Principles of Corporate Finance 11th Edition Brealey Solutions Manual 1

Chapter 05 - Net Present Value and Other Investment Criteria
Solution Manual for Principles of Corporate Finance 11th

Edition Brealey Myers Allen 0078034760 9780078034763
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CHAPTER 5
Net Present Value and Other Investment Criteria
Answers to Problem Sets
1. a. A = 3 years, B = 2 years, C = 3 years.
b. B
c. A, B, and C
d. B and C (NPVB = $3,378; NPVC = $2,405)
e. True. The payback rule ignores all cash flows after the cutoff date,
meaning that future years’ cash inflows are not considered. In addition, the
payback rule ignores the timing of cash inflows. For example, for a
payback rule set at two years, a project with a payback period of one year
is given equal weight as a project with a payback period of two years.
f. It will accept no negative-NPV projects, but will turn down some with
positive NPVs. A project can have positive NPV if all future cash flows are
considered but still do not meet the stated cutoff period.
Est. time: 6 – 10
2. Given the cash flows C0, C1, . . . , CT, IRR is defined by:
It is calculated by trial and error, by financial calculators, or by spreadsheet

programs.
Est. time: 1 – 5
5-1
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3. a. $15,750; $4,250; $0
b. 100%
Est. time: 1 – 5
4. No (you are effectively “borrowing” at a rate of interest higher than the

opportunity cost of capital).
Est. time: 1 – 5
5 a. Two. There are multiple internal rates of return for a project when there
are changes in the sign of the cash flows.
b. −50% and +50%. The NPV for the project using both of these IRRs is 0.
c. Yes, NPV = +14.6.

Est. time: 1 – 5
6. The incremental flows from investing in Alpha rather than Beta are −200,000;
+110,000; and 121,000. The IRR on the incremental cash flow is 10% (i.e., −200
+ 110/1.10 + 121/1.102 = 0). The IRR on Beta exceeds the cost of capital and so
does the IRR on the incremental investment in Alpha. Choose Alpha.
Est. time: 1 – 5
7. 1, 2, 4, and 6
The profitability index for each project is shown below:
Project NPV Investment Profitability Index (NPV/Investment)
1 5,000 10,000 5,000/10,000 = 0.5
2 5,000 5,000 5,000/5,000 = 1
3 10,000 90,000 10,000/90,000 = 0.11
4 15,000 60,000 15,000/60,000 = 0.25
5 15,000 75,000 15,000/75,000 = 0.2
6 3,000 15,000 3,000/15,000 = 0.2
Start with the project with the highest profitability index and go from there. Project
2 has the highest profitability index and has an initial investment of $5,000. The
next highest profitability index is for Project 1, which has an initial investment of
5-2
$10,000. The next highest is Project 4, which will cost $60,000 up front. So far we
have spent $75,000. Projects 5 and 6 both have profitability indexes of .2, but we
only have $15,000 left to spend, so we will add Project 6 to our list. This gives us
Projects 1, 2, 4, and 6.
Est. time: 1 – 5
$1000
8. a. NPVA   $1000   $90.91
(1.10)
$1000 $1000 $4000 $1000 $1000
NPVB   $2000       $4,044.73
(1.10) (1.10) 2 (1.10) 3 (1.10) 4 (1.10) 5
$1000 $1000 $1000 $1000

NPVC   $3000   2
   $39.47
(1.10) (1.10) (1.10) 4 (1.10) 5
Projects B and C have positive NPVs.
b. Payback A = one year

Payback B = two years
Payback C = four years
c. A and B
$1000
d. PVA   $909.09
(1.10) 1
The present value of the cash inflows for Project A never recovers the initial
outlay for the project, which is always the case for a negative NPV project.
The present values of the cash inflows for Project B are shown in the third
row of the table below, and the cumulative net present values are shown
in the fourth row:
C0 C1 C2 C3 C4 C5
-2,000.00 +1,000.00 +1,000.00 +4,000.00 +1,000.00 +1,000.00
-2,000.00 909.09 826.45 3,005.26 683.01 620.92
-1,090.91 -264.46 2,740.80 3,423.81 4,044.73
Since the cumulative NPV turns positive between year 2 and year 3, the
discounted payback period is:
264.46
2  2.09 years
3,005.26
The present values of the cash inflows for Project C are shown in the third row of the
table below, and the cumulative net present values are shown in the fourth row:
5-3
C0 C1 C2 C3 C4 C5
-3,000.00 +1,000.00 +1,000.00 0.00 +1,000.00 +1,000.00
-3,000.00 909.09 826.45 0.00 683.01 620.92
-2,090.91 -1,264.46 -1,264.46 -581.45 39.47
Since the cumulative NPV turns positive between year 4 and year 5, the
discounted payback period is:
581.45
4  4.94 years
620.92
e. Using the discounted payback period rule with a cutoff of three years, the
firm would accept only Project B.
Est. time: 11– 15
9. a. When using the IRR rule, the firm must still compare the IRR with the
opportunity cost of capital. Thus, even with the IRR method, one must
specify the appropriate discount rate.
b. Risky cash flows should be discounted at a higher rate than the rate used
to discount less risky cash flows. Using the payback rule is equivalent to
using the NPV rule with a zero discount rate for cash flows before the
payback period and an infinite discount rate for cash flows thereafter.
Est. time: 1 – 5
10.
r = -17.44% 0.00% 10.00% 15.00% 20.00% 25.00% 45.27%
Year 0 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00 -3,000.00
Year 1 3,500.00 4,239.34 3,500.00 3,181.82 3,043.48 2,916.67 2,800.00 2,409.31
Year 2 4,000.00 5,868.41 4,000.00 3,305.79 3,024.57 2,777.78 2,560.00 1,895.43
Year 3 -4,000.00 -7,108.06 -4,000.00 -3,005.26 -2,630.06 -2,314.81 -2,048.00 -1,304.76
PV = -0.31 500.00 482.35 437.99 379.64 312.00 -0.02
The two IRRs for this project are (approximately): –17.44% and 45.27%.
Between these two discount rates, the NPV is positive.
Est. time: 06 - 10
11. a. The figure on the next page was drawn from the following points:
Discount Rate
0% 10% 20%
NPVA +20.00 +4.13 -8.33
NPVB +40.00 +5.18 -18.98
b. From the graph, we can estimate the IRR of each project from the point
where its line crosses the horizontal axis:
5-4
IRRA = 13.1% and IRRB = 11.9%
This can be checked by calculating the NPV for each project at their
respective IRRs, which give an approximate NPV of 0.
c. The company should accept Project A if its NPV is positive and higher
than that of Project B; that is, the company should accept Project A if the
discount rate is greater than 10.7% (the intersection of NPVA and NPVB on
the graph below) and less than 13.1% (the internal rate of return).
d. The cash flows for (B – A) are:

C0 = $ 0
C1 = –$60
C2 = –$60
C3 = +$140
Therefore:
Discount Rate
0% 10% 20%
NPVB − A +20.00 +1.05 -10.65
IRRB − A = 10.7%
The company should accept Project A if the discount rate is greater than
10.7% and less than 13.1%. As shown in the graph, for these discount
rates, the IRR for the incremental investment is less than the opportunity
cost of capital.
50.00
40.00
30.00
20.00 Project A
NPV
10.00 Project B
0.00 Increment
-10.00
-20.00
-30.00
0% 10% 20%
Rate of Interest
5-5
Est. time: 06 - 10
12. a. Because Project A requires a larger capital outlay, it is

possible that Project A has both a lower IRR and a higher NPV than
Project B. (In fact, NPVA is greater than NPVB for all discount rates less
than 10%.) Because the goal is to maximize shareholder wealth, NPV is
the correct criterion.
b. To use the IRR criterion for mutually exclusive projects, calculate the
IRR for the incremental cash flows:
C0 C1 C2 IRR
A-B −200 +110 +121 10%
Because the IRR for the incremental cash flows exceeds the cost of
capital, the additional investment in A is worthwhile.
250 300
c. NPVA   400    $ 81.86
1.09 (1.09)2
140 179
NPVB   200    $79.10
1.09 (1.09)2
Est. time: 06 - 10
13. Use incremental analysis:

C1 C2 C3
Current Arrangement −250,000 −250,000 +650,000
Extra Shift −550,000 +650,000 0
Incremental Flows −300,000 +900,000 -650,000
The IRRs for the incremental flows are (approximately): 21.13% and 78.87%
If the cost of capital is between these rates, Titanic should work the extra shift.
Est. time: 06 - 10
14. a. First calculate the NPV for each project.

The NPV for Project D is:
20,000
NPVD   10,000   $8,181.82
1.10
The NPV for Project E is:
35,000
NPVE   20,000   $11,818.18
1.10
5-6
Profitability index = NPV/initial investment.
For Project D: Profitability index = 8,181.82/10,000 = .82.

For Project E: Profitability index = 11,818.18/20,000 −.59.
b. Each project has a profitability index greater than zero, and so both are
acceptable projects. In order to choose between these projects, we must
use incremental analysis. For the incremental cash flows:
15,000
 10,000 
PIED  1.10  3,636  0.36
 (  10,000) 10,000
The increment is thus an acceptable project, and so the larger project
should be accepted, i.e., accept Project E. (Note that, in this case, the
better project has the lower profitability index.)
Est. time: 11 - 15
15. Using the fact that profitability index = (net present value / investment), we find:
Project Profitability Index
1 0.22
2 −0.02
3 0.17
4 0.14
5 0.07
6 0.18
7 0.12
Thus, given the budget of $1 million, the best the company can do is to accept
Projects 1, 3, 4, and 6.
If the company accepted all positive NPV projects, the market value (compared
to the market value under the budget limitation) would increase by the NPV of
Project 5 plus the NPV of Project 7: $7,000 + $48,000 = $55,000.
Thus, the budget limit costs the company $55,000 in terms of its market value.
Est. time: 06 - 10
16. The IRR is the discount rate which, when applied to a project’s cash flows, yields
NPV = 0. Thus, it does not represent an opportunity cost. However, if each
project’s cash flows could be invested at that project’s IRR, then the NPV of each
project would be zero because the IRR would then be the opportunity cost of
capital for each project. The discount rate used in an NPV calculation is the
opportunity cost of capital. Therefore, it is true that the NPV rule does assume
that cash flows are reinvested at the opportunity cost of capital.
5-7
Est. time: 06 - 10
17.
a.
C0 = –3,000 C0 = –3,000
C1 = +3,500 C1 = +3,500
C2 = +4,000 C2 + PV(C3) = +4,000 – 3,571.43 = 428.57
C3 = –4,000 MIRR = 27.84%
xC 2 C3
b. xC 1  
1.12 1.12 2
(1.122)(xC1) + (1.12)(xC2) = –C3
(x)[(1.122)(C1) + (1.12C2)] = –C3
- C3
x 
(1.12 )(C1 )  (1.12C 2 )
2
4,000
x   0.45
(1.12 )(3,500 )  ( 1.12)(4,00 0)
2
(1- x)C1 (1- x)C2

C0   0
(1  IRR) (1  IRR)2
(1- 0.45)(3,500) (1- 0.45)(4,000)
 3,000   0
(1 IRR) (1 IRR)2
Now, find MIRR using either trial and error or the IRR function (on a
financial calculator or Excel). We find that MIRR = 23.53%.
It is not clear that either of these modified IRRs is at all meaningful.
Rather, these calculations seem to highlight the fact that MIRR really has
no economic meaning.
Est. time: 11 - 15
18. Maximize: NPV = 6,700xW + 9,000xX + 0XY – 1,500xZ

subject to: 10,000xW + 0xX + 10,000xY + 15,000xZ  20,000
10,000xW + 20,000xX – 5,000xY – 5,000xZ  20,000
0xW - 5,000xX – 5,000xY – 4,000xZ  20,000
0  xW  1
0  xX  1
0  xZ  1
5-8
Using Excel Spreadsheet Add-in Linear Programming Module:

Optimized NPV = $13,450
with xW = 1; xX = 0.75; xY = 1 and xZ = 0
If financing available at t = 0 is $21,000:
with xW = 1; xX = (23/30); xY = 1 and xZ = (2/30)
Here, the shadow price for the constraint at t = 0 is $50, the increase in NPV for a
$1,000 increase in financing available at t = 0.
In this case, the program viewed xZ as a viable choice even though the NPV of
Project Z is negative. The reason for this result is that Project Z provides a
positive cash flow in periods 1 and 2.
If the financing available at t = 1 is $21,000:
with xW = 1; xX = 0.8; xY = 1 and xZ = 0
Hence, the shadow price of an additional $1,000 in t =1 financing is $450.
Est. time: 11 - 15
5-9

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Chapter 05 - Net Present Value and Other Investment Criteria

Solution Manual for Principles of Corporate Finance 11th

Answers to Problem Sets

1. a. A = 3 years, B = 2 years, C = 3 years.

d. B and C (NPVB = $3,378; NPVC = $2,405)

It is calculated by trial and error, by financial calculators, or by spreadsheet

4. No (you are effectively “borrowing” at a rate of interest higher than the

c. Yes, NPV = +14.6.

The profitability index for each project is shown below:

Project NPV Investment Profitability Index (NPV/Investment)

1 5,000 10,000 5,000/10,000 = 0.5

2 5,000 5,000 5,000/5,000 = 1

3 10,000 90,000 10,000/90,000 = 0.11

4 15,000 60,000 15,000/60,000 = 0.25

5 15,000 75,000 15,000/75,000 = 0.2

6 3,000 15,000 3,000/15,000 = 0.2

$1000 $1000 $1000 $1000

Projects B and C have positive NPVs.

b. Payback A = one year

Est. time: 11– 15

IRRA = 13.1% and IRRB = 11.9%

d. The cash flows for (B – A) are:

12. a. Because Project A requires a larger capital outlay, it is

13. Use incremental analysis:

14. a. First calculate the NPV for each project.

Profitability index = NPV/initial investment.

For Project D: Profitability index = 8,181.82/10,000 = .82.

(1- x)C1 (1- x)C2

18. Maximize: NPV = 6,700xW + 9,000xX + 0XY – 1,500xZ

Using Excel Spreadsheet Add-in Linear Programming Module:

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