Essentials of Corporate Finance 8th Edition Ross Solutions Manual

Essentials of Corporate Finance 8th
Edition Ross Solutions Manual

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Chapter 08 – Net Present Value and Other Investment Criteria
Chapter 8
NET PRESENT VALUE AND OTHER INVESTMENT
CRITERIA
Net Present Value and Other Investment Criteria
Slide
8 Chapter Organization Number
Slide Title
Introduction 8.2 Key Concepts and Skills

8.3 Chapter Outline
8.4 Capital Budgeting
8.5 Good Decision Criteria
8.1 Net Present Value
The Basic Idea 8.6 Net Present Value
8.8 NPV - Decision Rule
8.9 Sample Project Data
Estimating Net Present Value 8.10 Computing NPV for the Project
8.11 Computing NPV for the Project
8.12 Calculting NPVs with Excel
8.14 Rationale for the NPV Method
8.15 NPV Method
8.2 The Payback Rule
Defining the Rule 8.16 Payback Period
8.17 Computing Payback for the Project
Analyzing the Rule 8.18 Decision Criteria Test - Payback
Redeeming Qualities of the Rule 8.19 Advantages and Disadvantages of Payback
8.3 The Average Accounting Return
8.20 Average Accounting Return
8.21 Computing AAR for the Project
8.22 Decision Criteria Test - AAR
8.23 Advantages and Disadvantages of AAR
8.4 The Internal Rate of Return
8.24 Internal Rate of Return
8.25 IRR - Definition and Decision Rule
8.26 NPV vs. IRR
8.27 Computing IRR for the Project
8.28 Computing IRR for the Project
8.29 Calculating IRR with Excel
8.30 Calculating IRR with Excel
8.31 NPV Profile for the Project
8.32 Decision Criteria Test - IRR
8.33 IRR - Advantages
8.34 IRR - Disadvantages
8.35 Summary of Decisions for the Project
Problems with the IRR 8.36 NPV vs. IRR
Nonconventional Cash Flows 8.37 IRR and Non-conventional Cash Flows
8.38 Multiple IRRs
8.39 Non-conventional Cash Flows
8.40 Non-conventional Cash Flows
8.41 NPV Profile for the Project
Mutually Exclusive Projects 8.42 Independent versus Mutually Exclusive Projects
8.43 Reinvestment Rate Assumption
8.44 Example of Mutually Exclusive Projects
8.45 NPV Profiles
8.46 Two Reasons NPV Profiles Cross
8.47 Conflicts Between NPV and IRR
8-1
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Net Present Value and Other Investment Criteria

Slide
8 Chapter Organization Number
Slide Title
8.4 The Internal Rate of Return

The Modified Internal Rate of Return 8.48 Modified Internal Rate of Return (MIRR)
Method 1: Discounting Approach 8.49 MIRR Method 1
Method 2: Reinvestment Approach 8.50 MIRR Method 2
Method 3: Combination Approach 8.51 MIRR Method 3
8.52 MIRR in Excel
8.53 MIRR
8.54 Second: Find Discount rate that equates PV and TV
8.55 Second: Find Discount rate that equates PV and TV
MIRR or IRR: Which is better? 8.56 MIRR versus IRR
8.5 The Profitability Index
8.57 Profitability Index
8.59 Advantages and Disadvantages of Profitabioity Index
8.6 The Practice of Capital Budgeting
8.61 Capital Budegting in Practice
8.62 Summary of Decisions for the Project
8.63 NPV Summary
8.64 IRR Summary
8.65 Payback Summary
8.66 AAR Summary
8.67 Profitabiity Index Summary
8.68 Quick Quiz
8.69 Quick Quiz Solution
8.70 Chapter 8 END
CHAPTER WEBSITES
Websites may be referenced more than once in a chapter. This table just includes the
section for the first reference.
Chapter Section Web Address

What’s On the Web? www.datadynamica.com
Video Note: “Capital Budgeting” looks at how Navistar International approaches

capital budgeting.
Extended Ethics Notes (at end of Chapter Outline):

Financial Incentives
Financially Sound versus Ethically Sound
ANNOTATED CHAPTER OUTLINE
Slide 8.2 Key Concepts and Skills
Slide 8.3 Chapter Outline
8-2
website, in whole or part
Lecture Tip: A logical prerequisite to the analysis of investment opportunities is the

creation of investment opportunities—unlike the field of investments, where the
capital budgeting relies on the work of people in the areas of engineering, research
and development, information technology, and others for the creation of investment
opportunities. As such, it is important to suggest that students keep in mind the
importance of creativity in this area, as well as the importance of analytical
techniques. Capital budgeting involves the creation, as well as the analysis, of growth
opportunities
Lecture Tip: You may wish to emphasize that firm value comes primarily from the
asset side of the balance sheet; i.e., value is created primarily via good investment
decisions.
Point out that “investment assets” include intangibles such as human capital and
intellectual property, as well as tangible assets in the form of plant and equipment.
Slide 8.4 Capital Budgeting

Stress the importance of capital budgeting in determining the long-term direction of
the firm.
Slide 8.5 Good Decision Criteria

These are the decision criteria by which each method in the chapter will be evaluated.
Slide 8.6 Net Present Value

Net present value—the difference between the market value of an investment and its
cost. While estimating cost is usually straightforward, finding the market value of
assets can be tricky. The principle is to find the market price of comparables or
substitutes.
Lecture Tip: It is often helpful to stress the word “net” in net present value. It is not
uncommon for some students to carelessly calculate the PV of a project’s future cash
flows and fail to subtract out its cost (after all, that is what the programmers of Lotus
and Excel did when they programmed the NPV function). The PV of future cash flows
is not NPV, rather NPV is the amount remaining after offsetting the PV of future cash
flows with the initial cost. Thus, the NPV amount determines the incremental value
created by undertaking the investment.

The basic NPV formula. Since up to now, we’ve avoided cash flows at time t = 0, be
sure to point out that the summation begins with cash flow zero—not one.
The second version is shown to lead into Excel’s NPV function. And with a typical
project’s cash flows, CF0 is negative while the rest are positive.
8-3
Slide 8.8 NPV—Decision Rule

NPV is the only approach we cover that directly relates a project to the impact on
firm value.
Lecture Tip: Here’s another perspective on the meaning of NPV. If we accept a

project with a negative NPV of –$2,422, this is financially equivalent to investing
$2,422 today and receiving nothing in return. Therefore, the total value of the firm
would decrease by $2,422. This assumes that the various components (cash flow
estimates, discount rate, etc.) used in the computation are correct.
Lecture Tip: In practice, financial managers are rarely presented with zero NPV
projects. In most large firms, capital investment proposals are submitted to the
Finance group from other areas for analysis. Those submitting proposals recognize
the ambivalence associated with zero NPVs and are less likely to send them to the
Finance group in the first place.
Conceptually, a zero-NPV project earns exactly its required return. Because firm
value is completely unaffected by the investment, there is no reason for shareholders
to prefer either one.
However, several real-world considerations may come into play in these decisions.
For example, adjusting for risk in capital budgeting projects can be problematic.
And, some investment projects may have benefits that are difficult to quantify but
exist, nonetheless. Consider an investment with a low or zero NPV that enhances a
firm’s image as a good corporate citizen or helps a firm move into new markets.
Slide 8.9 Sample Project Data

This sample project will be used for each of the decision rules so students can
compare the different rules and see what problems and conflicts can arise.
Slide 8.10 Computing NPV for the Project

We will learn how to estimate the cash flows in Chapter 9.
We will learn how to estimate the required return in Chapter 12.
For now, consider both of these as given, while we learn the methodologies.
Slide 8.11 Computing NPV for the Project—Using the TIBAII+

Using the TI BAII+ Cash Flow worksheet introduced in Chapter 5.
Slide 8.12 Calculating NPV with Excel (Excel link)

Stress that Excel’s NPV function does NOT include cash flow 0! Actual “netting”
must be handled manually outside the NPV function. This is illustrated in cells D10
and D11.
8-4

Shows the formulas again to emphasize how calculators and Excel handle NPV
calculations.
Slide 8.14 Rationale for the NPV Method

One of the primary strong points of the NPV method is that it is directly related to the
increase in shareholder wealth.
The decision rule is simple: Accept if NPV > 0.
Slide 8.15 NPV Method

The NPV method meets all the desirable criteria for analysis and should ALWAYS
be the dominant decision method. If conflicts between the results of the different
methods exist (and we’ll show that they can), then the decision should be made based
on the NPV result.
Slide 8.16 Payback Period

Payback period—length of time until the accumulated cash flows equal or exceed the
original investment, i.e., how fast you recoup your initial investment.
Payback period rule—investment is acceptable if its calculated payback is less than

some arbitrarily selected target number of years.
Slide 8.17 Computing Payback for the Project

The payback period is year 3 if you assume that the cash flows occur at the end of the
year, which we do with all of the other decision rules.
If we assume that the cash flows occur evenly throughout the year, which is typical
for this method, then the project pays back in 2.34 years.
Slide 8.18 Decision Criteria Test—Payback

Answer = NO to all
• No discounting involved.
• Doesn’t consider risk differences.
• Determines the cutoff point.
• No indication of impact on firm value.
• Cannot rank projects.
• Bias for short-term investments.
8-5
Real-World Tip: While the payback period is widely used in practice, it is rarely the
primary decision criterion. As William Baumol pointed out in the early 1960s, the
payback rule serves as a crude “risk screening” device—the longer cash is tied up,
the greater the likelihood that it will not be returned. The payback period may be
helpful when comparing mutually exclusive projects. Given two similar projects with
different paybacks, the project with the shorter payback is often, but not always, the
better project.
Real-World Tip: Interestingly, the payback period technique is used quite heavily in
determining the viability of certain investment projects in the health care industry. In
health care, the technology is rapidly changing with extremely expensive equipment
and an increasingly competitive industry. An equipment purchase may be
complicated by the fact that, while the machine may be able to perform its function
for, say, 6 years or more, new and improved equipment is likely to be developed that
will supersede the “old” equipment long before its useful life is over. Demand from
patients and physicians for “cutting-edge technology” can drive a push for new
investment. In the face of such a situation, many hospital administrators then focus on
how long it will take to recoup the initial outlay, in addition to the NPV and IRR of
the equipment.
Slide 8.19 Advantages and Disadvantages of Payback

Beyond its obvious drawbacks, the overriding problem with payback is that it asks the
wrong question. The firm is looking for projects that will increase firm value, and this
criterion picks the project that will recoup the initial investment the quickest—not the
same thing.
International Note: Firms that have operations in countries with volatile politics may
also be concerned with quick paybacks. When there is always a possibility that the
government may seize your assets, you want to make sure that you have recouped
your investment as quickly as possible.
Lecture Tip: One of the criticisms of payback is that it doesn’t account for time value
of money. Discounted payback was developed to counter this problem. The basic idea
is to compute the PV of each of the cash flows, using the appropriate discount rate,
and determine how long it takes for the investment to pay back on a discounted basis.
You still have an arbitrary cutoff and ignore the cash flows beyond the cutoff period.
Because you are computing present values anyway, you may as well go ahead and
compute the NPV because you have already lost payback’s simplicity.
Slide 8.20 Average Accounting Return

Average accounting return = measure of accounting profit / measure of average
accounting value. In other words, it is a benefit/cost ratio that produces a pseudo rate
of return. However, due to the accounting conventions involved, the lack of risk
adjustment, and the use of profits rather than cash flows, it isn’t clear what is being
measured.
8-6
The text gives the following specific definition:
AAR = average net income / average book value
AAR rule = accept if AAR > target return
Slide 8.21 Computing AAR for the Project

Computations use the Sample Project data from slide 8.9 repeated here. This is the
one method that uses the net incomes (NI) and average book value given.
Students may ask where you came up with the 25%. Point out that this is one of the
drawbacks of this rule. There is no good theory for determining what the return
should be. We generally just use some rule of thumb.
Slide 8.22 Decision Criteria Test—AAR

The answer to all of these questions is NO. In fact, this rule is even worse than the
payback rule in that it doesn’t even use cash flows for the analysis. It uses net income
and book value.
Lecture Tip: An alternative view of the AAR is that it is the micro-level analogue to
the ROA discussed in a previous chapter. As you remember, firm ROA is normally
computed as Firm net income / Firm total assets. And, it is not uncommon to employ
values averaged over several quarters or years in order to smooth out this measure.
Some analysts ask, “If the ROA is appropriate for the firm, why is it less appropriate
for a project?” Perhaps the best answer is that whether you compute the measure for
the firm or for a project, you need to recognize the limitations—it doesn’t account for
risk or the time value of money, and it is based on accounting, rather than market,
data.
Slide 8.23 Advantages and Disadvantages of AAR

Clearly, AAR’s main drawback is that it uses accounting data rather than cash flows
and is, therefore, not comparable to any other true “return” figures.
Real-World Tip: Surveys indicate that few large firms employ the payback period
and/or the AAR methods exclusively; rather, these techniques are used in conjunction
with one or more of the DCF techniques. On the other hand, anecdotal evidence
suggests that many smaller firms rely more heavily on non-DCF approaches. Reasons
for this include (1) small firms don’t have direct access to the capital markets and,
therefore, find it more difficult to estimate discount rates based on funds cost; (2) the
AAR is the project-level equivalent to the ROA measure used for analyzing firm
profitability; and (3) some small-firm decision makers may be less aware of DCF
approaches than their large-firm counterparts.
8-7
Slide 8.24 Internal Rate of Return

Internal rate of return (IRR)—the rate that makes the present value of the future cash
flows equal to the initial cost or investment. In other words, the discount rate that
gives a project a $0 NPV.
The IRR rule is very important. Management and individuals in general, often have a
much better feel for percent returns and the value that is created than they do for
dollar increases. A dollar increase doesn’t seem to provide as much information if we
don’t know what the initial expenditure was.
Slide 8.25 IRR—Definition and Decision Rule

Lecture Tip: Remind students that the goal of IRR is not to find zero NPV projects,
but rather to find a range of discount rates for which the project is acceptable.
Slide 8.26 NPV versus IRR

Shows both the NPV and IRR formulas for comparison.
Slide 8.27 Computing IRR for the Project

Without a financial calculator or Excel, computing IRR (like YTM for a bond) is a
trial-and-error process. In fact, the YTM of a bond is its IRR.
Many financial calculators compute the IRR as soon as the key is pressed; others (like
the TI BAII+) require that you press compute.
Slide 8.28 Computing IRR for the Project—TI BAII+

The TU BAII+ uses the Cash Flow worksheet to compute IRR. Cash flows are
entered in the same manner as for NPV. When the final CF has been entered, press
the IRR key. “IRR” will display on the screen. Press compute .
Slide 8.29 Computing IRR for the Project—Excel

Excel also has an IRR function, BUT, unlike the NPV function, the cash flow range
for IRR INCLUDES cash flow zero. (next slide)
Slide 8.30 Computing IRR for the Project—Excel (Excel link)

Click on the Excel link to pull up the spreadsheet displayed on the slide.
The row and column headings are shown to emphasize that the function requires the
range to include cash flow 0.
Slide 8.31 NPV Profile for the Project

Lecture Tip: Notice that the NPV profile is also a form of sensitivity analysis—the
slope of the NPV profile indicates how much a project’s estimated NPV is affected by
a change in the discount rate used to compute it.
8-8
Slide 8.32 Decision Criteria Test—IRR

The answer to all of these questions is YES, although it is not always obvious.
• The IRR rule accounts for time value because it is finding the rate of return
that equates all of the cash flows on a time value basis.
• The IRR rule provides an indication of value because we will always increase
value if we can earn a return greater than our required return.
• We should not consider the IRR rule as our primary decision rule. It has some
problems that NPV does not have, thus NPV is our ultimate decision rule.
Slide 8.33 Advantages of IRR

You should point out, however, that if you get a very large IRR, you should go back
and look at your cash flow estimation again. In competitive markets, extremely high
IRRs should be rare.
Slide 8.34 Disadvantages of IRR

These are some rather serious flaws in the IRR method, which are discussed on the
following slides.
Slide 8.35 Summary of Decisions for the Project

So, what should we do? We have two rules that indicate to accept and two that
indicate to reject. Easy—NPV prevails.
Slide 8.36 NPV versus IRR

If a project’s cash flows are conventional (costs are paid early and benefits are
received over the life), and if the project is independent, then NPV and IRR will give
the same accept or reject signal, which was the case with our Sample Project.
There are situations where NPV and IRR will give conflicting answers.
Slide 8.37 IRR and Nonconventional Cash Flows

Nonconventional cash flows means the sign of the cash flows changes more than
once or the cash inflow comes first and outflows come later. If this occurs, you will
have multiple internal rates of return. This is problematic for the IRR rule; however,
the NPV rule still works correctly.
Nonconventional cash flows and multiple IRRs occur when there is a net cost to
shutting down a project. The most common examples deal with collecting natural
resources. After the resource has been harvested, there is generally a cost associated
with restoring the environment.
8-9
Slide 8.38 Multiple IRRs

Explains why nonconventional cash flows result in multiple IRRs.
The IRR formula is a polynomial of degree n, which implies n roots.
Descartes’ Rule of Signs says that for every sign change, a real root will exist.
Conventional cash flow streams have one sign change (CF0 = negative, CF1–N =
positive) and result in one real root—the IRR.
With more than one sign change, we get more than one real root (the rest are
imaginary).
Slide 8.39 Nonconventional Cash Flows

The example problem on this slide is solved on the next slide. Note that CF0 = –
90,000 and CF3 = –150,000—two sign changes.
Slide 8.40 Nonconventional Cash Flows (Excel link)

Summary of Decision Rules
The steps to compute NPV are not shown because we have covered them previously.
If you compute the IRR on the calculator, you get 10.11% because it is the first one
that you come to. So, if you just blindly use the calculator without recognizing the
uneven cash flows, NPV would say to accept and IRR would say to reject.
Slide 8.41 NPV Profile

You should accept the project if the required return is between 10.11% and 42.66%.
This provides a good visual of the 2 IRRs.
Slide 8.42 Independent versus Mutually Exclusive Projects

Lecture Tip: A good introduction to mutually exclusive projects is to provide
examples that students can relate to. An excellent example of mutually exclusive
projects is the choice of which college or university to attend. Most students apply
and are accepted to more than one college, yet they cannot attend more than one at a
time. Consequently, they have to decide between mutually exclusive projects.
Slide 8.43 Reinvestment Rate Assumption

If a project analysis results in a high IRR, the reinvestment rate assumption tends to
inflate that result because it assumes that cash flows from the project are reinvested at
that high rate—which is attractive but not reasonable.
8-10
Slide 8.44 Example of Mutually Exclusive Projects

This is a simple example of two mutually exclusive projects that result in conflicting
signals from NPV and IRR.
The important point is that we DO NOT use IRR to choose between projects.
Slide 8.45 NPV Profiles

If the required return is less than the crossover point of 11.8%, then you should
choose A. If the required return is greater than the crossover point of 11.8%, and
doesn’t exceed B’s IRR of 22.17%, then you should choose B.
Slide 8.46 Two Reasons NPV Profiles Cross

The situations that result in crossing NPV profiles are:
• Scale differences
• Timing differences
Slide 8.47 Conflicts between NPV and IRR

Emphasizing that NPV is the dominant decision criteria and the situations where IRR
is unreliable.
Slide 8.48 Modified Internal Rate of Return (MIRR)

Executives clearly prefer IRR yet it has shortcomings. MIRR, or Modified Internal
Rate of Return, controls for these problems.
There are three methods of computing MIRR, each demonstrated on the next three
slides.
Slide 8.49 MIRR Method 1—Discounting Approach (Excel link)

Slide 8.50 MIRR Method 2—Reinvestment Approach (Excel link)
Slide 8.51 MIRR Method 3—Combination Approach (Excel link)
Slide 8.52 MIRR in Excel (Excel link)

Excel’s embedded MIRR function uses Method 3 shown on slide 8.51.
Two rates of interest are used:
• A financing rate is used to discount cash outflow.

• A reinvestment rate is used to compound cash inflows.
For our example, the same rate will be used for both.
8-11
Slide 8.53 MIRR- First, find PV and TV

Manually calculating MIRR is somewhat confusing. Much like valuing a nonconstant
growth stock, seeing the timeline can help students understand the process.
Step 1 is to find the PV of cash outflows and the Terminal Value (TV) of cash
inflows.
Slide 8.54 MIRR—Second, Find the Discount Rate That Equates PV

and TV
Once the values in step 1 are computed, use the standard TVM functions to find the
rate that grows the PV to TV in n periods. This is illustrated on the next slide.
Slide 8.55 MIRR—Second, Find the Discount Rate That Equates PV

and TV
Formula, Calculator, and Excel solutions.
In Excel, you can use the basic RATE function or the specialized MIRR function.
Note that the TI BAII+ professional calculator has the MIRR function built-in.
Slide 8.56 MIRR versus IRR

Summarizes why MIRR is a better choice than IRR if a rate of return metric is
preferred. MIRR is used by major firms, including Federal Express, in their project
analysis.
Slide 8.57 Profitability Index

Profitability index—present value of the future cash flows divided by the initial
investment (both numerator and denominator are positive).
This definition assumes no negative cash flows after year zero. Technically, PI = PV
of inflows / PV of outflows; thus a nonconventional project’s PI will have a PV in
both the numerator and the denominator. If a project has a positive NPV, then the PI
will be greater than 1.
Slide 8.58 Profitability Index

Formula for PI
Slide 8.59 Advantages and Disadvantages of Profitability Index

Because the profitability index is closely related to NPV, it does generally lead to
identical signals. However, project scale can lead to incorrect choices with mutually
exclusive projects as is shown on the next slide.
8-12
Lecture Tip: The profitability index is often used when a firm faces capital rationing.
The basic idea is to compute the PI for all independent projects and choose those
projects that have the highest PI until you run out of funds. If a high PI project uses
the majority of funds, then you should see if skipping it and taking the next highest set
of PI projects results in a higher overall NPV (some trial-and-error may be required).
Slide 8.60 Profitability Index—Example of Conflict with NPV

Due to the difference in scale, the PI of project A is greater than that of B, yet clearly
B is a better choice because it will increase firm value five times as much in dollars as
project A.
Slide 8.61 Capital Budgeting in Practice

It is common among large firms to employ a discounted cash flow technique such as
IRR or NPV along with payback period or average accounting return. It is suggested
that this is one way to resolve the considerable uncertainty over future events that
surrounds the estimation of NPV.
Even though payback and AAR should not be used to make the final decision, we
should consider the project very carefully if they suggest rejection. There may be
more risk than we have considered, or we may want to pay additional attention to our
cash flow estimations. Sensitivity and scenario analysis can be used to help us
evaluate our cash flows.
The fact that payback is commonly used as a secondary criteria may be because short
paybacks allow firms to have funds sooner to invest in other projects without going to
the capital markets
Slide 8.62 Summary of Methods

Recaps the five methods covered in the chapter—what each measures and the metric
used.
Stress that, while NPV is the dominant decision criteria, there are reasons to calculate
all five because each provides indications concerning the value and/or risk of a
proposed project.
Lecture Tip: While uncertainty about inputs and interpretation of the outputs help
explain why multiple criteria are used to judge capital investment projects in
practice, another reason is managerial performance assessment. When managers are
judged and rewarded primarily on the basis of periodic accounting figures, there is
an incentive to evaluate projects with methods such as payback or average
accounting return. On the other hand, when compensation is tied to firm value, it
makes more sense to use NPV as the primary decision tool.
8-13
The following five slides give a brief review of each of the methods and its
advantages and drawbacks:
Slide 8.63 NPV Summary
Slide 8.64 IRR Summary
Slide 8.65 Payback Summary
Slide 8.66 AAR Summary
Slide 8.67 Profitability Index Summary
Slide 8.68 Quick Quiz

Problem solution on next slide.
Slide 8.69 Quick Quiz Solution (Excel link)
Slide 8.70 Chapter 8 END

Extended Ethics Note: Financial Incentives
The use of various financial incentives to induce firms to locate in a given
municipality raises some interesting issues in the capital budgeting area. From the
viewpoint of the firm’s analysts, how do you estimate the impact of such incentives? A
reduction in the initial outlay? Increases in future cash inflows? And what discount
rate should be assigned to these tax reductions? Are these promises riskless?
And what about the municipal officials who offer such incentives? Stated reasons are
typically related to “employment growth” or “increased economic activity.” But,
from a capital budgeting standpoint, have you ever seen a fully developed cash flow
analysis of the stated benefits relative to the costs?
Consider this example from a Federal Reserve publication:
“Alabama offered Mercedes-Benz a package valued at more than the cost

of the plant itself. To lure the $300 million plant, with about 1,500 jobs,
the state promised to buy the site for $30 million, and lease it to Mercedes
for $100. Surrounding communities will contribute an additional $5
million each, and the University of Alabama will offer German language
and culture classes to the children of plant employees. On top of this, the
state will provide a package of tax breaks valued at more than $300
million, which will, among other things, allow the plant to be paid for with
money that would have been paid to the state.”
8-14
Several incentives described above directly affect the costs and benefits of the
proposed project and would be accounted for in the capital budgeting analysis
performed by Mercedes. However, the state officials should perform their own capital
budgeting analysis—they too are incurring economic costs in the hope for future
benefits. But at least one aspect is different: When a corporation makes a poor
investment, shareholders suffer; when a state makes poor decisions, all of the
residents of the state suffer. Thus, the ethics of the capital budgeting decision come
into play more clearly in the latter case.
Extended Ethics Note: Financially Sound versus Ethically Sound

Because a project is financially sound, it must be ethically sound, right? Well … the
question of ethical appropriateness is less frequently discussed in the context of
capital budgeting than is financial appropriateness.
Consider the following simple example. The American Association of Colleges and
Universities estimates that 10% of all college students cheat at some point during
their postsecondary education careers. You might pose the ethical question of
whether it would be proper for a publishing company to offer a new book, “How to
Cheat: A User’s Guide.” The company has a cost of capital of 8% and estimates it
could sell 10,000 volumes by the end of year 1 and 5,000 volumes in each of the
following two years. The immediate printing costs for the 20,000 volumes would be
$20,000. The book would sell for $7.50 per copy and net the company a profit of $6
per copy after royalties, marketing costs, and taxes. Year 1 net would be $60,000.
From a capital budgeting standpoint, is it financially wise to buy the publication

rights? What is the payback of this investment? Payback = 20,000 / 60,000 = .33
year, assuming continuous cash flows during the year. The project has a quick
payback—it looks good, right? Now ask the class if the publishing of this book would
encourage cheating and if the publishing company would want to be associated with
this text and its message. Some students may feel that one should accept these
profitable investment opportunities, while others might prefer that the publication of
this profitable text be rejected due to the behavior it could encourage. Although the
example is simplistic, this type of issue is not uncommon in real life and serves as a
starting point for a discussion of the value of “reputational capital.”
8-15

Essentials of Corporate Finance 8th Edition Ross Solutions Manual

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Essentials of Corporate Finance 8th Edition Ross Solutions Manual

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Essentials of Corporate Finance 8th

Edition Ross Solutions Manual

Introduction 8.2 Key Concepts and Skills

Net Present Value and Other Investment Criteria

8.4 The Internal Rate of Return

Chapter Section Web Address

Video Note: “Capital Budgeting” looks at how Navistar International approaches

Extended Ethics Notes (at end of Chapter Outline):

ANNOTATED CHAPTER OUTLINE

Slide 8.2 Key Concepts and Skills

Slide 8.3 Chapter Outline

Lecture Tip: A logical prerequisite to the analysis of investment opportunities is the

Slide 8.4 Capital Budgeting

Slide 8.5 Good Decision Criteria

Slide 8.6 Net Present Value

Slide 8.7 Net Present Value

Slide 8.8 NPV—Decision Rule

Lecture Tip: Here’s another perspective on the meaning of NPV. If we accept a

Slide 8.9 Sample Project Data

Slide 8.10 Computing NPV for the Project

We will learn how to estimate the required return in Chapter 12.

Slide 8.11 Computing NPV for the Project—Using the TIBAII+

Slide 8.12 Calculating NPV with Excel (Excel link)

Slide 8.13 Net Present Value

Slide 8.14 Rationale for the NPV Method

The decision rule is simple: Accept if NPV > 0.

Slide 8.15 NPV Method

Slide 8.16 Payback Period

Payback period rule—investment is acceptable if its calculated payback is less than

Slide 8.17 Computing Payback for the Project

Slide 8.18 Decision Criteria Test—Payback

Slide 8.19 Advantages and Disadvantages of Payback

Slide 8.20 Average Accounting Return

The text gives the following specific definition:

AAR = average net income / average book value

AAR rule = accept if AAR > target return

Slide 8.21 Computing AAR for the Project

Slide 8.22 Decision Criteria Test—AAR

Slide 8.23 Advantages and Disadvantages of AAR

Slide 8.24 Internal Rate of Return

Slide 8.25 IRR—Definition and Decision Rule

Slide 8.26 NPV versus IRR

Slide 8.27 Computing IRR for the Project

Slide 8.28 Computing IRR for the Project—TI BAII+

Slide 8.29 Computing IRR for the Project—Excel

Slide 8.30 Computing IRR for the Project—Excel (Excel link)

Slide 8.31 NPV Profile for the Project

Slide 8.32 Decision Criteria Test—IRR

Slide 8.33 Advantages of IRR

Slide 8.34 Disadvantages of IRR

Slide 8.35 Summary of Decisions for the Project

Slide 8.36 NPV versus IRR

Slide 8.37 IRR and Nonconventional Cash Flows

Slide 8.38 Multiple IRRs

The IRR formula is a polynomial of degree n, which implies n roots.

Slide 8.39 Nonconventional Cash Flows

Slide 8.40 Nonconventional Cash Flows (Excel link)

Slide 8.41 NPV Profile

This provides a good visual of the 2 IRRs.

Slide 8.42 Independent versus Mutually Exclusive Projects

Slide 8.43 Reinvestment Rate Assumption

Slide 8.44 Example of Mutually Exclusive Projects

Slide 8.45 NPV Profiles

Slide 8.46 Two Reasons NPV Profiles Cross