Professional Documents
Culture Documents
Chapter Nine End of Chapter Useful Questions and Solutions
Chapter Nine End of Chapter Useful Questions and Solutions
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 A B C D
Cost $10,000 $25,000 $45,000 $100,000
Cash Flow Year One $4,000 $2,000 $10,000 $40,000
Cash Flow Year Two $4,000 $8,000 $15,000 $30,000
Cash Flow Year Three $4,000 $14,000 $20,000 $20,000
Cash Flow Year Four $4,000 $20,000 $20,000 $10,000
Cash Flow year Five $4,000 $26,000 $15,000 $0
Cash Flow Year Six $4,000 $32,000 $10,000 $0
Solution
1
Project C: Year One: -$45,000 + $10,000 = $35,000 left to recover
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,
Projects E F G H
Cost $40,000 $250,000 $75,000 $100,000
Cash Flow Year One $10,000 $40,000 $20,000 $30,000
Cash Flow Year Two $10,000 $120,000 $35,000 $30,000
Cash Flow Year Three $10,000 $200,000 $40,000 $30,000
Cash Flow Year Four $10,000 $200,000 $40,000 $20,000
Cash Flow year Five $10,000 $200,000 $35,000 $10,000
Cash Flow Year Six $10,000 $200,000 $20,000 $0
Solution
2
Year Four: -$10,000 + $10,000 = fully recovered
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
3
20% discount rate. What do you notice about the payback period as the discount rate
Projects A B C D
Cost $10,000 $25,000 $45,000 $100,000
Cash Flow Year One $4,000 $2,000 $10,000 $40,000
Cash Flow Year Two $4,000 $8,000 $15,000 $30,000
Cash Flow Year Three $4,000 $14,000 $20,000 $20,000
Cash Flow Year Four $4,000 $20,000 $20,000 $10,000
Cash Flow year Five $4,000 $26,000 $15,000 $10,000
Cash Flow Year Six $4,000 $32,000 $10,000 $0
4
Discounted Payback Period: -$25,000 + $1,904.76 + $7,256.24 + $12,093.73 +
5
Solution at 10% discount rate
6
PV Cash flow year five -- $15,000 / 1.105 = $9,313.82
7
Discounted Payback Period is 4 years.
8
PV Cash flow year five -- $10,000 / 1.205 = $4,018.78
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?
Solution at 8%
9
PV Cash flow year two -- $8,000 / 1.082 = $6,858.71
Solution at 12%
10
PV Cash flow year two -- $6,000 / 1.122 = $4,783.16
Solution at 16%
= -$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
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 Discounted Payback Period for the project at any positive discount
$4,852.95 = -$295.04 so the payback period is over 3 years and the project is a no-go!
12
6. Comparing Payback Period and Discounted Payback Period Neilsen Incorporated is
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
Solution
Calculate the Discounted Payback Periods of each project at 10% discount rate:
Project One
$3,005.26 = -$52.60 so the discount payback period is over 3 years and the project is
a no-go!
Project Two
13
Present Value of cash flow year three = $4,000 / 1.103 = $3,005.26
$3,005.26 = $327.58 so the discount payback period is 3 years and the project is a go!
Project Three
$2,629.20 = -$618.33 so the discount payback period is over 3 years and the project is
a no-go!
Project Four
Projects one and three will now be rejected using discounted payback period with
7. Net Present Value Swanson Industries has a project with the following projected
cash flows:
14
Cash flow year two: $75,000
a. Using a 10% discount rate for this project and the NPV model should this
Solution
$150,000/1.104
$150,000/1.154
$150,000/1.204
8. Net Present Value Campbell Industries has a project with the following projected
cash flows:
15
Initial Cost, Year 0: $468,000
a. Using an 8% discount rate for this project and the NPV model should this
Solution
$135,000/1.084
$135,000/1.144
$135,000/1.204
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
Solution, find the NPV of each project and compare the NPVs.
+ $411,351.24 + $391,763.08
+ $425,055.13 + $389,958.83
+ $228,701.30 + $99,435.34
17
Project Os NPV = $197,126.53
$406,259.18 + $406,999.18
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
Solution, find the NPV of each project and compare the NPVs.
18
Project Qs NPV = -$1,500,000 + $336,538.46 + $323,594.67 + $311,148.73
+ $299,181.47 + $287,674.49
+ $294,011.94 + $272,233.28
$245,327.49 + $162,827.98
$412,631.10 + $437,109.22
19
Campbell Industries should pick Project S.
11. Internal Rate of Return What are the IRRs of the four projects for Swanson
spreadsheet.
Enter the keys noted for each project in the CF of a Texas BA II Plus calculator
12. Internal Rate of Return -- Internal Rate of Return What are the IRRs of the four
spreadsheet.
Enter the keys noted for each project in the CF of a Texas BA II Plus calculator
20
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
The hurdle rate for IRR is the same as the discount rate for NPV
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
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
Solution, find the present value of benefits and divide by the present value of the
$500,000/1.054 + $500,000/1.055
$600,000/1.094 + $600,000/1.095
22
Project Vs PV Benefits = -$2,000,000 + $550,458.72 + $505,008.00 +
16. Profitability Index -- Given the discount rates and the future cash flows of each
23
Solution, find the present value of benefits and divide by the present value of the
$350,000/1.044 + $350,000/1.045
$400,000/1.084 + $400,000/1.085
$400,000/1.134 + $300,000/1.135
$800,000/1.184 + $1,000,000/1.185
24
Project Ds PV Benefits = $169,491.53 + $287,273.77 + $365,178.52 +
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
Solution:
part of year seven, $4,500,000 / $7,500,000 = 0.6 so total Payback is 7.6 years
25
Net Present Value: -$10,400,000 + $2,600,000/1.12 + $2,600,000/1.122 +
$7,500,000/1.127 + $750,000/1.128
$680,912.23 = $11,080,912.23
18. Comparing All Methods -- Toms Risky Business is looking at a project with the
26
Cash Flow at end of Year 10: $385,000
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
Solution:
$600,000 / $625,000 = 0.96 and Payback Period is 5.96 years and project is
accepted.
27
Present Value of Benefits = $438,596.49 + $480,917.21 + $421,857.20 +
28