Problem Set: Capital Budgeting d) What is the corresponding NPV of the project if the

appropriate discount rate is 10% and 20%,

RJW 4th Ed. Chapter 6 respectively?

e) Are the choices under the NPV rule consistent with

those of the IRR rule?
The Payback Period Rule:
The Profitability Index
RJW 6.1’ Fuji Software, Inc., has the following projects:
RJW 6.14’ The treasurer of Davids, Inc., has projected
Year Project A Project B
the cash flows of project A, B and C as follows. Suppose
0 -$7,500 -$5,000
the relevant discount rate is 12% per year.
1 4,000 2,500
2 3,500 1,200 Year Project A Project B Project C
3 1,500 3,000 0 -$100,000 -$200,000 -$100,000
a) Suppose Fuji’s cutoff payback period is two years. 1 70,000 130,000 75,000
Which of these two projects should be chosen? 2 70,000 130,000 60,000
a) Compute the profitability indices for each of the
b) Suppose Fuji uses the NPV rule to rank these two
three projects.
projects. If the appropriate discount rate is 15%, which
project should be chosen? b) Compute the NPV for each of the three projects.
The Average Accounting Return: c) Suppose these three projects are independent.
Which project should Davids accept based on the
RJW 6.3’ The annual, end-of-year, book-investment
profitability index rule?
accounts for the machine whose purchase your firm is
considering are shown below. d) Suppose these three projects are mutually exclusive.
Purchase Year 1 Year 2 Year 3 Year 4
Which project should Davids accept based on the
Date profitability index rule?
Gross $16,000 $16,000 $16,000 $16,000 $16,000
investment
Less: 0 4,000 8,000 12,000 16,000 e) Suppose Davids’ budget for these projects is
accumulated
depreciation
$300,000. The projects are not divisible. Which projects
Net 16,000 12,000 8,000 4,000 0 should Davids accept?
Investment

Comparison of Investment Rules

If your firm purchases this machine, you can expect it RJW 6.16’ Consider the following cash flows of two
to generate, on average, $4,500 per year in additional mutually exclusive projects for Chinese Daily News.
income.
Year New Sunday New Saturday
a) What is the average accounting return for this Early Edition Late Edition
machine? 0 -$1,200 -$2,100
1 600 1,000
b) What flaws are inherent in this decision rule? 2 550 900
3 450 800
The Internal Rate of Return
a) Based on the payback period rule, which project
RJW 6.8’ Suppose you are offered $5,000 today and should be chosen?
obligated to make scheduled payments as follows:
b) Suppose there is no corporate tax and the cash flows
Year Cash Flows ($) above are income before the depreciation. The firm
0 5,000 uses a straight –line depreciation method (i.e. equal
1 -2,500 amounts of depreciation in each year). What is the
2 -2,000 average accounting return for each of these two
3 -1,000 projects?
4 -1,000
a) What is the IRR of this offer? c) Which project has a greater IRR?

b) If the appropriate discount rate is 10 percent, should

you accept the offer in (a)?

c) If the appropriate discount rate is 20 percent, should

you accept offer in (a)?