SELF-REVIEW PROBLEMS

7.1 Investment criteria

A proposed overseas expansion has the following cash flows:
Year Investment A ($)
0 -100
1 50
2 40
3 40
4 15
Calculate the payback, the discounted payback, and the NPV at a required return of 15 per
cent.
Year Cash flow ($) Discounted cash flow ($) Accumulated cash flow ($)
1 50 43.48 43.48
2 40 30.25 73.73
3 40 26.30 100.03
4 15 8.58 108.61
Payback period: 2.25 years
Discounted payback period: 3 years
NPV: $8.61

7.2 Mutually exclusive investments

Consider the following two mutually exclusive investments. Calculate the IRR for each and
the crossover rate. Under what circumstances will the IRR and NPV criteria rank the two
projects differently?
Year Investment A ($) Investment B ($)
0 –100 –100
1 50 70
2 40 75
3 40 10

7.3 Accounting rate of return

You are looking at a three-year project with a projected net profit of $1,000 in year 1,
$2,000 in year 2 and $4,000 in year 3. The cost is $9,000, which will be depreciated straight-
line to zero over the three-year life of the project. What is the accounting rate of return
(ARR)?
Average net profit = ($1,000 + $2,000 + $4,000) / 3 = $2,333.33
Average book value = $9,000 / 2 = $4,500
 ARR = $2,333.33 / $4,500 = 51.85%

QUESTIONS AND PROBLEMS

3. Calculate payback
Method One is considering the following cash flows for two investments:
Year Investment A ($) Investment B ($)
0 –4,000 –4,000
1 2,080 1,640
2 2,520 1,760
3 3,908 7,600
What are the paybacks on the two investments? If Method One requires a two-year
payback to take an investment, which of these two is acceptable? Is it necessarily the best
investment? Explain.
Payback periods:
Investment A = 1.76 years
Investment B = 2.08 years

 Using two-year payback requirement, Investment A is better as it has shorter payback period.

It is not necessarily the best investment because payback period ignores cash flows that occur
after cut-off period, resulting in a bias for short-term projects.

4. Calculate NPV
Given the following cash flows, which of the two investments is better if we require a 6 per
cent of return?
Year Investment A ($) Investment B ($)
0 –2,000 –2,000
1 1,400 820
2 1,260 880
3 1,954 3,700

Investment A: Investment B:
NPV = $2,082.77 NPV = $2,663.37

 Investment B is better as it has higher NPV.

5. Calculate IRR
Compute the internal rate of return on a project with cash flows of:
Year Cash Flows ($)
0 –4,100
1 2,008
2 3,494.40

 IRR = 20%

10. IRR versus NPV

Consider the following cash flows for two mutually exclusive investments:
Year 0 ($) Year 1 ($) Year 2 ($)
Project A –100 80 90
Project B –100 70 102
For what range of discount rates is project A better? Illustrate your answer with an NPV
profile. (if u see the underlined keywords, meaning u need to find crossover rate)
Project A ($) Project B ($) Differences ($)
Year 0 -100 -100 0
Year 1 80 70 10
Year 2 90 102 -12

NPV when I = 0% 70 72
NPV when I = 20% 29.17 29.17
Solve IRR (Crossover rate) 20%

15. Project choice using several techniques

You have been asked by Rainy Days Ltd to consider the following cash flows for two
mutually exclusive investments:
Year Investment A ($) Investment B ($)
0 –10,000 –10,000
1 4,000 6,000
2 6,000 6,000
3 9,000 6,000
a) Based on the payback periods, which of these might you prefer?
Payback periods:
Investment A = 2 years
Investment B = 1.67 years

 Prefer Investment B.

b) Sketch the NPV profiles for both investments. Over what range is investment A
preferred?
NPV when I = 0%:
Investment A = $9,000
Investment B = $8,000

c) Find the IRR for the two investments and indicate them on graph.
IRR:
Investment A = 34.43%
Investment B = 36.31%

d) Find the exact crossover point and indicate it on graph.

Year Investment A ($) Investment B ($) Differences ($)
0 –10,000 –10,000 0
1 4,000 6,000 -2,000
2 6,000 6,000 0
3 9,000 6,000 3,000

NPV when I = 0% $9,000 $8,000

NPV when I = C rate $2,164.97 $2,164.97
Solve IRR (Crossover rate) 22.47%

e) Suppose the required return is 10 per cent. Which of these investments do you
prefer?
NPV when I = 10%:
Investment A = $5,356.87
Investment B = $4,921.11
16. Applications of various techniques
The Seaview Company owns 60 acres of prime ocean-front property. It is considering
several different development options. One option is a hotel, casino, and resort complex
(option A). Also under consideration is a more expensive hotel / amusement park / casino
department (option B). The cash flows (in millions of dollars) for the two options are
projected to be:
Year Option A ($) Option B ($)
0 –14,000 –18,000
1 –1,000 –2,000
2 2,100 3,200
3 5,080 6,500
4 5,000 7,000
5 6,000 7,500
6 26,000 32,000
a) What is the payback of option A? Option B?
Payback period of option A = 4.47 years
Payback period of option B = 4.44 years

b) Assuming a required return of 20 per cent, what are the present value indices or
benefit / cost ratios for the projects? How do you interpret these?
Year Option A ($) Option B ($)
0 0 0
1 0 0
2 2,100 3,200
 3 5,080 6,500
4 5,000 7,000
5 6,000 7,500
6 26,000 32,000
NPV for inflows $17,916.45 $23,090.38
NPV for outflows $14,000 + ($1,000 / 1.2) $18,000 + (2,000 / 1.2)
= $14,833.34 = $19,666.67
*To find NPV for outflows, have to plus the NPV of year 0 and 1. However, the cash
flow of year 1 is not NPV yet, so we need to divide 120% first.

PI:
Option A = $17,916.45 / $14,833.34 = 1.21
Option B = $23,090.38 / $19,666.67 = 1.17

c) Do the present value index and NPV criteria always rank projects the same way?
Why or why not? Which of these two projects is preferable, again assuming a 20 per
cent discount rate?
NPV:
Option A = $17,916.45 – $14,833.34 = $3,083.11
Option B = $23,090.38 – $19,666.67 = $3,423.71

 PI and NPV do not always rank the projects in the same way. This is because option A
has lower NPV but higher PI, whereas option B has higher NPV but lower PI.

23. Mutually exclusive investments

Consider the following two mutually exclusive investments:
Year Investment Limp ($) Investment Stumble
($)
0 –750 –750
1 200 600
2 400 500
3 700 150
Calculate the internal rate of return for each and the crossover rate. Under what
circumstances will the internal rate of return and the net present value rank the projects
differently?
Internal rate of return:
Investment Limp = 26.79%
Investment Stumble = 38.54%

Crossover rate:
 Year Investment Limp ($) Investment Stumble ($) Differences ($)
1 200 600 -400
2 400 500 -100
3 700 150 550
Crossover rate = 5.42%

NPV when I = 5.42%

Investment Limp = $397
Investment Stumble = $397

NPV when I = 0%
Investment Limp = $550
Investment Stumble = $500

24. Accounting rate of return

There is a six-year project that is expected to have the following net income:
Year Net income ($) Year Investment B ($)
0 20,000 3 40,000
1 40,000 4 40,000
2 60,000 5 10,000
The cost is $120,000, which will depreciate straight line to zero over the six-year life of the
project. What is the accounting rate of return?
Average net profit = ($20,000 + $40,000 + $60,000 + $40,000 + $40,000 + $10,000) / 6
= $35,000
Average book value = $120,000 / 2 = $60,000
 ARR = $35,000 / $60,000 = 58.33%