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Foundations of Finance (8th Edition)

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Solutions for Chapter 10

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Step-by-step solution Chapter: CH10 Problem: 1MC

Step 1 of 31

(a)

Importance of capital budgeting process:

• The capital budgeting influences the firm’s growth in the long run

• It affect the risk of the firm

• It involve commitment of large amount of funds

• The capital budgeting decisions are irreversible, or reversible at substantial loss

Step 2 of 31

(b)

In the long run, all projects generate normal profits. Exceptionally profitable projects are very rare, since the new
inventions most of the times fail. The first step in the capital budgeting process i.e. Generation of exceptionally
profitable project idea is very crucial. Screening of profitable projects also plays an important role in selecting the
exceptionally profitable project.

Step 3 of 31

(c)

Payback period is the time required for an investment to generate cash flows sufficient to recover its initial costs.

Calculate the Payback-period for Project A:

Year Cash inflows Cumulative cash inflows

1 $20,000 $20,000

2 $30,000 $50,000

3 $40,000 $90,000

4 $50,000 $140,000

5 $70,000 $210,000

After the first 3 years, the total of the cash flows = $90,000

Therefore the project pays back sometime between the years to 3 and 4.

The total accumulated cash flows for the first 3 years = $90,000
The $20,000 will be recovered from the cash flow of 4th year.

Since the 4th year cash flows is $50,000, so the time required to recover remaining amount is calculated as:

Payback Period =3 years + 0.4 years

= 3.4 years

Therefore, the Payback Period for Project A is 3.4 years

Step 4 of 31

Calculate the Payback-period for Project B:

Year Cash inflows Cumulative cash inflows

1 $40,000 $40,000

2 $40,000 $80,000

3 $40,000 $120,000

4 $40,000 $160,000

5 $40,000 $200,000

After the first 2 years, the total of the cash flows = $80,000

Therefore the project pays back sometime between the years to 2 and 3.

The total accumulated cash flows for the first 2 years = $80,000

The $30,000 will be recovered from the cash flow of 3rd year.

Since the 3rd year cash flows is $40,000, so the time required to recover remaining amount is calculated as:

Payback Period =2 years + 0.75 years

= 2.75 years

Therefore, the Payback Period for Project B is 2.75 years

Conclusion: Project ‘B’ should be selected since it recovers the initial outlay of $110,000 in 2.75 years.

Step 5 of 31

(d)

Criticisms of Payback-period:

• It will not take into consideration the cash flows occurred after the payback-period.

• It will not consider the time value of money.

Step 6 of 31
(e)

Net Present Value ( NPV ): Net Present Value is the difference between the sum of the present values of the future
cash flows of the project and the initial cost of the project. Companies use weighted average cost of capital as the
discount rate to calculate the NPV.

The formula for calculating the Net Present Value is

The decision rule for the Net Present Value method is – accept the project if the Net Present Value is greater than
zero or reject the project if the Net Present Value is less than zero. The value of the firm rises by the Net Present
Value of the project.

Calculate the NPV for the Project A:

Project A

Year Cash flows PV Factor at 12% Net Present Value

0 ($110,000) 1 ($110,000)

1 $20,000 0.892857143 $17,857.14

2 $30,000 0.797193878 $23,915.82

3 $40,000 0.711780248 $28,471.21

4 $50,000 0.635518078 $31,775.90

5 $70,000 0.567426856 $39,719.88

Net Present Value $31,739.95

Step 7 of 31

Calculate the NPV for the Project B:

Project B

Year Cash flows PV Factor at 12% Net Present Value

0 ($110,000) 1 ($110,000)

1 $40,000 0.892857143 $35,714.29

2 $40,000 0.797193878 $31,887.76

3 $40,000 0.711780248 $28,471.21

4 $40,000 0.635518078 $25,420.72

5 $40,000 0.567426856 $22,697.07

Net Present Value $34,191.05

Conclusion: Since both the projects are generating positive NPVs, both the projects can be accepted.

Step 8 of 31

(f)

Describe the logic behind the NPV:

The logic behind the NPV is whether the new investments are contributing to increase the shareholders’ value
after meeting the capital costs and after recovering the investments.

Step 9 of 31

(g)
Calculate the Profitability Index (PI):

Profitability index is defined as the present value of the future cash flows divided by the initial investment.

Initial investment = $110,000.

Step 10 of 31
Calculate the Profitability Index for the Project A:
Project A

Year Cash flows PV Factor at 12% Net Present Value

1 $20,000 0.892857143 $17,857.14

2 $30,000 0.797193878 $23,915.82

3 $40,000 0.711780248 $28,471.21

4 $50,000 0.635518078 $31,775.90

5 $70,000 0.567426856 $39,719.88

Total Present Value of Future Cash flows $141,739.95

Therefore, the Profitability Index of Project A is 1.29

Step 11 of 31

Calculate the Profitability Index for the Project B:

Project B

Year Cash flows PV Factor at 12% Net Present Value

1 $40,000 0.892857143 $35,714.29

2 $40,000 0.797193878 $31,887.76

3 $40,000 0.711780248 $28,471.21

4 $40,000 0.635518078 $25,420.72

5 $40,000 0.567426856 $22,697.07

Total Present Value of Future Cash flows $144,191.05

Therefore, the Profitability Index of Project B is 1.31

Conclusion: Since the Profitability Index is more than one for both the projects, both the projects can be accepted.

Step 12 of 31

(h)

The NPV and PI methods will give the same accepting or rejecting decisions. The reason is when the NPV is
Positive; the PI is also greater than one.

Step 13 of 31

(i)

NPV is a function of required rate of return and cash flows. If the required rate of return is increased the NPV will
be reduced. Even the NPV goes to negative if the required rate of return is more. PI also moves in the same
direction as the NPV. If the required rate of return is decreased the NPV and PI are also increase and the projects
will be accepted.

Step 14 of 31

(j)

IRR (Internal Rate of Return) is a discount rate that forces the PV of cash inflows to equal the cost. This is
equivalent to forcing the NPV to equal zero. The IRR is an estimate of the project’s rate of return, and it is
comparable to the YTM on a bond.

Calculate the IRR for Project A:

Internal rate of return is given by:

Outflow = Inflow

Calculate the IRR for the above cash flows using excel spreadsheet.

The formula is “=IRR (values)”

Year Cash Flow

0 ($110,000)

1 $20,000

2 $30,000

3 $40,000

4 $50,000

5 $70,000

IRR 20.97% 

The IRR formula in the spreadsheet will appear as follows:

Explanation:

• Select B column for the cash flows.

• Input these cash flows each one in one cell of the column followed by the year 0 cash flows to year 5 cash flows.

• Click on the cell where you want your IRR

• Select “C5” and enter ‘=IRR (B2:B8) and then Press Enter Key

• Then your located cell displays the answer IRR of 20.97%

• IRR =20.97%

Step 15 of 31

Calculate the IRR for Project B:

Internal rate of return is given by:

Outflow = Inflow

Calculate the IRR for the above cash flows using excel spreadsheet.

The formula is “=IRR (values)”

Year Cash Flow

0 ($110,000)

1 $40,000

2 $40,000

3 $40,000

4 $40,000

5 $40,000

IRR 23.92% 

Step 16 of 31
The IRR formula in the spreadsheet will appear as follows:

Explanation:

• Select B column for the cash flows.

• Input these cash flows each one in one cell of the column followed by the year 0 cash flows to year 5 cash flows.

• Click on the cell where you want your IRR

• Select “C5” and enter ‘=IRR (B2:B8) and then Press Enter Key

• Then your located cell displays the answer IRR of 23.92%

• IRR =23.92%

Conclusion: Since the IRR of both the projects are more than the required rate of return of 12%, both the projects
can be accepted.

Step 17 of 31

(k)

A change in required rate of return will affect the decision, but it will not affect the IRR. IRR will be the same
whether the required rate of return is 15% or 20% or 25%. But a change in required rate of return affects the
decision.

Step 18 of 31

(l)

Under the NPV the reinvestment rate is same as the required rate of return. Under the IRR the reinvestment rate is
the Internal Rate of Return (IRR). NPV is better than IRR, since the required rate of return is nothing but the cost of
capital, where as the IRR is not equal to cost of capital. It may be greater than the cost of capital or less than the
cost of capital.

Step 19 of 31

(m)

(1) Calculate the NPV for Project A:

Project A

Year Cash flows PV Factor at 10% Net Present Value

0 ($195,000) 1 ($195,000)

1 $240,000 0.909090909 $218,181.82

Net Present Value $23,181.82

Calculate the NPV for Project B:

Project B

Year Cash flows PV Factor at 10% Net Present Value

0 ($1,200,000) 1 ($1,200,000)

1 $1,650,000 0.909090909 $1,500,000.00

Net Present Value $300,000.00

Step 20 of 31

(2) Calculate the Profitability Index for Project A:

Present value of future cash flows for Project A is $218,181.82

Initial Investment for Project A is $195,000

Calculate the Profitability Index for Project B:

Present value of future cash flows for Project A is $1,500,000

Initial Investment for Project A is $1,200,000

Step 21 of 31

(3) Calculate the IRR for Project A:

Internal rate of return is given by:

Outflow = Inflow

Calculate the IRR for the above cash flows using excel spreadsheet.

The formula is “=IRR (values)”

Year Cash Flow

0 ($195,000)

1 $240,000

IRR 23.08% 

Step 22 of 31

The IRR formula in the spreadsheet will appear as follows:

Explanation:

• Select B column for the cash flows.

• Input these cash flows each one in one cell of the column followed by the year 0 cash flows to year 1 cash flows.

• Click on the cell where you want your IRR

• Select “C4” and enter ‘=IRR (B2:B4) and then Press Enter Key

• Then your located cell displays the answer IRR of 23.08%

• IRR =23.08%

Step 23 of 31

Calculate the IRR for Project B:

Internal rate of return is given by:

Outflow = Inflow
Calculate the IRR for the above cash flows using excel spreadsheet.

The formula is “=IRR (values)”

Year Cash Flow

0 ($1,200,000)

1 $1,650,000

IRR 37.50% 

The IRR formula in the spreadsheet will appear as follows:

Explanation:

• Select B column for the cash flows.

• Input these cash flows each one in one cell of the column followed by the year 0 cash flows to year 1 cash flows.

• Click on the cell where you want your IRR

• Select “C4” and enter ‘=IRR (B2:B4) and then Press Enter Key

• Then your located cell displays the answer IRR of 37.50%

• IRR =37.50%

Conclusion: Project B is selected since it is giving 37.50% return.

Step 24 of 31

(n)

(1) Calculate the Project’s Payback period:

Project A:

Year Cash inflows Cumulative cash inflows

1 $32,000 $32,000

2 $32,000 $64,000

3 $32,000 $96,000

4 $32,000 $128,000

5 $32,000 $160,000

After the first 3 years, the total of the cash flows = $96,000

Therefore the project pays back sometime between the years to 3 and 4.

The total accumulated cash flows for the first 3 years = $96,000
The $4,000 will be recovered from the cash flow of 4th year.

Since the 4th year cash flows is $32,000, so the time required to recover remaining amount is calculated as:

Payback Period =3 years + 0.125 years

= 3.125 years

Therefore, the Payback Period for Project A is 3.125 years

Step 25 of 31

Project B:

Year Cash inflows Cumulative cash inflows

1 $0 $0

2 $0 $0

3 $0 $0

4 $0 $0

5 $200,000 $200,000

Therefore, the Payback Period for Project B is 5 years

Step 26 of 31

(2) calculate each Project’s NPV:

Project A:

Year Cash flows PV Factor at 11% Net Present Value

0 ($100,000) 1 ($100,000)

1 $32,000 0.900900901 $28,828.83

2 $32,000 0.811622433 $25,971.92

3 $32,000 0.731191381 $23,398.12

4 $32,000 0.658730974 $21,079.39

5 $32,000 0.593451328 $18,990.44

Net Present Value $18,268.70

Project B:

Year Cash flows PV Factor at 11% Net Present Value

0 ($100,000) 1 ($100,000)

1 $0 0.900900901 $0.00

2 $0 0.811622433 $0.00

3 $0 0.731191381 $0.00

4 $0 0.658730974 $0.00

5 $200,000 0.593451328 $118,690.27

 Net Present Value $18,690.27

Step 27 of 31

(3) Calculate the IRR for each project:

Calculate the IRR for Project A:

Internal rate of return is given by:

Outflow = Inflow

Calculate the IRR for the above cash flows using excel spreadsheet.

The formula is “=IRR (values)”

Year Cash Flow

0 ($100,000)

1 $32,000

2 $32,000

3 $32,000

4 $32,000

5 $32,000

IRR 18.03% 

The IRR formula in the spreadsheet will appear as follows:

Step 28 of 31

Explanation:

• Select B column for the cash flows.

• Input these cash flows each one in one cell of the column followed by the year 0 cash flows to year 5 cash flows.

• Click on the cell where you want your IRR

• Select “C5” and enter ‘=IRR (B2:B8) and then Press Enter Key
• Then your located cell displays the answer IRR of 18.03%

• IRR =18.03%

Step 29 of 31

Calculate the IRR for Project B:

Internal rate of return is given by:

Outflow = Inflow

Calculate the IRR for the above cash flows using excel spreadsheet.

The formula is “=IRR (values)”

Year Cash Flow

0 ($100,000)

1 $0,000

2 $0,000

3 $0,000

4 $0,000

5 $200,000

IRR 14.87% 

The IRR formula in the spreadsheet will appear as follows:

Explanation:

• Select B column for the cash flows.

• Input these cash flows each one in one cell of the column followed by the year 0 cash flows to year 5 cash flows.

• Click on the cell where you want your IRR

• Select “C5” and enter ‘=IRR (B2:B8) and then Press Enter Key

• Then your located cell displays the answer IRR of 14.87%

• IRR =14.87%
 Step 30 of 31
IRR for project-B is approximately 15%
(4)

Ranking conflict: According to NPV project B should be selected since it is giving $18,690.27 NPV. But according to
IRR method Project A should be selected since it is generating 18% return.

Step 31 of 31

(5) Project B should be selected since NPV is the superior method to IRR.

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Corresponding Textbook

Foundations of Finance | 8th Edition

ISBN-13: 9780132994873 Alternate ISBN: 9780133019292,
ISBN: 0132994879 9780133019926, 9780133145021,
9780133423983, 9780133423990
Authors: J William Petty, Arthur J. Keown,
John D Martin

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Solutions for Problems in Chapter 10 is solved

1MC 1RQ 1SP 2RQ 2SP

3RQ 3SP 4RQ 4SP 5RQ

5SP 6RQ 6SP 7RQ 7SP

8RQ 8SP 9RQ 9SP 10SP

11SP 12SP 13SP 14SP 15SP

16SP 17SP 18SP 19SP 20SP

21SP 22SP 23SP 24SP 25SP

26SP 27SP 28SP 29SP 30SP

31SP 32SP 33SP

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