CHAPTER 11

1. Matrix Associates is evaluating a project whose expected cash flows are as follows:

Year Cash flow (Rs. in million)

0 (23)
1 6
2 8
3 9
4 7

The cost of capital for Matrix Associates is 14 percent.

(i) What is the NPV of the project?

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Solution:

6 8 9 7
NPV = -23 + -------- + --------- + -------- + ---------
(1.14) ( 1.14)2 ( 1.14)3 ( 1.14)4

= -23 + 5.263 + 6.156 + 6.075 + 4.145

= -1.361

(ii) What is the IRR of the project?

Solution:

When the discount rate is 14 %, the NPV is -1.361

Trying a lower rate of 12%
6 8 9 7
NPV = -23 + -------- + -------- + -------- + ---------
(1.12) (1.12)2 (1.12)3 (1.12)4

= -23 + 5.357 + 6.378 + 6.406 + 4.449 = -0.41

Trying a still lower rate of 11%

6 8 9 7
NPV = -23 + -------- + -------- + -------- + -------
(1.11) (1.11)2 (1.11)3 (1.11)4

= -23 + 5.405 + 6.493 + 6.581+ 4.611 = 0.09

By linear interpolation we get

0.09
IRR = 11 + ------------------ = 11.18%
(0.41 + 0.09)

(iii) What is the NPV* of the project if the reinvestment rate is 18 percent?

Solution:

Terminal value = 6(1.18)3 + 8(1.18)2 + 9(1.18) + 7 = 38.617

NPV* = 38.617 / (1.14)4- 23 = -0.136

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 (iv) What is the MIRR of the project if the reinvestment rate is 18 percent?

Solution:

23 (1+MIRR)4 = 38.617

(1+MIRR)4 = 38.617 / 23 = 1.679

MIRR = (1.679)1/4 – 1 = 13.83%

2. Sigma Corporation is evaluating a project whose expected cash flows are as

follows:
Year Cash flow (Rs.in million)
0 - 16.0
1 3.2
2 4.5
3 7.0
4 8.4

The cost of capital for Sigma Corporation is 12 percent .

(i) What is the NPV of the project?
Solution:

3.2 4.5 7.0 8.4

+ + + +
NPV = -16.0 (1.12) (1.12)2 (1.12)3 (1.12)4
2.8576 + 3.5865 + 4.984 + 5.3424

= 0.7705

(ii) What is the IRR of the project?

Solution:

At 12% discount rate NPV is 0.7705

Try 13%
NPV = -16 + 3.2 (0.885) + 4.5 (0.783) + 7 (0.693) + 8.4 (0.613)
= -16 + 2.832 + 3.5235 + 4.851 + 5.1492
= 0.3557

Try 14%
NPV = -16 + 3.2 (0.877) + 4.5 (0.769) + 7 (0.675) + 8.4 (0.592)
= -16 + 2.8064 + 3.4605 + 4.725 + 4.9728
= -0.0353
As this is very nearly zero, the IRR of the project is 14 %
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 (iii) What is the NPV * of the project if the reinvestment rate is 16%?

Solution:

Terminal
Value = 3.2 (1.16)3 + 4.5 (1.16)2 + 7 (1.16)1 + 8.4
= 3.2 (1.561) + 4.5 (1.346) + 7 (1.16) + 8.4
= 4.9952 + 6.057 + 8.12 + 8.4
= 27.5722
NPV* = 27.5722 - 16 = 1.5359
(1.12)4

(iv) What is the IRR* if the reinvestment rate is 16%?

Solution:

16 ( 1 + 1RR*)4 = 27.5722
27.5722
( 1 + 1RR*)4 = = 1.7233
16
1RR* = (1.7233) 1/4 -1
= 1.1457 -1 = 14.57 %

3. Dumas Company is evaluating a project whose expected cash flows are as follows:

Year Cash flow

0 - Rs.700,000
1 Rs.150,000
2 Rs.200,000
3 Rs.300,000
4 Rs.350,000
The cost of capital for Dumas Company is 12 percent

(i) What is the NPV of the project?

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Solution:

- 700,000 1.000 -700,000

150,000 0.893 133,950
200,000 0.797 159,400
300,000 0.712 213,600
350,000 0.636 222,600
29,550

(ii)

Solution:

13% 14%
PVIF PV PVIF PV
150,000 0.885 132,750 0.877 131,550
200,000 0.783 156,600 0.769 153,800
300,000 0.693 207,900 0.675 202,500
350,000 0.613 214,550 0.592 207,200
711,800 695,050

711,800 - 700,000
IRR = 13 % + x 1% = 13.70%
711,800 - 695,050

(iii) What is the NPV * of the project if the reinvestment rate is 15% ?

Solution:

Terminal value = 150,000 (1.15)3 + 200,000 (1.15)2 + 300,000 ( 1.15)1

+ 350,000

= 150,000 (1.521) + 200,000 (1.322) + 300,000 (1.150)

+ 350,000

= 228,150 + 264,400 + 345,000 + 350,000

= 1,187,550

1,187,550
NPV * = - 700,000
(1.12)4

= 54,709
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(iv) What is the IRR* if the reinvestment rate is 15%?

Solution:

700,000 ( 1 + IRR*)4 = 1,187,550

(1 + IRR*)4 = 1,187,550 / 700,000 = 1.6965
¼
IRR* = (1.6965) - 1
= 1.1413 - 1 = 14.13%

4. You are evaluating a project whose expected cash flows are as follows:

Year Cash flow

0 -1,000,000
1 200,000
2 300,000
3 400,000
4 500,000

What is the NPV of the project (in '000s) if the discount rate is 10 percent for year 1
and rises thereafter by 2 percent every year?

Solution:

200 300 400

PVB = + +
(1.10) (1.10) (1.12) (1.10) (1.12) (1.14)
500
+
(1.10) (1.12) (1.14) (1.16)

= 181.82 + 243.51 + 284.80 + 306.90

= 1017.03 ;
NPV = 1,017,030 – 1,000,000 = 17,030

5. The cash flows associated with an investment are given below:

Year Cash flow
0 Rs.(850,000)
1 120,000
2 450,000
3 360,000
4 210,000
5 130,000

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 Calculate the benefit cost ratio of this investment, if the discount rate is 12
percent.

Solution:

PV of benefits (PVB) =120,000x PVIF (12,1)+450,000x PVIF (12,2)

+360,000x PVIF (12,3)+210,000x PVIF (12,4)
+130,000x PVIF (12,5)
=107,160+358,650+256,320+133,560+73,710
= Rs. 929,400(A)

Investment = 850,000 (B)

Benefit cost ratio (A/B) = 929,400/850,000 = 1.09

6. The cash flows associated with an investment are given below:

Year Cash flow

0 Rs.(260,000)
1 85,420
2 103,240
3 128,430
4 92,480
5 78,350

Calculate the benefit cost ratio of this investment, if the discount rate is 18
percent.

Solution:

PV of benefits (PVB) =85,420xPVIF (18,1)+ 103,240x PVIF (18,2)

+128,430xPVIF (18,3)+ 92,480x PVIF (18,4)
+78,350xPVIF (18,5)
=72,351+74,126+78,214+47,720+34,239
= Rs. 306,650(A)

Investment = 260,000 (B)

Benefit cost ratio(A/B) = 306,650/260,000 = 1.18

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7. Your company is considering two mutually exclusive projects, A and B. Project A
involves an outlay of Rs.250 million which will generate an expected cash inflow
of Rs.60 million per year for 8 years. Project B calls for an outlay of Rs.100
million which will produce an expected cash inflow of Rs.25 million per year for
8 years. The company's cost of capital is 14 percent.

a. Calculate the NPV and IRR of each project

b. What is the NPV and IRR of the differential project (the project that reflects
the difference between Project B and Project A)
Solution:
(a) Project A

NPV at a cost of capital of 14%

= - 250 + 60 x PVIFA (14,8)
= Rs.-250+ 60x 4.639 = Rs.28.34 million

IRR (r ) can be obtained by solving the following equation for r.

60 x PVIFA (r,8) = 250
PVIFA (r,8) =4.17

From tables we see that when:

r =17 %, RHS = 4.207

r = 18%, RHS = 4.078

By extrapolation,

r =17 + (4.207-4.17)/(4.207-4.078) = 17.29 %

Project B

NPV at a cost of capital of 14%

= - 100 + 25 x PVIFA (14,8)
= Rs.15.98 million

IRR (r') can be obtained by solving the equation

25 x PVIFA (r',8) = 100
PVIFA (r’,8) =4

From tables we see that when:

r’ =18 %, RHS = 4.078

r’ = 19%, RHS = 3.954
By extrapolation,
r’ =18 + (4.078-4)/(4.078- 3.954) = 18.63 %

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(b) Difference in capital outlays between projects A and B is Rs.150 million
Difference in net annual cash flow between projects A and B is Rs.35 million.
NPV of the differential project at 14%
= -150 + 35 x PVIFA (14,8)
= Rs.12.37 million

IRR (r'’) can be obtained by solving the equation

35 x PVIFA (r'’,8) = 150
PVIFA (r’’,8) = 4.286
From tables we see that when:
r’’ =16 %, RHS = 4.344
r’’ = 17%, RHS = 4.207

By extrapolation,
r’’ =16 + (4.344-4.286)/(4.344- 4.207) = 16.42 %

8. Your company is considering two projects, M and N. Each of which requires an

initial outlay of Rs.240 million. The expected cash inflows from these projects
are:

Year Project M Project N

1 85 100
2 120 110
3 180 120
4 100 90

a. What is the payback period for each of the projects?

b. What is the discounted payback period for each of the projects if the cost of
capital is 15 percent?
c. If the two projects are independent and the cost of capital is 15 percent, which
project(s) should the firm invest in?
d. If the two projects are mutually exclusive and the cost of capital is 12 percent,
which project should the firm invest in?
e. If the two projects are mutually exclusive and the cost of capital is 20 percent,
which project should the firm invest in?
f. If the cost of capital is 13 percent, what is the modified IRR of each project?

Solution:
Project M
The pay back period of the project lies between 2 and 3 years. Interpolating in
this range we get an approximate pay back period of 2.19 years.

Project N
The pay back period lies between 2 and 3 years. Interpolating in this range we
get an approximate pay back period of 2.25 years.

(b)
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 Project M
Cost of capital = 15 % p.a

Year Cash flow PV of cash flow Cumulative PV of

cash flow
1 85 73.91 73.91
2 120 90.74 164.65
3 180 118.35 283
4 100

Discounted pay back period (DPB) lies between 2 and 3 years. Interpolating in
this range we get an approximate DPB of 2.64 years.

Project N

Cost of capital = 15 % p.a

Year Cash flow PV of cash flow Cumulative PV of

cash flow
1 100 86.96 86.96
2 110 83.18 170.14
3 120 78.90 249.04
4 90

Discounted pay back period (DPB) lies between 2 and 3 years. Interpolating in
this range we get an approximate DPB of 2.89 years.

(c ) Project M
Cost of capital = 15% per annum
NPV = - 240 + 85 x PVIF (15,1)
+ 120 x PVIF (15,2) + 180 x PVIF (15,3)
+ 100 x PVIF (15,4)
= - 240 + 85 x 0.870+120 x 0.756 + 180 x0.658
+ 100 x 0.572
= Rs. 100.31million

Project N
Cost of capital = 12% per annum
NPV = - 240 + 100 x PVIF (15,1)
+ 110 x PVIF (15,2) + 120 x PVIF (15,3)
+ 90 x PVIF (15,4)
=- 240 + 100 x0.870+ 110 x 0.756 + 120 x 0.658
+ 90 x 0.572
= Rs. 60.6 million

Since the two projects are independent and the NPV of each project is positive,

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 both the projects can be accepted. This assumes that there is no capital constraint.

(d) Project M
Cost of capital = 12% per annum
NPV = Rs.123.23 million

Project N
Cost of capital = 10% per annum
NPV = Rs.79.59 million

Since the two projects are mutually exclusive, we need to choose the project with
the higher NPV i.e., choose project M.

NOTE: The MIRR can also be used as a criterion of merit for choosing between
the two projects because their initial outlays are equal.

(e) Project M

Cost of capital = 15% per annum

NPV = 66.56 million

Project N
Cost of capital: 15% per annum
NPV = Rs.32.57 million

Again the two projects are mutually exclusive. So we choose the project with the
higher NPV, i.e., choose project M.

(f) Project M

Terminal value of the cash inflows: 579.27

MIRR of the project is given by the equation
240 (1 + MIRR)4 = 579.27
i.e., MIRR = 24.64 %

Project N

Terminal value of the cash inflows: 510.35

MIRR of the project is given by the equation
240 ( 1+ MIRR)4 = 510.35
i.e., MIRR = 20.76 %

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9. If an equipment costs Rs.350,000 and lasts 6 years, what should be the minimum
annual cash inflow before it is worthwhile to purchase the equipment ? Assume
that the cost of capital is 12 percent

Solution:

Let NCF be the minimum constant annual net cash flow that justifies the
purchase of the given equipment. The value of NCF can be obtained from the
equation

NCF x PVIFA (12,6) = 350,000

NCF = 350,000 / 4.111
= 85,137

10. If an equipment costs Rs.2.000,000 and lasts 8 years, what should be the
minimum annual cash inflow before it is worthwhile to purchase the equipment ?
Assume that the cost of capital is 14 percent

Solution:

Let NCF be the minimum constant annual net cash flow that justifies the
purchase of the given equipment. The value of NCF can be obtained from the
equation

NCF x PVIFA (14,8) = 2,000,000

NCF = 2,000,000 / 4.639
= 431,127

11. How much can be paid for a machine which brings in an annual cash inflow of
Rs.50,000 for 8 years ? Assume that the discount rate is 15 percent.

Solution:

Define I as the initial investment that is justified in relation to a net annual cash
inflow of Rs.50,000 for 8 years at a discount rate of 15% per annum. The value
of I can be obtained from the following equation

50,000 x PVIFA (15,8) = I

i.e., I = 50,000 x 4.487 = Rs. 224,350

12. How much can be paid for a machine which brings in an annual cash inflow of
Rs.600,000 for 12 years ? Assume that the discount rate is 16 percent.

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Solution:

Define I as the initial investment that is justified in relation to a net annual cash
inflow of Rs.600,000 for 12 years at a discount rate of 16% per annum. The value
of I can be obtained from the following equation

600,000 x PVIFA (16 ,12) = I

i.e., I = 600,000 x 5.197 = Rs. 3,118,200

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