Business Finance

Module 9

Module Mathematical Concepts and Tools in

Computing for Finance and Investment
11 Problems

Figure 1. Graph of Risk-return Trade-off

Figure 1 shows that the higher risk is associated with greater probability of
higher return and lower risk with a greater probability of smaller return. This
trade off which an investor faces between risk and return while considering the
investment decision is called the risk-return trade off.

In this Module, you will learn about mathematical concepts and tools in
computing for finance and investment problems and will explain risk-return
trade-off.

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.

Discover

Capital Budgeting is the process of evaluating and selecting long-term

investments that are consistent with the firm’s goal of maximizing owner’s
wealth.

Examples of capital expenditure:

 Expand or enter into a new line of business
 Replace or renew fixed assets
 Construct new premises
 Opening a new branch
 Acquisition of machineries and equipment

Steps in Capital Budgeting

1. Investment Proposal. Proposals for capital expenditure come from
different levels within a business organization. These are submitted to the
finance team for thorough analysis.
2. Review and Analysis. Financial personnel perform formal review and
analysis to assess the benefits and cost of the investment proposals. These
personnel make use of several financial tools which they see fit in evaluating
the project.
3. Decision Making. Companies usually delegate capital expenditure
decisions on the basis of value limits. The analysis is presented to the proper
approving body who will in turn make the decision on whether to push through
with the project or not.
4. Implementation. Release of funds and start of the project occurs after
approval. Large expenditures are usually released in phases.
5. Monitoring. Results are monitored and actual cost and benefits are
compared with those that were expected. Action may be required if deviations
from the plan are significant in amount.

Basic Terminologies related to capital budgeting

 Independent vs Mutually Exclusive Investments
 Independent Projects are those whose cash flows are independent of one
another. The acceptance of one project does not eliminate the others
from further consideration. Mutually exclusive projects, on the other
hand, are projects which serve the same function and therefore compete
with one another. The acceptance of one eliminates all other proposals

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 that serve a similar function from further consideration. Unlimited
Funds vs. Capital Rationing
 The amount and availability of funds affects the company’s decisions in
capital outlays. If the company has unlimited funds, then all projects
which pass the risk-return criteria will be accepted and implemented.
Otherwise, firms will operate under capital rationing and will accept only
projects which provide the best opportunity to increase shareholder
wealth.
 Accept-Reject vs. Ranking Approaches
 The Accept-Reject is usually done for mutually exclusive projects where
one project is favored over the others. The approach accepts project
which pass a certain criterion. Ranking is done when there are several
projects passing the criteria and the company is only able to fund so
much. The highest ranking projects will be selected for implementation.

Different Techniques in Capital Budgeting

Relevant cash flows include in the initial investment, cash inflows from
income from the project, and the expected terminal value of the project if any.
These are the cash flows considered in analyzing whether an investment adds
value to the firm. Cash flows should be net of tax.

For example, Mr. Alfonso is deciding on which of the 2 mutually exclusive

projects he should accept, Project A requires an initial outlay of PhP72,000.00
and is expected to receive PhP17,000.00 annually for the next 5 years. Project
B, on the other hand, requires an investment of PhP80,000.00 but will earn
PhP21,000.00 annually for the next 5 years. In this example, we can see that
the relevant cash flows are the upfront investment and the annual income from
investment.

Project A

(72,000) 17000 17000 17000 17000 17000

Project B

(80,000) (21000) (21000) (21000) (21000) (21000)

1. Playback Method
This is the simplest method used in capital budgeting. It measures the
amount of time, usually in years, to recover the initial investment. To illustrate
this method, let us use the previous examples for relevant cash flows.

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 For project A, the initial cash flow is PhP72,000.00. In 4 years, Mr.
Alfonso would have generated total cash flow of PhP68,000.00. To get the actual
time period, let us divide the remaining amount (4,000) * and divide it by the
cash flow for year 5. we get .24, so the total playback period for Project A is 4
+ .24 = 4.24 years. Conversely, if the cash flows are equal, you may derive the
answer by dividing the initial cash flow by the annuity, 72,000/17,000 = 4.24
years. Using the method for Project B, we get the payback period of
80,000/21,000 = 3.81 years.

Let us also illustrates an example of computing the payback period for

uneven cash flows.
Initial Investment =15,000
Year 1 = 7,000
Year 2 = 4,000
Year 3 = 6,000
Year 4 = 3,000

For years 1 and 2, we have already recovered 11,000 of our investment.

We need 4,000 more to each 15,000 thus for the third year, we have
4,000/6,000 = 0.67. The payback period is 2.67 years. Notice that the cash flow
for year 4 is already ignored.

2. Net Present Value (NPV)

This method is more sophisticated than the payback method since it
considers the time value of money and it considers all the cash flows during the
life of the project including the terminal value. The NPV can be computed by
comparing the present value of cash inflows against the present value of cash
outflows. Cash flows are discounted using the firm’s cost of capital (cost of
acquiring funding needs) to get the present values.

NPV = Present value of cash inflows - present value of cash outflows

If the NPV of a project is zero or positive, it should be accepted. In

finance, if these projected cash flows are realized, the NPV of the project should
be equivalent to the increase in total shareholder’s value.
Assuming that the amount cost of capital is 8%, let us compute the NPV
for our previous example.

Project A = 17,000 x PVA (3,993) - 72,000 = 67.881-72,000 = (4,119)

Project B = 21,000 x PVA (3,993) - 80,000 = 83,853 - 80,000 = 3,853

We can see Project A’s NPV is negative and Project B’s NPV is positive, thus, we
only accept Project B.

3. Internal Rate of Return (IRR)

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 The IRR is one of the most widely used technique in capital budgeting. It
is defined as the discount rate that equates the NPV of an investment to zero. If
this method is used for capital budgeting analysis, the project’s IRR is
compared to the company’s cost of capital. If the IPP is greater than the cost of
capital, the project should be accepted otherwise, it should be rejected. Manual
computation of the IRR involves trial and error, however, this IRR computation
is a lot easier using applications like Microsoft Excel.

For example, you are planning to build a branch for your business at
PhP350,000 and expect to receive PhP400,000 in 1 year. First, compute for the
rate of return (profit/investment).

Rate of return = 50,000/350,000 = 14.3%

We compute for the rate of return because the NPV of a project with cost
of capital equal to the rate of return is equal to zero. To illustrate:

NPV = 400,000/ (1+0.143)-350,000 = 0

The IRR can easily be computed using Microsoft Excel using the IRR
function.

The NPV and IRR are interrelated techniques. An IRR greater than the
cost equates to a positive NPV and vice versa. On a purely theoretical view, NPV
is the better measure since it measures the actual cash value a project creates
for shareholders. However, IRR is also a widely used tool since financial
managers usually like to think in terms of ratios and percentages.

RISK-RETURN TRADE-OFF

Risk and return are two parameters for selecting investment in the
finance world. Risk is the possibility of loss or harm while return is the
appreciation (gain) or depreciation (loss) in the value of the asset.

Risk-return trade-off is a concept that the level of return to be earned

from an investment should increase as the level of risk increases. Conversely,
this means that investors will be likely to pay a high price for investments that
have a low risk level, such as high-grade corporate or government bonds.
Different investors will have different tolerances for the level of risk they will be
willing to accept, so that some will readily invest in low-return investments
because there is a low risk of losing the investment. Others have a higher risk
tolerance and so will buy riskier investment in pursuit of a higher return,
despite the risk of losing their investments. Some investors develop a portfolio
of low-risk, low-return investments and high-risk, higher return investments in
hope of achieving a more balanced risk-return trade-off.

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 In making investment decisions, financial managers take note of the risk
and returns they are entering.

Recall the story of Jack and the Beanstalk. In the story, Jack trades his
cow for three magic beans. This is a very risky move for Jack since these beans
may be fake and therefore, worthless. Luckily those magic beans grew into
beanstalk that gave Jack the opportunity to gather riches beyond his wildest
dreams, while fighting with a giant along the way. Jack gambles in this
transaction. Should Jack decide not to sell the cow for magic beans and instead
sold it at the current market value, the story would be different. As we can see,
the higher the risk, the higher the returns, but of course, if turned sour, the
higher the losses as well.

This situation is also true for making financial decisions. Taking a higher
risk gives you the opportunity to earn higher returns. Low risk investments like
treasury, also called risk-free instruments, earn a low and steady income flow.
In making investment decisions, financial managers ensure that the proposed
business will earn more than the risk-free rate since they need to compensate
for the risk the investment entail.

Ways on how the risk and return trade-off can be applied in real life:
 Fixed income vs. commission based income
 Earning interest from time deposits vs. earning from stocks
 Entering in a business with steady income vs. entering into seasonal high
profit business
 Investing in preferred vs. common stock

Explore

Here are some enrichment activities for you to work on to master and
strengthen the basic concepts you have learned from this lesson.

Assessment: Solve Me if You Can!

Direction: Use a separate sheet to answer the following exercises.

Year Project Pizza

0 (100,000)
1 50,000
2 50,000

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 1. Given the cash flow above and a discount rate of 5%, compute the
payback period and NPV of Project Pizza.

3. If PhP50,000 is earned on the 3rd year of the project, what is the new
NPV of the project? What is the payback period?
Year Project A Project B
0 (200,000) (200,000)
1 80,000 100,000
2 80,000 100,000
3 80,000 100,000
4 80,000 100,000

4. If the opportunity cost of capital is 11%, which of this project worth

pursuing? Find the NPV of both projects.

5. Suppose that you can only choose one of the projects. Which is more
favorable to the firm given that the discount rate remain at 11%?
(Which has the higher NPV?)

6. Which project would you choose if the opportunity cost of capital were
16%? (NPV/IRR)

7. What is the payback period for each project?

Great job! You have understood the lesson. Are

you now ready to summarize?

Gauge
Directions: Read carefully each item. Use separate sheet for your answers.
Write only the letter of the best answer for each test item.
1. Elimann Systems is considering a project that has the following cash flow
and cost of capital (r) data. What is the project’s NPV? Note that if a project’s
expected NPV is negative, it should be rejected. r = 9.00%
Year Cash Flows
0 1000
1 500

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 2 500
3 500

A. 265.65 B. 278.93 C. 307.52 D. 322.90

2. Scott Enterprises is considered a project that has the following cash flow
and cost of capital (r) data. What is the project’s NPV? Note that if project’s
expected NPV is negative, it should be rejected.
r = 11.00%
Year Cash Flows
0 1000
1 350
2 350
3 350
4 350

A. 77.49 B. 81.56 C. 85.86 D. 90.15

3. Robbins Inc. is considering a project that has the following cash flows and
cost capital (r) data. What is the project’s NPV? Note that if project’s expected
NPV is negative, it should be rejected.
r = 10.25%
Year Cash Flows
0 1000
1 300
2 300
3 300
4 300
5 300

A. 111.47 B. 117.33 C. 123.51 D. 130.01

4. Reed Enterprises is considering a project that has the following cash flow
and cost of capital (r) data. What is the project’s NPV? Note that if project’s
expected NPV is negative, it should be rejected. r = 10.00%
Year Cash Flows
0 1050
1 450
2 450
3 450

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 A. 92.37 B. 96.99 C. 101.84 D. 106.93
5. Patterson Co. is considering a project that has the following cash flow
and cost of capital (r) data. What is the project’s NPV? Note that if project’s
expected NPV is negative, it should be rejected.
r = 10.00%
Year Cash Flows
0 950
1 500
2 400
3 300

A. 54.62 B. 57.49 C. 60.52 D. 63.54

6. Hart Corp is considering a project that has the following cash flow data.
What is the project’s IRR? Note that a project’s IRR can be less than the
cost of capital or negative, in both cases it will be rejected.
Year Cash Flows
0 1000
1 425
2 425
3 425

A. 12.55% B. 13.21% C. 13.87% D. 14.56%

7. Spence Company is considering a project that has the following cash flow.
What is the project’s IRR? Note that a project’s IRR can be less than the
cost of capital or negative, in both cases it will be rejected.
Year Cash Flows
0 1050
1 400
2 400
3 400
4 400

A.14.05% B. 15.61% C. 17.34% D. 19.27%

8. Nichols Inc. is considering a project that has the following cash flow data.
What is the project’s IRR? Note that a project’s IRR can be less than the
cost of capital or negative, in both cases it will be rejected.

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 Year Cash Flows
0 1250
1 325
2 325
3 325
4 325
D.
A. 9.43% B. 9.91% C. 10.40% 10.92%
9. Kiley Electronics is considering a project that has the following cash flow
data. What is the project’s IRR? Note that a project’s IRR can be less than
the cost of capital or negative, in both cases it will be rejected.
Year Cash Flows
0 1100
1 450
2 470
3 490

A. 10.78% B. 11.98% C. 13.31% D. 14.64%

10. Modern Refurbishing Inc. is considering a project that has the following
cash flow data. What is the project’s IRR? Note that a project’s IRR can be
less than the cost of capital or negative, in both cases it will be rejected.
Year Cash Flows
0 850
1 300
2 290
3 280
4 270

A. 13.13% B. 14.44% C. 15.89% D. 17.48%

11. McGlothin Inc. is considering a project that has the following cash flow
data. What is the project’s payback?
Year Cash Flows
0 1150
1 500
2 500
3 500

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 A. 2.07 yrs. B. 2.30 yrs. C. 2.53 yrs. D. 2.78 yrs.
12. Garner Inc. is considering a project that has the following cash flow data.
What is the project’s payback?
Year Cash Flows
0 350
1 200
2 200
3 200

A. 1.42 yrs. B. 1.58 yrs. C. 1.75 yrs. D. 1.95 yrs.

13. Worthington Inc. is considering a project that has the following cash flow
data. What is the project’s payback?
Year Cash Flows
0 500
1 150
2 200
3 300

A. 2.03 yrs. B. 2.25 yrs. C. 2.50 yrs. D. 2.75 yrs.

14. Ponder Inc. is considering a project that has the following cash flow data.
What is the project’s payback?
Year Cash Flows
0 750
1 300
2 325
3 350

A. 2.12 yrs. B. 2.36 yrs. C. 2.59 yrs. D. 2.85 yrs.

15. Suzanne’s Cleaners is considering a project that has the following cash flow
data. What is the project’s payback?
Year Cash Flows
0 1100
1 300
2 310

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 3 320
4 330
5 340
D. 3.52
A. 2.56 yrs. B. 2.85 yrs. C. 3.16 yrs. yrs.
16. Lancaster Corp is considering two equally risky, mutually exclusive
projects, both of which have normal cash flows. Project A has an IRR of 11%
while Project B’s IRR is 14%. When the cost of capital is 8%, the projects
have the same NPV. Given this information, which of the following
statements is CORRECT?
A. If the cost of capital is 9%, Project A’s NPV will be higher than Project
B’s.
B. If the cost of capital is 6%, Project B’s NPV will be higher than Project
A ‘s.
C. If the cost of capital is 9%, Project B’s NPV will be higher than Project
A’s.
D. If the cost of capital is 13%, Project A’s NPV will be higher than Project
B’s.

17. You are considering two mutually exclusive, equally risky projects. Both
have IRRs that exceed the cost of capital. Which of the following statements
is CORRECT? Assume that the projects have normal cash flows, with one
outflow followed by a set of inflows.
A. If the cost of capital is greater than the crossover rate, then the IRR
and the NPV criteria will not result in a conflict between the projects.
The same project will rank higher by both criteria.
B. If the cost of capital is less than the crossover rate, then the IRR and
the NPV criteria will not result in a conflict between the projects. The
same project will rank higher by both criteria.
C. For a conflict to exist between NPV and IRR, the initial investment cost
of one project must exceed the cost of the criteria.
D. If the two project’s NPV profiles do not cross, then there will be a sharp
conflict as to which one should be selected.

18. Consider projects S and L. Both have normal cash flows and the projects
have the same risk, hence both are evaluated with the same cost of capital,
10%. However, S has a higher IRR than L. Which of the following
statements is CORRECT?
A. If project S has a positive NPV, Project L must also have a positive
NPV.
B. If the cost of capital increases, each project’s IRR will decrease.

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 C. If the cost of capital fails, each project’s IRR will increase.
D. If Projects S and L have the same NPV at the current cost of capital,
10%, then Project L, the one with the lower IRR, would have a higher
NPV if the cost of capital used to evaluate the projects decline.

19. Suppose a firm relies exclusively on the payback method when making
capital budgeting decisions, and it sets a 4-year payback regardless of
economic conditions. Other things held constant, which of the following
statements is most likely to be true?
A. It will accept too many long-term projects and reject too many
shortterm projects (as judged by the NPV).
B. The firm will accept too many projects in all economic states because a
4-year payback is too low.
C. The firm will accept too few projects in all economic states because a
4-year payback is too high.
D. If the 4-year payback results in accepting just the right set of projects
under average economic conditions, then this payback will result in
too few long-term projects when the economy is weak.

20. Which of the following statement is CORRECT? Assume that the project
being considered has normal cash flows, with one outflow followed by a
series of inflows.
A. If a project has normal cash flows and its IRR exceeds its cost of
capital, then the project’s NPV must be positive.
B. The IRR calculation implicitly assumes that cash flows are withdrawn
from the business rather than being reinvested in the business.
C. The IRR calculation implicitly assumes that all cash flows are
reinvested at the cost of capital.
D. If Project A has a higher IRR than project B, then Project A must also
have a higher NPV.

Great job! You are almost done with this module.

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