.4
1.
What are the major shortcomings of using the ARR method as a capital budgeting
method?
The biggest shortcoming of using ARR as a capital budgeting tool is that it uses
historical, or book value data rather than cash flows and thus disregards the time value of
money principle. In addition, as in the payback method, it fails to establish a rationale
behind picking the appropriate hurdle rate.
Section 10.5
1.
2.
3.
Why should the NPV method be the primary decision tool used in making capital
investment decisions?
Given all the different methods to evaluate capital investment decisions, the NPV method
is the preferred valuation tool as it accounts for both time value of money and the
projects risk. Furthermore, NPV is not sensitive to nonconventional projects, and
therefore it is superior to the IRR technique and it gives a measure of the value
increase/decrease to the firm by undertaking the project.
Section 10.6
1.
What changes have taken place in the capital budgeting techniques used by U.S.
companies?
Over the years, there has been a shift from using payback and ARR as the primary capital
budgeting tools to using NPV and IRR instead. Managers today understand the
importance of the time value of money and discounting and thus regard ARR as an
inaccurate and obsolete decision tool.
Self-Study Problems
10.1
Premium Manufacturing Company is evaluating two forklift systems to use in its plant that
produces the towers for a windmill power farm. The costs and the cash flows from these
systems are shown below. If the company uses a 12 percent discount rate for all projects,
determine which forklift system should be purchased using the net present value (NPV)
approach.
Year 0
Year 1
Year 2
Year 3
Otis Forklifts
$3,123,450
$979,225
$1,358,886
$2,111,497
Craigmore Forklifts
$4,137,410
$875,236
$1,765,225
$2,865,110
Solution:
NPV for Otis Forklifts:
CFt
t
t = 0 (1 + k )
n
NPV =
= $3,123,450 +
NPV =
Premium should purchase the Otis forklift since it has a larger NPV.
10.2
Rutledge, Inc., has invested $100,000 in a project that will produce cash flows of
$45,000, $37,500, and $42,950 over the next three years. Find the payback period for the
project.
Solution:
Payback period for Rutledge project:
Cumulative
Year
CF
Cash Flow
(100,000)
(100,000)
45,000
(55,000)
37,500
(17,500)
42,950
25,450
$17,500
$42,950 per year
= 2.41years
=2+
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 2 + ($17,500 / $42,950)
= 2.41 years
10.3
Perryman Crafts Corp. is evaluating two independent capital projects that together will
cost the company $250,000. The two projects will provide the following cash flows:
Year
Project A
Project B
$80,750
$32,450
$93,450
$76,125
$40,325
$153,250
$145,655
$96,110
Which project will be chosen if the companys payback criterion is three years? What if the
company accepts all projects as long as the payback period is less than five years?
Solution:
Payback periods for Perryman projects A and B:
Project A
Cumulative
Year
Cash Flow
Cash Flows
$(250,000)
$(250,000)
80,750
(169,250)
93,450
(75,800)
40,235
(35,565)
145,655
110,090
Project B
Cumulative
Year
Cash Flow
Cash Flows
$(250,000)
$(250,000)
32,450
(217,550)
76,125
(141,425)
153,250
11,825
96,110
107,935
$35,565
$145,655 per year
= 3.24 years
= 3+
$141, 425
$153, 250 per year
= 2.92 years
=2+
If the payback period is three years, only project B will be chosen. If the payback criterion is
five years, both A and B will be chosen.
10.4
Terrell Corp. is looking into purchasing a machine for its business that will cost $117,250
and will be depreciated on a straight-line basis over a five-year period. The sales and
expenses (excluding depreciation) for the next five years are shown in the following table.
Year 1
Year 2
Year 3
Year 4
Year 5
The
company w$123,450
ill accept all projects
that provi
de an accou$255,440
nting rate of re$267,125
turn (ARR) of at least 45 percent. Sh
$176,875
$242,455
Sales
Expenses
$137,410
$126,488
$141,289
$143,112
$133,556
The company will accept all projects that provide an accounting rate of return (ARR) of at
least 45 percent. Should the company accept the project?
Solution:
Year 1
Sales
Year 2
$123,450 $176,875
Expenses
Depreciation
EBIT
Taxes (34%)
Year 4
Year 5
$242,455
$255,440
$267,125
137,410
126,488
141,289
143,112
133,556
23,450
23,450
23,450
23,450
23,450
$ (37,410) $ 26,937
$ 77,716
$ 88,878
$110,119
9,159
26,423
30,219
37,440
$ (24,691) $ 17,778
$ 51,293
$ 58,659
$ 72,679
12,719
Net Income
Year 3
117,250
93,800
70,350
46,900
23,450
Less: Depreciation
(23,450)
(23,450)
(23,450)
(23,450)
(23,450)
$ 93,800 $ 70,350
$ 46,900
$ 23,450
= $35,143.6 / $58,625
= 0.599 or 59.9%
10.5
Refer to Problem 10.1. Compute the IRR for each of the two systems. Is the investment
decision different from the one determined by NPV?
Solution:
Explain why the cost of capital is referred to as the hurdle rate in capital budgeting.
The cost of capital is the minimum required return on any new investment that allows a
firm to break even. Since we are using the cost of capital as a benchmark or hurdle to
compare the return earned by any project, it is sometimes referred to as the hurdle rate.
10.2
a. A company is building a new plant on the outskirts of Smallesville. The town has
offered to donate the land, and as part of the agreement, the company will have to
build an access road from the main highway to the plant. How will the project of
building the road be classified in capital budgeting analysis?
b. Sykes, Inc., is considering two projects: a plant expansion and a new computer
system for the firms production department. Classify these projects as independent,
mutually exclusive, or contingent projects and explain your reasoning.
c. Your firm is currently considering the upgrading of the operating systems of all the
firms computers. The firm can choose the Linux operating system that a local
computer services firm has offered to install and maintain. Microsoft has also put in a
bid to install the new Windows operating system for businesses. What type of project
is this?
a. This is a contingent project. Acceptance of the road-building project is contingent
on the new plant being a financially viable project. If the new plant will not have
a positive value, then the firm will not even consider this project. However, this
projects cost will have to be considered along with the cost of building the new
plant in the capital budgeting analysis.
b. These two projects are independent projects. Accepting or rejecting one will not
influence the decision on the other project. The cash flows of the two projects are
unrelated.
c. These are two mutually exclusive projects. The companys computers need only
one operating system. Either the Linux or the Windows operating system needs to
be installed, not both. Hence, the selection of one will eliminate the other from
consideration.
10.3
10.4
Provide two conditions under which a set of projects might be characterized as mutually
exclusive.
When projects are mutually exclusive, acceptance of one project precludes the acceptance
of others. Typically, mutually exclusive projects perform the same function and so only
one of them needs to be accepted. A funding or resource constraint can also cause
projects to be mutually exclusive.
10.5
a. A firm invests in a project that would earn a return of 12 percent. If the appropriate
cost of capital is also 12 percent, did the firm make the right decision. Explain.
b. What is the impact on the firm if it accepts a project with a negative NPV?
a. We would normally argue that a firm should only accept projects in which the
projects return exceeds the cost of capital. In other words, only if the net present
value exceeds zero should a project be accepted. But in reality, projects with a
zero NPV should also be accepted because the project earns a return that equals
the cost of capital. For some firms like the one above, this could be the situation
because they may not have projects that provide a return greater than the cost of
capital for the firm.
b. When a firm takes on positive NPV projects, the value of the firm increases. By
the same token, when a project undertaken has a negative NPV, the value of the
firm will decrease by the amount of the net present value.
10.6
The payback period ignores the time value of money by not discounting future
cash flows.
A firm may establish payback criteria with no economic basis for that decision
and thereby run the risk of losing out on good projects.
The method ignores cash flows beyond the payback period, thus leading to nonselection of projects that may produce cash flows well beyond the payback period
or more cash flows than accepted projects. This leads to a bias against longer-term
projects.
10.7
What are the strengths and weaknesses of the accounting rate of return (ARR) approach?
The biggest advantage of ARR is that it is easy to compute since accounting data is
readily available, whereas estimating cash flows is more difficult. However, the
disadvantages outweigh this specific advantage. Similar to the payback, it does not
discount cash flows, but merely averages net income over time. No economic rationale is
used in establishing an ARR cutoff rate. Finally, the ARR uses net income to evaluate the
project and not cash flows or market data. This is a serious flaw in this approach.
10.8
Under what circumstances might the IRR and NPV approaches have conflicting results?
IRR and the NPV methods of evaluating capital investment projects might produce
dissimilar results under two circumstances. First, if the projects cash flows are not
conventionalthat is, if the sign of the cash flow changes more than once during the life
of a projectthen multiple IRRs can be obtained as solutions. We would be unable to
identify the correct IRR for decision making. (See Learning by Doing Application 10.3.)
The second situation occurs when two or more projects are mutually exclusive. The
project with the highest IRR may not necessarily be the one with the highest NPV and
thereby be the right choice. There is an important reason for this. IRR assumes that all
cash flows received during the life of a project are reinvested at the IRR, whereas the
NPV method assumes that they are reinvested at the cost of capital. Since the cost of
capital is the better proxy for opportunity cost, NPV uses the better proxy, while the IRR
may use an unrealistically higher rate as proxy.
10.9
The modified IRR (MIRR) alleviates two concerns with using the IRR method for
evaluating capital investments. What are they?
IRR assumes that the cash flows from a project are reinvested at the projects IRR, while
the NPV assumes that they are invested at the firms cost of capital. The NPV
assumption is correct more often than not. The MIRR assumes that each operating cash
flow is reinvested at the firms cost of capital.
The second appeal of MIRR is that under this method all of the compounded operating
cash flow values are summed up to get the projects terminal value. Since most projects
generate positive total net operating cash flows, MIRR does not suffer from issues
associated with unconventional cash flows.
10.10 Elkridge Construction Company has an overall (composite) cost of capital of 12 percent. This
cost of capital reflects the cost of capital for an Elkridge Construction project with average
risk. However, the firm takes on projects of various risk levels. The company experience
suggests that low-risk projects have a cost of capital of 10 percent and high-risk projects have
a cost of capital of 15 percent. Which of the following projects should the company select to
maximize shareholder wealth?
Project
Expected Return
Risk
13%
Low
1. Single-family homes
2. Multifamily residential
12
Average
3. Commercial
18
High
4. Single-family homes
Low
5. Commercial
13
High
Project
1. Single-family homes
2. Multifamily residential
Required
Expected
Return
Return
Low
10%
13%
Accept
Average
12
12
Accept / Indifferent
Risk
Decision
3. Commercial
High
15
18
Accept
4. Single-family homes
Low
10
Reject
5. Commercial
High
15
13
Reject
BASIC
10.1
Net present value: Riggs Corp. management is planning to spend $650,000 on a new
marketing campaign. They believe that this action will result in additional cash flows of
$325,000 over the next three years. If the discount rate is 17.5 percent, what is the NPV
on this project?
LO 2
Solution:
NPV =
= $62,337
10.2
Net present value: Kingston, Inc. management is considering purchasing a new machine
at a cost of $4,133,250. They expect this equipment to produce cash flows of $814,322,
$863,275, $937,250, $1,017,112, $1,212,960, and $1,225,000 over the next six years. If
the appropriate discount rate is 15 percent, what is the NPV of this investment?
LO 2
Solution:
NPV =
= $4,133,250 +
$
= 441,933
10.3
Net present value: Crescent Industries management is planning to replace some existing
machinery in its plant. The cost of the new equipment and the resulting cash flows are
shown in the accompanying table. If the firm uses an 18 percent discount rate, should
management go ahead with the project?
Year
Cash Flow
$3,300,000
$875,123
$966,222
$1,145,000
$1,250,399
$1,504,445
LO 2
Solution:
Initial investment = $3,300,000
Length of project = n = 5 years
Required rate of return = k = 18%
NCFt
t
t = 0 (1 + k )
n
NPV =
Since the NPV is positive, the firm should accept the project.
10.4
Solution:
Initial investment = $312,500
Annual cash flows = $121,450
Length of project = n = 7 years
Required rate of return = k = 14%
NCFt
t
t = 0 (1 + k )
n
NPV =
10.5
firm uses a 9 percent discount rate for their production systems, in which system should
the firm invest?
LO 2
Year
0
1
2
3
System1
15,000
15,000
15,000
15,000
System2
45,000
32,000
32,000
32,000
Solution
The NPV of System 1 is $22,969.42 and the NPV of System 2 is $36,001.43. Since the
NPV of the System 2 is larger than the NPV for System 1, and the investments are
mutually exclusive, the firm should take System 2.
10.6
Payback: Refer to problem 10.5. What are the payback periods for production systems
1 and 2? If the systems are mutually exclusive and the firm always chooses projects with
the lowest payback period, in which system should the firm invest?
LO 3
Solution
System 1 has a payback of exactly one year. System 2 has a payback of 1.41 years.
Given the shorter payback period for system 1, the investment should be made in System
1 based on the payback criteria.
10.7
Solution:
Cumulative
Year
CF
Cash Flow
$(3,768,966)
$(3,768,966)
979,225
(2,789,741)
1,158,886
(1,630,855)
1,881,497
250,642
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 2 + ($1,630,855 / $1,881,497) = 2.87 years
10.8
Solution:
Cumulative
Year
CF
Cash Flow
$(1,645,276)
$(1,645,276)
212,455
(1,432,821)
292,333
(1,140,488)
387,479
(753,009)
516,345
(236,664)
645,766
409,102
618,325
1,027,427
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($236,664 / $645,766)
= 4.37 years
10.9
$1,875,000. Management expects productivity gains and cost savings over the next
several years. If the firm is expected to generate cash flows of $586,212, $713,277,
$431,199, and $318,697 over the next four years, what is the investments payback
period?
LO 3
Solution:
Cumulative
Year
CF
Cash Flow
$(1,875,000)
$(1,875,000
586,212
(1,288,788)
713,277
(575,511)
431,199
(144,312)
318,697
174,385
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 3 + ($144,312 / $318,697)
= 3.45 years
10.10 Average accounting rate of return (ARR): Capitol Corp. is expecting a project to
generate after-tax income of $63,435 over each of the next three years. The average book
value of its equipment over that period will be $212,500. If the firms acceptance
decision on any project is based on an ARR of 37.5 percent, should this project be
accepted?
LO 4
Solution:
Annual after-tax income = $63,435
Average after-tax income = ($63,435 +$63,435 + $63,435) / 3 = $63,435
Average book value of equipment = $212,500
Since the projects ARR is below the acceptance rate of 37.5 percent, the project should be
rejected.
10.11 Internal rate of return: Refer to Problem 10.4. What is the IRR that Franklin Mints
management can expect on this project?
LO 5
Solution:
Initial investment = $312,500
Annual cash flows = $121,450
Length of project = n = 7 years
Required rate of return = k = 14%
To determine the IRR, a trial-and-error approach can be used. Set NPV = 0.
Since the project had a positive NPV of $134,986, try IRR > k.
Try IRR = 25%.
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1 (1.25) 7
0 $312,500 + $121,450
0.25
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1 (1.34) 7
0 $312,500 + $121,450
0.34
NPV = 0 =
1
(1.338) 7
0 = $312,500 + $121,450
0.338
10.12 Internal rate of return: Hathaway, Inc., a resort company, is refurbishing one of its
hotels at a cost of $7.8 million. The firm expects that this will lead to additional cash
flows of $1.8 million for the next six years. What is the IRR of this project? If the
appropriate cost of capital is 12 percent, should Hathaway go ahead with this project?
LO 5
Solution:
Initial investment = $7,800,000
Annual cash flows = $1,800,000
Length of project = n = 6 years
Required rate of return = k = 12%
To determine the IRR, a trial-and-error approach can be used. Set NPV = 0.
Try IRR = 12%.
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1 (1.12) 6
0 $7,800,000 + $1,800,000
0.12
NPV = 0 =
1 (1.10)6
0 $7,800,000 + $1,800,000
0.10
NPV = 0 =
1 (1.102) 6
0 $7,800,000 + $1,800,000
0.102
NPV = 0 =
1 (1.1015) 6
0 $7,800,000 + $1,800,000
0.1015
INTERMEDIATE
10.13 Net present value: Champlain Corp. is investigating two computer systems. The Alpha
8300 costs $3,122,300 and will generate annual cost savings of $1,345,500 over the next
five years. The Beta 2100 system costs $3,750,000 and will produce cost savings of
$1,125,000 in the first three years and then $2 million for the next two years. If the
companys discount rate for similar projects is 14 percent, what is the NPV for the two
systems? Which one should be chosen based on the NPV?
LO 2
Solution:
Cost of Alpha 8300 = $3,122,300
Annual cost savings = $1,345,500
Length of project = n = 5 years
Required rate of return = k = 14%
FCFt
(1.14)5
=
NPV =
$
3
,
122
,
300
$
1
,
345
,
500
t
t = 0 (1 + k )
0.14
= $3,122,300 + $4,619,210
= $1,496,910
Cost of Beta 2100 = $3,750,000
Length of project = n = 5 years
Required rate of return = k = 14%
1
FCFt
(1.14)3 $2,000,000 $2,000,000
= $3,750,000 + $1,125,500
+
NPV =
+
t
(1.14) 4
(1.14)5
t = 0 (1 + k )
0.14
10.14 Net present value: Briarcrest Condiments is a spice-making firm. Recently, it developed
a new process for producing spices. This process requires new machinery that would cost
$1,968,450, have a life of five years and would produce cash flows as shown in the table.
What is the NPV if the firm uses a discount rate of 15.9 percent?
Year
Cash Flow
$512,496
$(242,637)
$814,558
$887,225
$712,642
LO 2
Solution:
Cost of equipment = $1,968,450
Length of project = n = 5 years
Required rate of return = k = 15.9%
FCFt
t
t = 0 (1 + k )
n
NPV =
+
+
+
(1.159)1
(1.159) 2
(1.159) 3
(1.159) 4
(1.159) 5
= $1,968,450 + $442,188 $180,630 + $523,205 + 491,700 + 340,764
= $351,223
= $1,968,450 +
10.15 Net present value: Cranjet Industries is expanding its product line and its production
capacity. The costs and expected cash flows of the two independent projects are given in
the following table. The firm typically uses a discount rate of 16.4 percent.
a.
Product Line
Production Capacity
Year
Expansion
Expansion
$(2,575,000)
$(8,137,250)
$600,000
$2,500,000
$875,000
$2,500,000
$875,000
$2,500,000
$875,000
$3,250,000
$875,000
$3,250,000
LO 2
Solution:
a.
NPV =
+
+
+
(1.164)1
(1.164) 2
(1.164)3
(1.164) 4
(1.164)5
= $2,575,000 + $515,464 $645,806 + $554,816 + 476,646 + 409,490
= $27,222
= $2,575,000 +
NPV =
Since they are independent, and both have NPV > 0, both projects should be
accepted.
10.16 Net present value: Emporia Mills is evaluating two alternative heating systems. Costs
and projected energy savings are given in the following table. The firm uses 11.5 percent
to discount such project cash flows. Which system should be chosen?
Year
System 100
System 200
$(1,750,000)
$(1,735,000)
$275,223
$750,000
$512,445
$612,500
$648,997
$550,112
$875,000
$384,226
LO 2
Solution:
Required rate of return = 11.5%
System 100:
Cost of product line expansion = $1,750,000
FCFt
$275,223 $512,445 $648,997 $875,000
= $1,750,000 +
+
+
t
(1.115)1
(1.115) 2
(1.115) 3
(1.115) 4
t = 0 (1 + k )
= $1,750,000 + $246,837 $412,190 + $468,186 + 566,120
n
NPV =
= $56,667
System 200:
Cost of product line expansion = $1,735,000
FCFt
$750,000 $612,500 $550,112 $384,226
= $1,735,000 +
+
+
t
(1.115)1
(1.115) 2
(1.115)3
(1.115) 4
t = 0 (1 + k )
= $1,735,000 + $672,446 $492,670 + $396,850 + 248,592
n
NPV =
= $75,758
Since System 200 has a positive NPV, select that system. Reject System 100 as it has
negative NPV.
10.17 Payback: Creative Solutions, Inc., has just invested $4,615,300 in equipment. The firm
uses payback period criteria of not accepting any project that takes more than four years
to recover its costs. The company anticipates cash flows of $644,386, $812,178,
$943,279, $1,364,997, $2,616,300, and $2,225,375 over the next six years. Does this
investment meet the firms payback criteria?
LO 3
Solution:
Cumulative
Year
CF
Cash Flow
$(4,615,300)
$(4,615,300)
644,386
(3,970,914)
812,178
(3,158,736)
943,279
(2,215,457)
1,364,997
(850,460)
2,616,300
1,765,840
2,225,375
3,991,215
$850, 460
$2,616,300
= 4.33 years
=4+
Since the project payback period exceeds the firms target of four years, it should not
have been accepted.
10.18 Discounted payback: Timeline Manufacturing Co. is evaluating two projects. It uses
payback criteria of three years or less. Project A has a cost of $912,855, and project Bs
cost is $1,175,000. Cash flows from both projects are given in the following table. What
are their discounted payback periods, and which will be accepted with a discount rate of 8
percent?
Year
Project A
Project B
$ 86,212
$586,212
$313,562
$413,277
$427,594
$231,199
$285,552
LO 3
Solution:
Project A
Cumulative
Year
CF
CF
Cumulative
PVCF
PVCF
$(912,855)
$(912,855)
$(912,855)
$(912,855)
86,212
(826,643)
79,826
(833,029)
313,562
(513,081)
268,829
(564,200)
427,594
(85,487)
339,438
(224,762)
285,552
200,065
209,889
(14,873)
CF
CF
$(1,175,000) $(1,175,000)
Cumulative
PVCF
PVCF
$(1,175,000)
$(1,175,000)
586,212
(588,788)
542,789
(632,211)
413,277
(175,511)
354,318
(277,893)
231,199
55,688
183,533
(94,359)
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 3 + years
Since the firms acceptance criteria is three years, neither project will be accepted.
10.19 Payback: Regent Corp. is evaluating three competing pieces of equipment. Costs and
cash flow projections for all three are given in the following table. Which would be the
best choice based on payback period?
Type 1
Type 2
Type 3
$(1,311,450)
$(1,415,888)
$(1,612,856)
$212,566
$586,212
$786,212
$269,825
$413,277
$175,000
$455,112
$331,199
$175,000
$285,552
$141,442
$175,000
$121,396
Year
$175,000
$175,000
LO 3
Solution:
Type 2
Type 1
Cumulative
Type 3
Cumulative
Cumulative
Year
CF
CF
CF
CF
CF
CF
$(1,311,450)
$(1,311,450)
$(1,415,888)
$(1,415,888)
$(1,612,856)
($1,612,856)
212,566
(1,098,884)
586,212
(829,676)
786,212
(826,644)
269,825
(829,059)
413,277
(416,399)
175,000
(651,644)
455,112
(373,947)
331,199
(85,200)
175,000
(476,644)
285,552
(88,395)
141,442
56,242
175,000
(301,644)
121,396
33,001
175,000
(126,644)
175,000
48.356
Type 1:
=4+
Type 2:
$85, 200
$141, 442
= 3.6 years
= 3+
Type 3:
$126,644
$175,000
= 5.72 years
= 5+
Years
Cash flows
47
$2,265,433
$4,558,721
$3,378,911
$1,250,000
LO 3
Solution:
Discount rate = k = 10%
Cumulative
Year
0
1
CF
CF
$(9,365,000) $(9,365,000)
2,265,433
(7,099,567)
Cumulative
PVCF
PVCF
$(9,365,000)
$(9,365,000)
2,059,485
(7,305,515)
4,588,721
(2,540,846)
3,767,538
(3,537,977)
3,378,911
838,065
2,538,626
(999,352)
1,250,000
2,088,065
853,767
(145,585)
1,250,000
3,338,065
776,152
630,567
1,250,000
4,588,065
705,592
1,336,159
1,250,000
5,838,065
641,448
1,977,607
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($145,585 / $1,250,000)
= 4.19 years
10.21 Modified internal rate of return (MIRR): Morningside Bakeries has recently purchased
equipment at a cost of $650,000. The firm expects to generate cash flows of $275,000 in each
of the next four years. The cost of capital is 14 percent. What is the MIRR for this project?
LO 5
Solution:
PV of costs = $650,000
Length of project = n = 4 years
Cost of capital = k = 14%
Annual cash flows = CFt = $275,000
TV
(1 + MIRR ) t
$1,353,315
$650,000 =
(1 + MIRR ) 4
$1,353,315
= 2.0820
(1 + MIRR ) 4 =
$650,000
PVCosts =
10.22 Modified internal rate of return (MIRR): Sycamore Home Furnishings is considering
acquiring a new machine that can create customized window treatments. The equipment will
cost $263,400 and will generate cash flows of $85,000 over each of the next six years. If the
cost of capital is 12 percent, what is the MIRR on this project?
LO 5
Solution:
PV of costs = $263,400
Length of project = n = 6 years
Cost of capital = k = 12%
Annual cash flows = CFt = $85,000
TV = CF1 (1 + k ) n 1 + CF2 (1 + k ) n 2 + LL + CFn (1 + k ) n n
= $85,000(1.12)5 + $85,000(1.12) 4 + $85,000(1.12) 3 + $85,000(1.12) 2
+ $85,000(1.12)1 + $85,000(1.12)0
= $149,799 + $133,749 + $119,419 + $106,624 + $95,200 + $85,000
= $689,791
Now we can solve for the MIRR using Equation 10.5.
TV
(1 + MIRR) t
$689,791
$263, 400 =
(1 + MIRR)6
$689,791
(1 + MIRR)6 =
= 2.6188
$263, 400
PVCosts =
10.23 Internal rate of return: Great Flights, Inc., an aviation firm, is considering purchasing
three aircraft for a total cost of $161 million. The company would lease the aircraft to an
airline. Cash flows from the proposed leases are shown in the following table. What is the
IRR of this project?
Years
Cash Flow
14
$23,500,000
57
$72,000,000
810
$80,000,000
Years
Cash Flow
Initial investment =
14
$23,500,000
$161,000,000
Length of project =
57
$72,000,000
n = 10 years
Required rate of
810
$80,000,000
return = k = 15%
LO 5
Solution:
To determine the IRR, the trial-and-error approach can be used. Set NPV=0.
Try a higher rate than k = 15%; try IRR = 22%.
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1
1
1 (1.22) 4
1 (1.22)3
1
0 $161,000,000 + $23,500,000
+ $72,000,000
4
0.22
0.22 (1.22)
1 (1.22)3
1
+ $80,000,000
7
0.22 (1.22)
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1
1
1 (1.23) 4
1 (1.23)3
1
0 $161,000,000 + $23,500,000
+ $72,000,000
4
0.23
0.23 (1.23)
1 (1.23) 3
1
+ $80,000,000
7
0.23 (1.23)
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1
1
1 (1.227) 4
1 (1.227) 3
1
0 $161,000,000 + $23,500,000
+ $72,000,000
4
0.227
0.227 (1.227)
1 (1.227) 3
1
+ $80,000,000
7
0.227 (1.227)
The IRR of the project is between 22 and 23 percent. Using a financial calculator, we find
that the IRR is 22.65 percent.
10.24 Internal rate of return: Refer to problem 10.5. Compute the IRR for both
production system 1 and production system 2. Which has the higher IRR? Which
production system has the highest NVP? Explain why the IRR and NPV rankings
of systems 1 and 2 are different?
LO 5
Solution
The IRR of system 1 is 83.93 percent and the IRR of system 2 is 50.07%. The NPV of
system 1 is $22,969.42 and the NPV of system 2 is $36,001.43. System 1 delivers a
higher IRR because it requires a lower initial investment and the cost is recovered the
first year. Thus, even with lower cash inflows in the years after startup, system 1is able
to deliver a higher return on the initial investment. System 2 has a higher initial
investment but delivers a higher net cash flow for the firm.
10.25 Internal rate of return: Ancala Corporation is considering investments in two new golf
apparel lines for next season: golf hats and belts. Due to a funding constraint, these lines
are mutually exclusive. A summary of each projects estimated cash flows over its three year life, as well as the IRRs and NPVs of each are outlined below. The CFO of the firm
has decided to manufacture the belts; however, the CEO of Ancala is questioning this
decision given that the IRR is higher for manufacturing hats. Explain to the CEO why the
IRRs and NPVs of the belt and hat projects disagree? Is the CFOs decision the correct .
Year
0
1
2
3
Golf Belts
-$1,000
1,000
500
500
Golf Hats
-$500
500
300
300
NPV
IRR
$697.97
54%
$427.87
61%
LO 5
Solution
The IRRs and NPVs of the belt and hat lines disagree because of the differences in the
scale of the project. Hats deliver a higher IRR because they require a lower initial
investment. Thus, even with lower cash inflows in the years after startup, the hat project
is able to deliver a higher return on the initial investment. While the golf belts project
does cost more, it delivers a higher net cash flow for Ancala investors. This NPV factors
in the initial cost of the project, and reflects the total net cash flow for the firms
shareholders.
The CFOs decision to choose the golf belts project is the right choice because it yields
the higher net cash flows for Ancalas investors.
10.26 Internal rate of return: Compute the IRR on the following cash flow streams:
a.
b.
c.
LO 5
Solution:
a.
NPV = 0 =
NPV = 0 =
The IRR of the project is approximately 6.97 percent. Using a financial calculator,
we find that the IRR is 6.968 percent.
b.
NPV = 0 =
FCFt
t
t = 0 (1 + IRR )
$1,650,000
0 $1,000,000 +
(1.13) 4
$1,000,000 + $1,011,976 $11,976
n
NPV = 0 =
NPV = 0 =
The IRR of the project is approximately 13.3 percent. Using a financial calculator,
we find that the IRR is 13.337 percent.
c.
NPV = 0 =
NPV = 0 =
The IRR of the project is between 14 and 15 percent. Using a financial calculator,
we find that the IRR is 14.202 percent.
10.27 Internal rate of return: Compute the IRR for the following project cash flows.
a.
An initial outlay of $3,125,000 followed by annual cash flows of $565,325 for the
next eight years
b.
An initial investment of $33,750 followed by annual cash flows of $9,430 for the
next five years
c.
An initial outlay of $10,000 followed by annual cash flows of $2,500 for the next
seven years
LO 5
Solution:
a.
FCFt
(1.08)8
NPV =
$
3
,
125
,
000
$
565
,
325
=
t
t = 0 (1 + k )
0.08
= $3,125,000 + $3,249,006
= $124,006
Try a higher rate, IRR = 9%.
1
FCFt
(1.09)8
NPV =
$
3
,
125
,
000
$
565
,
325
=
t
t = 0 (1 + k )
0.09
= $3,125,000 + $3,129,248
n
= $4,248
The IRR of the project is approximately 9 percent. Using a financial calculator,
we find that the IRR is 9.034 percent.
b.
FCFt
(1.12)5
NPV =
= $33,750 + $9,430
t
t = 0 (1 + k )
0.12
= $33,750 + $33,993
= $243
(1.123)5
n
FCFt
NPV =
= $33,750 + $9,430
t
t = 0 (1 + k )
0.123
= $33,750 + $33742
= $8 0
The IRR of the project is approximately 12.3 percent. Using a financial calculator,
we find that the IRR is 12.29 percent.
c.
(1.16)7
n
FCFt
NPV =
$
10
,
000
$
2
,
500
=
t
t = 0 (1 + k )
0.16
= $10,000 + $10,096
= $96
1
7
FCFt
(1.163)
NPV =
= $10,000 + $2,500
t
t = 0 (1 + k )
0.163
= $10,000 + $10,008
= $8 0
n
The IRR of the project is approximately 16.3 percent. Using a financial calculator,
we find that the IRR is 16.327 percent.
ADVANCED
10.28 Draconian Measures, Inc., is evaluating two independent projects. The company uses a
13.8 percent discount rate for such projects. The cost and cash flows are shown in the
following table. What are the NPVs of the two projects?
Year
Project 1
Project 2
$(8,425,375)
$(11,368,000)
$3,225,997
$2,112,589
$1,775,882
$3,787,552
$1,375,112
$3,125,650
$1,176,558
$4,115,899
$1,212,645
$4,556,424
$1,582,156
$1,365,882
LO 2
Solution:
Project 1:
Cost of Project 1 = $8,425,375
Length of project = n = 7 years
Required rate of return = k = 13.8%
FCFt
t
t = 0 (1 + k )
n
NPV =
+ $552,608
= $668,283
Project 2:
Cost of Project 2 = $11,368,000
Length of project = n = 5 years
Required rate of return = k = 13.8%
FCFt
t
t = 0 (1 + k )
n
NPV =
b.
Does the IRR criterion indicate a different decision than the NPV criterion?
c.
Explain how you would expect the management of Draconian Measures to decide.
LO 5
Solution:
a.
Project 1:
At the required rate of return of 13.8 percent, Project 1 has a NPV of $(668,283).
To find the IRR, try lower rates.
Try IRR = 11%.
FCFt
t
t = 0 (1 + k )
n
NPV =
+ $845,885 + $657,889
= $73,801
NPV =
+ $1,582,156 + $1,365,882
= $5,235
The IRR of the project is approximately 10.7 percent. Using a financial calculator,
we find that the IRR is 10.677 percent.
Project 2:
At the required rate of return of 13.8 percent, Project 1 has a NPV of $ 375,375.
To find the IRR, try higher rates.
Try IRR = 15%.
FCFt
t
t = 0 (1 + IRR )
$2,112,589 $3,787,552 $3,125,650 $4,115,889 $4,556,424
+
+
+
+
0 = $11,368,000 +
(1.15)1
(1.15) 2
(1.15)3
(1.15) 4
(1.15)5
= $11,368,000 + $1,837,034 + $2,863,933 + $2,055,166 + $2,353,279 + $2,265,348
= $6,760
n
NPV = 0 =
NPV = 0 =
The IRR of the project is between 15 and 15.1 percent. Using a financial
calculator, we find that the IRR is 15.023 percent.
b.
Based on the IRR, Project 1 will be rejected and Project 2 will be accepted. These
decisions are identical to those based on NPV. (Given that Project 1 had a
negative NPV, the IRR will always be less than the required rate of return 0.
c.
Management would use the decision spelled out by NPV, although in this case the
IRR has come up with the same decision.
10.30 Dravid, Inc., is currently evaluating three projects that are independent. The cost of funds
can be either 13.6 percent or 14.8 percent depending on their financing plan. All three
projects cost the same at $500,000. Expected cash flow streams are shown in the
following table. Which projects would be accepted at a discount rate of 14.8 percent?
What if the discount rate was 13.6 percent?
Year
Project 1
Project 2
Project 3
$245,125
$125,000
$212,336
$150,000
$500,000
$112,500
$375,000
$500,000
$74,000
LO 2
Solution:
Cost of projects = $500,000
Length of project = n = 4 years
Required rate of return = k = 14.8%
Project 1:
FCFt
$0
$125,000 $150,000 $375,000
= $500,000 +
+
+
+
t
1
(1.148)
(1.148) 2
(1.148)3
(1.148) 4
t = 0 (1 + k )
= $500,000 + $0 + $94,848 + $99,144 + $215,906
n
NPV =
= $90,103
Project 2:
FCFt
$0
$0
$500,000 $500,000
= $500,000 +
+
+
+
t
1
2
(1.148) (1.148)
(1.148)3
(1.148) 4
t = 0 (1 + k )
= $500,000 + $0 + $0 + $330,479 + $287,874
n
NPV =
= $118,353
Project 3:
FCFt
$245,125 $212,336 $112,500 $74,000
= $500,000 +
+
+
+
t
(1.148)1
(1.148) 2
(1.148)3 (1.148) 4
t = 0 (1 + k )
= $500,000 + $213,524 + $161,116 + $74,358 + $42,605
n
NPV =
= $8,397
At a discount rate of 14.8 percent, only project 2 will be accepted. At a discount rate of
13.6 percent, the NPVs of the three projects are -$75,645, $141,295, and $1,491
respectively. Both projects 2 and 3 have positive NPVs and will be accepted.
Year
Project 1
PVCF
Project 2
PVCF
Project 3
PVCF
$(500,000)
$(500,000)
$(500,000)
$(500,000)
$(500,000)
$(500,000)
245,125
215,779
125,000
96,862
150,000
102,319
500,000
375,000
225,175
500,000
NPV
(75,645)
212,336
164,538
341,063
112,500
76,739
300,232
74,000
44,434
141,295
1,491
10.31 Intrepid, Inc., is looking to invest in two or three independent projects. The costs and the
cash flows are given in the following table. The appropriate cost of capital is 14.5
percent. Compute the IRRs and identify the projects that will be accepted.
Year
Project 1
Project 2
Project 3
$(275,000)
$(312,500)
$(500,000)
$63,000
$153,250
$212,000
$85,000
$167,500
$212,000
$85,000
$112,000
$212,000
$100,000
$212,000
LO 5
Solution:
Project 1:
Cost of Project 1 = $275,000
Length of project = n = 4 years
Required rate of return = k = 14.5%
FCFt
t
t = 0 (1 + k )
n
NPV =
At the required rate of return of 14.5 percent, Project 1 has a NPV of $(40,338). To find
the IRR, try lower rates.
Try IRR = 7.6%.
FCFt
t
t = 0 (1 + IRR )
$63,000 $85,000 $85,000 $100,000
+
+
+
0 = $275,000 +
(1.075)1 (1.075) 2 (1.075)3 (1.075) 4
= $275,000 + 58,550 + $73,417 + $68,231 + $74,602
= $200 0
n
NPV = 0 =
The IRR of the project is approximately 7.6 percent. Using a financial calculator, we find
that the IRR is 7.57 percent.
Project 2:
Cost of Project 2 = $312,500
Length of project = n = 3 years
Required rate of return = k = 14.5%
FCFt
$153,250 $167,500 $112,000
= $312,500 +
+
+
t
(1.145)1
(1.145) 2
(1.145)3
t = 0 (1 + k )
= $312,500 + $ 133,843 + $127,763 + $74,611
n
NPV =
= $23,717
At the required rate of return of 14.5 percent, Project 1 has a NPV of $23,717. To find the
IRR, try higher rates.
Try IRR =19%.
FCFt
t
t = 0 (1 + IRR )
$153,250 $167,500 $112,000
+
+
0 = $312,500 +
(1.19)1
(1.19) 2
(1.19)3
= $312,500 + $128,782 + $118,283 + $66,463
= $1,027
n
NPV = 0 =
Try IRR=19.2%.
FCFt
t
t = 0 (1 + IRR )
$153,250 $167,500 $112,000
+
+
0 = $312,500 +
(1.192)1
(1.192) 2
(1.192) 3
= $312,500 + $128,565 + $117,886 + $66,129
= $80 0
n
NPV = 0 =
The IRR of the project is approximately 19.2 percent. Using a financial calculator, we
find that the IRR is 19.22 percent.
Project 3:
Cost of Project 3 = $500,000
Length of project = n = 4 years
Required rate of return = k = 14.5%
1
1
4
FCFt
(1.145)
= $500,000 + $212,000
NPV =
t
t = 0 (1 + k )
0.145
= $500,000 + $611,429
n
= $111,429
At the required rate of return of 14.5 percent, Project 1 has a NPV of $111,429. To find
the IRR, try higher rates.
Try IRR =25%.
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1 (1.25) 4
0 = $500,000 + $212,000
0.25
= $500,000 + $500,659
$659
Try IRR=25.1%.
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1
(1.251) 4
0 = $500,000 + $212,000
0.251
= $500,000 + $500,659
= $231 0
The IRR of the project is approximately 25.1 percent. Using a financial calculator, we
find that the IRR is 25.07 percent.
Only Projects 2 and 3 will be accepted as the IRRs exceed the required rate of return of
14.5 percent.
10.32 Jekyll & Hyde Corp. is evaluating two mutually exclusive projects. The cost of capital is
15 percent. Costs and cash flows are given in the following table. Which project should
be accepted?
Year
Project 1
Project 2
$(1,250,000)
$(1,250,000)
$250,000
$350,000
$350,000
$350,000
$450,000
$350,000
$500,000
$350,000
$750,000
$350,000
LO 5
Solution:
Project 1:
Cost of project = $1,250,000
Length of project = n = 5 years
Required rate of return = k = 15%
FCFt
t
t = 0 (1 + k )
n
NPV =
NPV = 0 =
0 = $1,250,000 +
NPV = 0 =
The IRR of the project is approximately 20.1 percent. Using a financial calculator, we
find that the IRR is 20.132 percent.
Project 2:
Cost of project = $1,250,000
Length of project = n = 5 years
Required rate of return = k = 15%
1
FCFt
(1.15)5
=
NPV =
$
1
,
250
,
000
$
350
,
000
t
t = 0 (1 + k )
0.15
= $1,250,000 + $1,173,254
n
= $76,746
At the required rate of return of 15 percent, Project 1 has an NPV of $(76,746). Based on
the negative NPV, Project 2 should be rejected.
NPV = 0 =
1 (1.12)5
0 = $1,250,000 + $350,000
0.12
= $1,250,000 + $1,261,672
= $11,672
NPV = 0 =
1 (1.124)5
0 = $1,250,000 + $350,000
0.124
= $1,250,000 + $1,249,269
= $732 0
The IRR of the project is approximately 12.4 percent. Using a financial calculator, we
find that the IRR is 12.376 percent.
Given a required rate of return of 15 percent, Project 1 will be accepted as the IRR of
20.1 percent exceeds the required rate of return. Project 2 will be rejected.
10.33 Larsen Automotive, a manufacturer of auto parts, is considering investing in two projects.
The company typically compares project returns to a cost of funds of 17 percent.
Compute the IRRs based on the given cash flows, and state which projects will be
accepted.
Year
Project 1
Project 2
$(475,000)
$(500,000)
$300,000
$117,500
$110,000
$181,300
$125,000
$244,112
$140,000
$278,955
LO 5
Solution:
Project 1:
Cost of project = $475,000
Length of project = n = 4 years
Required rate of return = k = 17%
FCFt
t
t = 0 (1 + k )
n
NPV =
At the required rate of return of 17 percent, Project 1 has an NPV of $14,524. To find the
IRR, try higher rates.
Try IRR = 19%.
FCFt
t
t = 0 (1 + k )
n
NPV =
FCFt
t
t = 0 (1 + k )
n
NPV =
The IRR of the project is approximately 18.8 percent. Using a financial calculator, we
find that the IRR is 18.839 percent.
Project 2:
Cost of project = $500,000
Length of project = n = 4 years
Required rate of return = k = 17%
FCFt
t
t = 0 (1 + k )
n
NPV =
At the required rate of return of 17 percent, Project 1 has an NPV of $34,150. To find the
IRR, try higher rates.
Try IRR = 20%.
FCFt
t
t = 0 (1 + IRR )
$117,500 $181,300 $244,312 $278,955
+
+
+
0 = $500,000 +
(1.20)1
(1.20) 2
(1.20)3
(1.20) 4
= $475,000 + $97,917 + $125,903 + $141,269 + $134,527
= $385 0
n
NPV = 0 =
The IRR of the project is approximately 20 percent. Using a financial calculator, we find
that the IRR is 19.965 percent.
Both projects can be accepted since their IRRs exceed the cost of capital of 17 percent.
Project 1
Project 2
Project 3
$(10,000)
$(10,000)
$(10,000)
$4,750
$1,650
$800
$3,300
$3,890
$1,200
$3,600
$5,100
$2,875
$2,100
$2,750
$3,400
$800
$6,600
LO 5
Solution:
Project 1:
Cost of project = $10,000
Length of project = n = 4 years
FCFt
t
t = 0 (1 + IRR )
$4,750 $3,300 $3,600 $2,100
+
+
+
0 = $10,000 +
(1.16)1 (1.16) 2 (1.16) 3 (1.16) 4
= $10,000 + $4,095 + $2,452 + $2,306 + $1,160
= $13 0
n
NPV = 0 =
The IRR of the project is approximately 16 percent. Using a financial calculator, we find
that the IRR is 16.076 percent.
Project 2:
Cost of project = $10,000
Length of project = n = 5 years
FCFt
t
t = 0 (1 + IRR )
$1,650
$3,890
$5,100
$2,750
$800
+
+
+
+
0 = $10,000 +
1
2
3
4
(1.137) (1.137)
(1.137)
(1.137)
(1.137)5
= $10,000 + $1,451 + $3,009 + $3,470 + $1,545 + $421
= $4 0
n
NPV = 0 =
The IRR of the project is approximately 13.7 percent. Using a financial calculator, we
find that the IRR is 13.685 percent.
Project 3:
Cost of project = $10,000
Length of project = n = 5 years
FCFt
t
t = 0 (1 + IRR )
$800
$1,200
$2,875
$3,400
$6,600
+
+
+
+
0 = $10,000 +
1
2
3
4
(1.109) (1.109)
(1.109)
(1.109)
(1.109)5
= $10,000 + $721 + $976 + $2,108 + $2,248 + $3,934
= $13 0
n
NPV = 0 =
The IRR of the project is approximately 10.9 percent. Using a financial calculator, we
find that the IRR is 10.862 percent.
10.35 Primus Corp. is planning to convert an existing warehouse into a new plant that will
increase its production capacity by 45 percent. The cost of this project will be
$7,125,000. It will result in additional cash flows of $1,875,000 for the next eight years.
The company uses a discount rate of 12 percent.
a.
b.
c.
LO 2, LO 3, LO 5
Solution:
a.
Year
Project 1
Cumulative CF
$(7,125,000)
$(7,125,000)
1,875,000
(5,250,000)
1,875,000
(3,375,000)
1,875,000
(1,500,000)
1,875,000
375,000
1,875,000
2,250,000
1,875,000
4,125,000
1,875,000
6,000,000
1,875,000
7,875,000
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the
year)
= 3 + ($1,500,000 / $1,875,000) = 3.80 years
b.
NPV =
(1.12)8
= $7,1250,000 + $1,875,000
0.12
= $7,125,000 + $9,314,325
= $2,189,325
c.
NPV = 0 =
(1.20)8
0 = $7,1250,000 + $1,875,000
0.20
= $7,125,000 + $7,194,675
= $69,675
FCFt
t
t = 0 (1 + k )
n
NPV = 0 =
1 (1.203)8
0 = $7,1250,000 + $1,875,000
0.203
= $7,125,000 + $7,130,832
= $5,832
The IRR of the project is approximately 20.3 percent. Using a financial calculator, we
find that the IRR is 20.328 percent.
10.36 Quasar Tech Co. is investing $6 million in new machinery that will produce the nextgeneration routers. Sales to its customers will amount to $1,750,000 for the next three
years and then increase to $2.4 million for three more years. The project is expected to
last six years and cost, excluding depreciation will be $898,620 annually. The machinery
will be depreciated to a salvage value of 0 over 6 years using the straight-line method.
The companys tax rate is 30 percent, and the cost of capital is 16 percent.
a.
b.
c.
d.
LO 2, LO 3, LO 5
Solution:
a.
Year
Net Income
Depreciation
Project 1
Cumulative
Cash Flows
CF
$(6,000,000)
$(6,000,000)
$(104,034)
$1,000,000
895,966
(5,104,034)
$(104,034)
$1,000,000
895,966
(4,208,068)
$(104,034)
$1,000,000
895,966
(3,312,102)
350,966
$1,000,000
1,350,966
(1,961,136)
350,966
$1,000,000
1,350,966
(610,170)
350,966
$1,000,000
1,350,966
740,796
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the
year)
= 5 + ($610,170 / $1,350,966) = 5.45 years
b.
Year 1
Sales
Year 2
Year 3
Year 4
Year 5
Year 6
Expenses
898,620
898,620
898,620
898,620
898,620
898,620
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
$(1,48,620)
$(1,48,620)
$(1,48,620)
$ 501,380
$ 501,380
$ 501,380
44,586
44,586
44,586
(150,414)
(150,414)
(150,414)
$ (104,034)
$ (104,034)
$ (104,034)
$ 350,966
$ 350,966
$ 350,966
Beginning BV
6,000,000
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
Less:
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
Depreciation
EBIT
Taxes (30%)
Net income
Depreciation
Ending BV
c.
FCFt
t
t = 0 (1 + k )
n
NPV =
1
1
1
1
3
(1.16)
(1.16)3
1
= $6.000,000 + $895,966
+ $1,350,966
3
0.16
0.16 (1.16)
NPV = 0 =
1
1
1 (1.03)3
1 (1.03)3
1
0 = $6.000,000 + $895,966
+ $1,350,966
3
0.03
0.03 (1.03)
NPV = 0
1
1
1
1
3
(1.031)
(1.031)3
1
0 = $6.000,000 + $895,966
+ $1,350,966
3
0.031
0.031 (1.031)
10.37 Skywards, Inc., an airline caterer, is purchasing refrigerated trucks at a total cost of $3.25
million. After-tax net income from this investment is expected to be $750,000 for the
next five years. Annual depreciation expense will be $650,000. The cost of capital is 17
percent.
a.
b.
c.
d.
LO 2, LO 3, LO 4, LO 5
Solution:
a.
Year
0
1
2
3
4
5
Project 1
$(3,250,000)
1,400,000
1,400,000
1,400,000
1,400,000
1,400,000
Cumulative
CF
$(3,250,000)
(1,850,000)
(450,000)
950,000
2,350,000
3,750,000
PVCF
$(3,250,000)
1,196,581
1,022,719
874,119
747,110
638,556
Cumulative
PVCF
$(3,250,000)
(2,053,419)
(1,030,700)
(156,581)
590,529
1,229,085
Discount payback period = Years before recovery + (Remaining cost / Next years CF)
= 3 + ($156,581 / $747,110) = 3.21 years
b.
Net income
Beginning BV
Less:
Depreciation
Ending BV
Year 1
$ 750,000
3,250,000
650,000
Year 2
$ 750,000
2,600,000
650,000
Year 3
$ 750,000
1,950,000
650,000
Year 4
$ 750,000
1,300,000
650,000
Year 5
$ 750,000
650,000
650,000
$2,600,000
$1,950,000
$1,300,000
$ 650,000
c.
1
(1.17) 5
n
FCFt
NPV =
=
$
3
,
250
,
000
$
1
,
400
,
000
t
t = 0 (1 + k )
0.17
= $3,250,000 + $4,479,085
= $1,229,085
d.
NPV = 0 =
1
(1.30) 5
0 = $3,250,000 + $1,400,000
0.30
= $3,250,000 + $3,409,798
= $159,798
Try IRR = 32.5%.
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1 (1.325) 5
0 = $3,250,000 + $1,400,000
0.325
= $3,250,000 + $3,252,904
= $2,904 0
The IRR of the project is approximately 32.5 percent. Using a financial calculator, we
find that the IRR is 32.548 percent.
10.38 Trident Corp. is evaluating two independent projects. The costs and expected cash flows
are given in the following table. The companys cost of capital is 10 percent.
Year
$(312,500)
$(395,000)
$121,450
$153,552
$121,450
$158,711
$121,450
$166,220
$121,450
$132,000
$121,450
$122,000
a.
b.
c.
d.
If you are the decision maker for the firm, which project or projects will be
accepted? Explain your reasoning.
LO 2, LO 5
Solution:
a.
Project A:
Cost of this project = $312,500
Annual cash flows = $121,450
Required rate of return = 10%
Length of project = n = 5 years
FCFt
(1.10)5
=
NPV =
312
,
500
$
121
,
450
t
t = 0 (1 + k )
0.10
= $312,5000 + 460,391
= $147,891
Project B:
Cost of this project = $395,000
Required rate of return = 10%
Length of project = n = 5 years
FCFt
t
t = 0 (1 + k )
n
NPV =
= $395,000 +
b.
Project A:
Since NPV > 0, to compute the IRR, try rates higher than 10 percent.
Try IRR = 27%.
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1 (1.27)5
0 = 312,500 + $121,450
0.27
= $312,5000 + 313,666
$1,166
FCFt
t
t = 0 (1 + IRR )
n
NPV = 0 =
1 (1.272)5
0 = 312,500 + $121,450
0.272
= $312,5000 + 313,666
= $82 0
NPV = 0 =
NPV = 0 =
The IRR of Project B is approximately 26.1 percent. Using a financial calculator, we find
that the IRR is 26.093 percent.
c.
Since both projects have positive NPVs and they are independent projects, both
should be accepted under the NPV decision criteria. Under the IRR decision
criteria, since both projects have IRRs greater than the cost of capital, both will be
accepted. Thus, there is no conflict between the NPV and IRR decisions.
d.
10.39 Tyler, Inc., is considering switching to a new production technology. The cost of
equipment will be $4 million. The discount rate is 12 percent. The cash flows that the
firm expects to generate are as follows.
Years
CF
$(4,000,000)
1-2
35
$845,000
69
$1,450,000
a.
Compute the payback and discounted payback period for the project.
b.
What is the NPV for the project? Should the firm go ahead with the project?
c.
What is the IRR, and what would be the decision under the IRR?
LO 2, LO 3, LO 5
Solution:
a.
Year
0
Cash Flows
$(4,000,000)
Cumulative
Cumulative
PVCF
CF
PVCF
$(4,000,000)
$(4,000,000)
$(4,000,000)
--
--
$(4,000,000)
$(4,000,000)
--
--
$(4,000,000)
$(4,000,000)
845,000
601,454
(3,155,000)
(3,398,546)
845,000
537,013
(2,310,000)
(2,861,533)
845,000
479,476
(1,465,000)
(2,382,057)
1,450,000
734,615
(15,000)
(1,647,442)
1,450,000
655,906
1,435,000
(991,536)
1,450,000
585,631
2,885,000
(405,905)
1,450,000
522,885
4,335,000
116,979.48
$15,000
$1, 450,000
= 6.01 years
= 6+
$405,905
$522,885
= 8.8 years
=8+
b.
FCFt
1
(1.12)3
=
+
+
+
NPV =
$
4
.
000
,
000
0
0
$
845
,
000
t
2
t = 0 (1 + k )
0.12 (1.12)
1 (1.12) 4
1
+ $1,450,000
5
0.12 (1.12)
Given a positive NPV, to compute the IRR, one should try rates higher than 12
percent.
Try IRR = 12.5%.
1
3
FCFt
1
(1.125)
= $4.000,000 + 0 + 0 + $845,000
NPV =
t
2
t = 0 (1 + k )
0.125 (1.125)
1
(1.125) 4
1
+ $1,450,000
5
0.125 (1.125)
CFA Problems
10.40. Given the following cash flows for a capital project, calculate the NPV and IRR. The
required rate of return is 8 percent.
Year
CASH FLOW
50,000
15,000
15,000
20,000
10,000
5,000
NPV
IRR
a.
$1,905
10.9%
b.
$1,905
26.0%
c.
$3,379
10.9%
d.
$3,379
26.0%
LO 2
SOLUTION:
c is correct.
NPV = 50, 000 +
CASH FLOW
50,000
15,000
15,000
3
20,000
b.
c.
d.
LO 3
SOLUTION:
c is correct.
4
10,000
5
5,000
YEAR
CASH FLOW
50,000
15,000
15,000
20,000
10,000
5,000
50,000
35,000
20,000
10,000
15,000
FLOW
50,000
13,888.89
12,860.08
15,876.64
7,350.30
3,402.92
CUMULATIVE DCF
50,000
36,111.11
23,251.03
7,374.38
24.09
3,378.83
CUMULATIVE CASH
FLOW
DISCOUNTED CASH
As the table shows, the cumulative cash flow offsets the initial investment in
exactly three years. The payback period is 3.00 years. The discounted payback
period is between four and five years. The discounted payback period is 4 years
plus 24.09/3,402.92 = 0.007 of the fifth year cash flow, or 4.007 = 4.01 years. The
discounted payback period is 4.01 3.00 = 1.01 years longer than the payback
period.
10.42. An investment of $100 generates after-tax cash flows of $40 in Year 1, $80 in Year 2,
and $120 in Year 3. The required rate of return is 20 percent. The net present value is
closest to
a.
$42.22
b.
$58.33
c.
$68.52
d.
$98.95
LO 2
SOLUTION:
b is correct.
3
NPV =
t =0
CFt
40
80
120
= 100 +
+
+
= $58.33
t
2
(1 + r )
1.20 1.20 1.203
28.19 percent
b.
28.39 percent
c.
28.59 percent
d.
28.79 percent
LO 5
SOLUTION:
d is correct. The IRR can be found using a financial calculator or with trial and
error. Using trial and error, the total PV is equal to zero if the discount rate is
28.79 percent.
YEA
CASH FLOW
PRESENT VALUE
28.19%
28.39%
28.59%
28.79%
150,000
150,000
150,000
150,000
150,000
100,000
78,009
77,888
77,767
77,646
120,000
73,025
72,798
72,572
72,346
1,034
686
338
Total
b.
c.
d.
LO 2
SOLUTION:
a is correct. The vertical intercept changes from $60 to $65, and the horizontal intercept
changes from 21.86 percent to 20.68 percent.
Net present value: Techno Corp. is considering developing new computer software. The
cost of development will be $675,000, and the company expects the revenue from the sale of
the software to be $195,000 for each of the next six years. If the company uses a discount rate
of 14 percent, what is the net present value of this project?
Solution:
Cost of this project = $675,000
Annual cash flows = $195,000
Required rate of return = 14%
Length of project = n = 6 years
1
FCFt
(1.14)6
NPV =
$
675
,
000
$
195
,
000
=
t
t = 0 (1 + k )
0.14
= $675,000 + $758,290
= $83,290
10.2
Payback method: Parker Office Supplies is considering replacing the companys outdated
inventory-management software. The cost of the new software will be $168,000. Cost
savings is expected to be $43,500 for each of the first three years and then to drop off to
$36,875 for the following two years. What is the payback period for this project?
Solution:
Cumulative
Year
CF
CF
$(168,000)
$(168,000)
43,500
(124,500)
43,500
(81,000)
43,500
(37,500)
36,875
(625)
36,875
36,250
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($625 / $36,875) = 4.02 years
10.3
Solution:
Annual after-tax income = $156,435
Average after-tax income = $156,435
Average book value of equipment = $322,500
Average after - tax income
Average book value
$156,435
=
= 48.5%
322,500
Since the projects ARR is above the acceptance rate of 40 percent, the project should be
accepted.
10.4
Internal rate of return: Refer to Sample Test Problem 10.1. What is the IRR on this
project?
Solution:
FCFt
(1.14)6
NPV =
$
675
,
000
$
195
,
000
=
t
t = 0 (1 + k )
0.14
= $675,000 + $758,290
= $83,290
Since NPV > 0, try IRR > k. Try IRR = 18%.
1
FCFt
(1.18) 6
NPV = 0 =
0
$
675
,
000
$
195
,
000
=
t
t = 0 (1 + IRR )
0.18
= $675,000 + $682,033
n
$7,033
Try IRR = 18.4%.
1
(1.184)6
n
FCFt
NPV = 0 =
= $675,000 + $195,000
t
t = 0 (1 + IRR )
0.184
= $675,000 + $675,096
= $96 0
The IRR is approximately 18.4 percent. Using the financial calculator, we find that the
IRR is 18.406 percent.
10.5
Net present value: Raycom, Inc. needs a new overhead crane and two alternatives are
available. Crane T costs $1.35 million and will produce cost savings of $765,000 for the
next three years. Crane R will cost $1.675 million and will yield cost savings of $815,000
for the next three years. The required rate of return is 15 percent. Which of the two
options should Raycom choose based on NPV criteria and why?
Solution:
Crane T:
Cost of this project = $1,350,000
Annual cash flows = $765,000
Required rate of return = 15%
Length of project = n = 3 years
1
FCFt
(1.15) 3
NPV =
$
1
,
350
,
000
$
765
,
000
=
t
t = 0 (1 + k )
0.15
= $1,350,000 + $1,746,667
n
= $396,667
Crane R:
Cost of this project = $1,675,000
Annual cash flows = $815,000
Required rate of return = 15%
Length of project = n = 3 years
1
(1.15)3
n
FCFt
NPV =
$
1
,
675
,
000
$
815
,
000
=
t
t = 0 (1 + k )
0.15
= $1,675,000 + $1,860,829
= $185,829
Raycom should choose Crane T since it has the higher NPV.