Professional Documents
Culture Documents
Chapter 3
Answer:
(a) Projects are said to be “mutually exclusive” when the selection of one
automatically eliminates the need for any of the alternatives; eg. choosing among a
number of alternative road designs between the same two points.
(b) It is possible that the ranking of projects using their NPVs changes when the
discount rate changes (“switching”). In this case one project will not be
unambiguously superior to another as a ranking by IRR would suggest.
YEAR 0 1 2 3 4 5 6
PROJECT A -60 20 20 20 20 20 20
PROJECT B -72 45 22 20 13 13 13
(i) Calculate the NPVs for each project, assuming 10% cost of capital.
(ii) Assuming that the two projects are independent, would you accept
them if the cost of capital is 15%?
(iii) What is the IRR of each project?
(iv) Which of the two projects would you prefer if they are mutually
exclusive, given a 15% discount rate?
Answer:
(i) NPVA(10%) = 27.11; NPVB(10%) = 26.41
(ii) Yes. NPVA(15%)=15.69;NPVB(15%)=16.43
(iii) IRR(A)=24%; IRR(B)=26%
(iv) Prefer B – higher NPV(15%)
3. Using a spreadsheet generate your own set of Discount and Annuity Tables
for, say, all discount rates between 1% and 20% (at 1 percentage point
intervals) and for time periods 1 to 30 (at one time period intervals), as well as
time periods 50 and 100. You should generate these tables by inserting the
numbers for the time periods in the first column of each row and the discount
rates in the first row of each column, and then inserting the appropriate
formula into one cell of the table – year 1 at 1% - and then copying it to all
other cells in the matrix. (Hint: Do not forget to anchor the references to
periods and discount rates using the “$” symbol.)
Answer: Write the discount formula into spreadsheet as shown below and then copy
across 20 columns (headed 1% through 20%) and down 50 rows (headed 1 to
50).
Column B
Row 2
1% 2% 3%
1 =1/(1+B$2)^$A2 0.980 0.971
2 0.980 0.961 0.943
3 0.971 0.942 0.915
4. A firm has a capital budget of $100 which must be spent on one of two
projects, each requiring a present outlay of $100. Project A yields a return of
$120 after one year, whereas Project B yields $201.14 after 5 years.
Calculate:
What are the project rankings on the basis of these two investment decision
rules? Suppose that you are told that the firm’s reinvestment rate is 12%,
which project should the firm choose?
Answer:
(i)NPV(A) = 9.09; NPV(B) = 24.89, B>A
(ii) IRR(A) = 20%; IRR(B) = 15%, A>B
Using a reinvestment rate of 12% the terminal values are TV(A) = 188.82; TV(B) =
201.14, hence B>A. Alternatively calculate the IRR of (B-A): IRR(B-A) = 13.78% >
12%, hence undertake the “extra project” (B-A) ie. undertake B.
5. A firm has a capital budget of $100 which must be spent on one of two
projects, with any unspent balance being placed in a bank deposit earning
15%. Project A involves a present outlay of $100 and yields $321.76 after 5
years. Project B involves a present outlay of $40 and yields $92 after one
year. Calculate:
What are the project rankings on the basis of these investment decision
rules? Suppose that if Project B is undertaken its benefit can be reinvested at
17%; what project should the firm choose? Show your calculations
(spreadsheet printout is acceptable as long as entries are clearly labelled).
Answer:
(a) Identify six combinations of project investments and a bank deposit which
exhaust the budget.
(b) Which of the above combinations should the firm choose:
(i) when the reinvestment rate is 15%?
(ii) when the reinvestment rate is 20%?
Answer:
A 30 40 0
B 30 0 50
C 70 0 100
(i) Work out the Net Present Value (NPV), Internal Rate of Return (IRR)
and Benefit/Cost Ratio (B/C) for each project;
(ii) Rank the projects according to the NPV, IRR and B/C investment
criteria;
Answer:
(In answering this question the student should assume that the full amount of
the budget must be exhausted on some combination of the three projects; ie.
it cannot be assumed that some part of the initial budget is invested at the
reinvestment rate. It should also be assumed that end of year 2 is the
terminal year.)
(i)
NPV IRR BCR
A $6.36 33% 1.21
B $11.32 29% 1.38
C $12.64 20% 1.18