ST-1

You are a financial analyst for the Hittle Company. The director of capital
budgeting has asked you to analyze two proposed capital investments,
Projects X and Y. Each project has a cost of $10,000, and the cost of capital
for each project is 12%. The projects’ expected net cash flows are as
follows:
Expected Net Cash Flows

Year Project X Project Y

0 ($10,000) ($10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
a. Calculate each project’s payback period, net present value (NPV), internal rate of return
(IRR), and modified internal rate of return (MIRR).

Payback period
0 1 2 3 4
 X (1000) 6500 3000 3000 1000

y (1000) 3500 3500 3500 3500

for x payback =1+1+0.16=2.16

6500 = 1

3000 = 1

500/3000 =0.16

For y payback =1+1+0.85=2.85

3500 = 1

3500 = 1

3000/3500 =0 .85

Net present value (NPV)

0 1 2 3 4
X (1000) 6500 3000 3000 1000

y (1000) 3500 3500 3500 3500

For X NPV

Using Excel

Interest (i)=12

If n=1 then 0.89286 * 6500 = 5803

If n=2 then 0.79719 * 3500 = 2790

If n=3 then 0.71178 * 3500= 2491

If n=4 then 0.63552 *3500= 2224

=10,970.52

Total NPV for project X= -10,000 + 10,970.52 = 970.52

For Y NPV

Using Excel

Interest (i)=12

If n=1 then 0.89286 * 3500 = 3125

If n=2 then 0.79719 * 3500 = 2790

If n=3 then 0.71178 * 3500= 2491

If n=4 then 0.63552 *3500= 2224

=10,630

Total NPV for Project Y= -10,000 + 10,630= 630

IRR financial feature then

IRR for Project X= 18%

IRR for Project Y= 15%

0 1 2 3 4

X (10000) 6500 3000 3000

WAAC=12

n=1 then FV= 6500*1.40493= 9132

n=2 then FV= 3000*1.25440= 3763

n=3 then FV= 3000*1.12000=3360

+1000

FV Terminal Value = 17255

TV= Initial investment (1+i)4

17255 = 10,000 (1+i)4

I= 0.146
MIRR for Project X= 14.6%
0 1 2 3 4

Y (10000) 3500 3500 3500

WAAC=12

n=1 then FV= 3500*1.40493= 4917

n=2 then FV= 3500*1.25440= 4390

n=3 then FV= 3500*1.12000=3920

+3500

FV Terminal Value = 16727

TV= Initial investment (1+i)4

16727 = 10,000 (1+i)4

I= 0.137

MIRR for Project Y= 13.7%

b. Which project or projects should be accepted if they are independent?

-Both X and Y will be accepted

c. Which project should be accepted if they are mutually exclusive?

-Project X as it has a higher NPV

d. How might a change in the cost of capital produce a conflict between the NPV and IRR rankings
of these two projects? Would this conflict exist if r were 5%? (Hint: Plot the NPV profiles.)

When the cost of capital for each project is 12% No conflict between the NPV and IRR rankings of
these two project

0 1 2 3 4

X (10000) 6500 3000 3000 1000

Y (10000) 3500 3500 3500 1000

Project X where i=5 Project Y where i=5

When n=1, 6500*0.95238 = 6190 3500*0.95238 = 3333

When n=2, 3000*0.90703= 2721 3500*0.90703= 3174
When n=3, 3000*0.86384= 2591 3500*0.86384= 3023
When n=4, 1000*0.82270= 822 3500*0.82270= 287

NPV X= -10,000 + 12324= 2324 NPV Y= -10,000 + 12409= 2409

IRR for project X= 18% IRR for project Y= 15%

Yes, there will be a conflict between X and Y. as NPV Y is higher but its IRR is lower than X, so
there is a conflict

e. Why does the conflict exist?

Because NPV in project Y is higher but its IRR is lower than X, so there is a conflict, but finally, we
should go to project Y as it is the one with higher NPV.

Easy Problems 1–7 (11-1)

A project has an initial cost of $52,125, expected net cash inflows of $12,000 per year for 8 years,
and a cost of capital of 12%. What is the project’s NPV? (Hint: Begin by constructing a timeline.)

NPV

0 1 2 3 4 5 6 7 8

(52125) 12000 12000 12000 12000 12000 12000 12000 12000

I=12%, PV= 10714 9566 8541 7626 6659 6079 5428 4846

NPV = -52125 + 59461 = 7336

IRR= 16%

NPV

0 1 2 3 4 5 6 7 8

(52125) 12000 12000 12000 12000 12000 12000 12000 12000

WAAC=12%

n=7 n=6 n=5 n=4 n=3 n=2 n=1

FV= 26528 23686 21148 18882 16859 15053 13440 12000

Terminal value = 147596

TV= initial investment (1+i)8

147596=52125 (1+i)8

MIRR= 13.8%

11-4) Refer to Problem 11-1. What is the project’s PI?

NPV

0 1 2 3 4 5 6 7 8

(52125) 12000 12000 12000 12000 12000 12000 12000 12000

PI= Discounted free cash flow/ initial investment amount

= 59461/52125

PI = 1.143

Payback period= -52125+12000+12000+12000+12000 =4125

1 1 1 1

4125/12000=0.343

Payback period= 4.343 years

What is the project’s discounted payback period?

NPV

0 1 2 3 4 5 6 7 8

(52125) 12000 12000 12000 12000 12000 12000 12000 12000

I=12%, PV= 10714 9566 8541 7626 6659 6079 5428 4846

Discounted payback period= -52125+ 10714 + 9566+ 8541+ 7626+ 6659+ 6079 = -2940

1 +1 +1 +1 +1 +1

2940/5428= 0.541

Discounted payback period= 6+0.245= 6.541 years

(11-7) Your division is considering two investment projects, each of which requires an up-front
expenditure of $15 million. You estimate that the investments will produce the following net cash
flows:

NPV
Year Project A Project B

1 5,000,000 20,000,000

2 10,000,000 10,000,000

3 20,000,000 6,000,000

What are the two projects’ net present values, assuming the cost of capital is 10%?5%? 15%?

Project A @cost 5%

I=5%

When n=1, 5,000,000*0.95238= 4,761,900

When n=2, 10,000,000*0.90703= 9,070,300

When n=3, 20,000,000*0.86384= 17,276,800

Project A NPV@5%= 31,109,900- 15,000,000= 16,109,000

Project A @cost 10%

I=10%

When n=1, 5,000,000* 0.90909= 4,545,450

When n=2, 10,000,000* 0.82645= 8,264,500

When n=3, 20,000,000* 0.75131= 15,026,200

Project A NPV@10%= 27,836,150- 15,000,000= 12,836,150

Project A @cost 15%

I=15%

When n=1, 5,000,000* 0.86957 = 4,347,850

When n=2, 10,000,000* 0.75614= 7,561,400

When n=3, 20,000,000* 0.65752= 13,150,400

Project A NPV@15%= 25,059,650- 15,000,000= 10,059,650

Project B @cost 5%

I=5%

When n=1, 20,000,000*0.95238= 19,047,600

When n=2, 10,000,000*0.90703= 9,070,300

When n=3, 6,000,000*0.86384= 5,183,040

Project B NPV @5%= 33,300,940 - 15,000,000= 18,300,940

Project B@ cost 10%

I=10%
When n=1, 20,000,000* 0.90909= 18,181,800

When n=2, 10,000,000* 0.82645= 8,264,500

When n=3, 6,000,000* 0.75131= 4,507,860

Project B NPV@10%= 30,954,160- 15,000,000= 15,954,160

Project B @cost 15%

I=15%

When n=1, 20,000,000* 0.86957 = 17,391,400

When n=2, 10,000,000* 0.75614= 7,561,400

When n=3, 6,000,000* 0.65752= 3,945,120

Project B NPV@15%= 28,897,920- 15,000,000= 13,897,920

Problems 8–18 (11-8)

NPVs, IRRs, and MIRRs for Independent Projects Edelman Engineering are considering including two
pieces of equipment, a truck, and an overhead pulley system, in this year’s capital budget. The
projects are independent. The cash outlay for the truck is $17,100, and that for the pulley system is
$22,430. The firm’s cost of capital is 14%. After-tax cash flows, including depreciation, are as follows:
Year Truck Pulley

1 5,100 7,500

2 5,100 7,500

3 5,100 7,500

4 5,100 7,500

5 5,100 7,500

Calculate the IRR, the NPV, and the MIRR for each project, and indicate the correct accept/reject
decision for each.

Truck IRR= 15% ----- Accept

Pulley IRR= 20% ---- Accept

Truck NPV

0 1 2 3 4 5

(22430) 7500 7500 7500 7500 7500

I=14%, PV= 6578.9 5771 5062 4440.6 3895.3

NPV for Truck= 25748– 22430= 3318 ---- Accept

Truck TV (FV) = 6.61010 *5100 = 33711.51

Pulley TV (FV) = 6.61010 *7500 = 49575.75

PV = FV/(1+MIRR)5

Truck MIRR = 14.54 Accept

Pulley MIRR = 17.19 Accept

(11-9) NPVs and IRRs for Mutually Exclusive Projects Davis Industries must choose between a gas-
powered and an electric-powered forklift truck for moving materials in its factory. Since both forklifts
perform the same function, the firm will choose only one. (They are mutually exclusive investments.)
The electric-powered truck will cost more, but it will be less expensive to operate; it will cost
$22,000, whereas the gas-powered truck will cost $17,500. The cost of capital that applies to both
investments is 12%. The life for both types of t is estimated to be 6 years, during which time the net
cash flows for the electric-powered truck will be $6,290 per year and those for the gas-powered
truck will be $5,000 per year. Annual net cash flows include depreciation expenses.

0 1 2 3 4 5 6

(22000) 6290 6290 6290 6290 6290 6290

(17500) 5000 5000 5000 5000 5000 5000

Electric NPV = (6290*4.11141) – 22000 = 3860.8

Electric IRR = 18%

Gas NPV = (5000*4.11141) – 17500 = 3057

Gas IRR = 18%

Purchase Electric – Powered it has a Higher NPV

(11-10) Capital Budgeting Methods Project S has a cost of $10,000 and is expected to produce
benefits (cash flows) of $3,000 per year for 5 years. Project L costs $25,000 and is expected to
produce cash flows of $7,400 per year for 5 years. Calculate the two projects’ NPVs, IRRs, MIRRs, and
PIs, assuming a cost of capital of 12%. Which project would be selected, assuming they are mutually
exclusive, using each ranking method? Which should actually be selected?

0 1 2 3 4 5

S (10000) 3000 3000 3000 3000 3000

L (25000) 7400 7400 7400 7400 7400

Cost of capital of 12%

S NPV = (3.60478 * 3000) – 10000 = 814.33

L NPV = (3.60478 * 7400) - 25000 = 1675.34

S IRR = 15.24%

L IRR = 14.67%

S FV = 6.35285*3000 = 19058.55

L FV = 6.35285*7400 = 47011

PV = FV/(1+MIRR)5

S MIRR = 13.77%

L MIRR = 13.46%

S PI = 10814.33/10000 = 1.081

L PI = 26675.34/25000 = 1.067

(11-11) MIRR and NPV Your company is considering two mutually exclusive projects, X and Y, whose
costs and cash flows are shown below:

Year X Y

0 ($1,000) ($1,000)

1 100 1,000

2 300 100

3 400 50

4 700 50

The projects are equally risky, and their cost of capital is 12%. You must make a recommendation,
and you must base it on the modified IRR (MIRR). What is the MIRR of the better project?

0 1 2 3 4

(1000) 100 300 400 700

I=12%, n=3 n=2 n=1

1.4049 1.2544 1.1200

FV= 140.493 376.32 448 700

TV= 1664.813

TV = Initial investment*(1+MIRR)4

1664.8=1000*(1+MIRR)4

MIRR= 13.59%

0 1 2 3 4

(1000) 1000 100 50 50

I=12%, n=3 n=2 n=1

1.4049 1.2544 1.1200

FV= 1404.93 125.44 56 50

TV= 1636.37 1636.37=1000(1+MIRR)4

MIRR= 13.10%

(11-12) NPV and IRR Analysis After discovering a new gold vein in the Colorado mountains, CTC
Mining Corporation must decide whether to mine the deposit. The most cost-effective method of
mining gold is sulfuric acid extraction, a process that results in environ- mental damage. To go ahead
with the extraction, CTC must spend $900,000 for new mining equipment and pay $165,000 for its
installation. The gold mined will net the firm an estimated $350,000 each year over the 5-year life of
the vein. CTC’s cost of capital is 14%. For the purposes of this problem, assume that the cash inflows
occur at the end of the year. a. What are the NPV and IRR of this project? b. Should this project be
undertaken, ignoring environmental concerns?

0 1 2 3 4 5

(1065000) 350000 350000 350000 350000 350000

cost of capital is 14%

NPV = (350000*3.91371) – 1065000 = 304798.5

IRR = 19%