Chapter 5

Net Present Value and Other Investment Criteria

2. a. NPVA = –$1,000 + $1,000 / (1 + .10) = –$90.91

NPVB = –$2,000 + $1,000 / (1 + .10) + $1,000 / (1 + .10)2 + $4,000 / (1 + .10)3 +

$1,000 / (1 + .10)4 + $1,000 / (1 + .10)5
NPVB = $4,044.73

NPVC = –$3,000 + $1,000 / (1 + .10) + $1,000 / (1 + .10)2 + $1,000 / (1 + .10)4

+ $1,000 / (1 + .10)5
NPVC = $39.47

Projects B and C have positive NPVs.

b. Payback A = 1 year
Payback B = 2 years
Payback C = 4 years

c. Accept projects A and B

10. NPV = 0 = [–$400,000 – (–$200,000)] + ($241,000 – 131,000) / (1 + IRR) +

($293,000 – 172,000) / (1 + IRR)2

Incremental IRR = 10%

The IRR on Project Beta exceeds the cost of capital. So, since the IRR on the incremental
investment in Project Alpha also exceeds the cost of capital, choose Alpha.
11. a. The figure shown below 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:
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 IRR).

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
NPV

10.00

0.00

-10.00

-20.00

-30.00
0% 10% 20%

Rate of Interest
Project A Project B Increment

16. The following table and plot outline each project’s sensitivity to the discount
rate:
 Project C0 C1 C2 C3 C4 IRR
A $ (200) $ 80 $ 80 $ 80 $ 80 22%
B (200) 100 100 100 - 23%

Net Present Value: Sensitivity Analysis

Discount Rate Project A Project B
10% 54 49
11% 48 44
12% 43 40
13% 38 36
14% 33 32
15% 28 28
16% 24 25
17% 19 21
18% 15 17
19% 11 14
20% 7 11

Net Present Value: Sensitivity to Discount Rate

60

50

40
Net Present Value

30

20

10 Project B
Project A
-
10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
Discount Rate

a. At an 11% discount rate, both projects are acceptable with positive NPV.

b. If mutually exclusive, project A yields a higher NPV than project B

c. At a 16% discount rate, Project B is more favorable than Project A.

d. Project A is fully paid back by year 3.

Project B is fully paid back by year 2.

e. The project with the highest NPV depends on the discount rate.

f. Project A has an IRR of 22%.

Project B has an IRR of 23%.

g. The project with the highest NPV depends on the discount rate.

h. Profitability Index = NPV/investment

Profitability IndexA = $48/$200 = 0.24

Profitability IndexB = $44/$200 = 0.22

In this case, since the investment amounts are the same, both NPV and profitability
index indicate the same answer: pick project A at an 11% discount rate. If capital is
rationed, then profitability index is preferable and used to accept projects with the
highest index descending until the capital ration is exhausted. Without capital
rationing, accept all projects with a positive NPV.
 CHAPTER 6
Making Investment Decisions with
the Net Present Value Rule

4. Cash Flow Forecasts:

Panel A Capital Investment 0 1 2 3 4
Investment in Fixed Assets -$40,000
Sale of Fixed Assets $12,000
Less Tax on Sale $2,520
Cash Flow from Capital Investment -$40,000 $0 $0 $0 $9,480

Panel B Operating Cash Flow 0 1 2 3 4

Revenues $20,000 $20,000 $20,000 $20,000
Cost of Goods Sold $7,000 $7,000 $7,000 $7,000
Depreciation $40,000
Pretax Profit -$40,000 $13,000 $13,000 $13,000 $13,000
Tax -$8,400 $2,730 $2,730 $2,730 $2,730
Profit after Tax -$31,600 $10,270 $10,270 $10,270 $10,270
Operating Cash Flow $8,400 $10,270 $10,270 $10,270 $10,270

Panel C Investment in Working Capital 0 1 2 3 4

Working Capital $0 $10,000 $10,500 $5,000 $0
Change in Working Capital $10,000 $500 -$5,500 -$5,000
Cash flow from investments in working capital $0 -$10,000 -$500 $5,500 $5,000

Panel D Project Valuation 0 1 2 3 4

Total Project Cash Flow -$31,600 $270 $9,770 $15,770 $24,750
Discount Factor (with six month lag) 1.0000 0.8910 0.8250 0.7639 0.7073
Discounted Cash Flow -$31,600 $241 $8,060 $12,046 $17,505
NPV $6,252

10. 2019 2020 2021 2022 2023

Net working capital $50,000 $230,000 $305,000 $250,000 $0
Cash flows –$50,000 – $180,000 –$75,000 $55,000 $250,000

Net working capital = accounts receivable + inventory – accounts payable

Cash flows = +Decrease (−Increase) in net working capital

15. Assume the following:

a. The firm will manufacture widgets for at least 10 years at a constant level.
b. There will be no inflation or technological change.
c. The 15% cost of capital is the real, after-tax rate of return.
d. All operating cash flows occur at the end of the year.
e. We cannot ignore incremental working capital costs and recovery.
f. The firm has sufficient profits that can be increased by tax shields.
Note: Since purchasing the lids can be considered a one-year ”project,” the
two projects have a common chain life of 10 years.
 Compute NPV for each project as follows:
NPVpurchase = – ($2 × 200,000) × (1 – .21) × ((1 / .15) – (1 / (.15 × (1 + .15) 10)))
NPVpurchase = –$1,585,931

NPVmake = –$150,000 – 30,000 + (.21 × $150,000) – [($1.50 × 200,000) × (1

– .21) × ((1 / .15) – (1 / (.15 × (1 + .15)10)))] + $30,000 / 1.1510

NPVmake = –$1,330,533

The widget manufacturer should make the lids.

17. The table below shows the nominal cash flows. The NPV is computed using
the nominal cost of capital:
Manufacturing Costs % of sale 90%
Rent $100
Inflation Rate 4%
Cost of Capital 12%

United Pigpen (in $1,000's) t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=7 t=8
Sales 4,200.0 4,410.0 4,630.5 4,862.0 5,105.1 5,360.4 5,628.4 5,909.8
Manufacturing Costs (3,780.0) (3,969.0) (4,167.5) (4,375.8) (4,594.6) (4,824.4) (5,065.6) (5,318.8)
Depreciation (120.0) (120.0) (120.0) (120.0) (120.0) (120.0) (120.0) (120.0)
Rent (100.0) (104.0) (108.2) (112.5) (117.0) (121.7) (126.5) (131.6)
Earnings before Taxes 200.0 217.0 234.9 253.7 273.5 294.4 316.3 339.4
Taxes (50.0) (54.3) (58.7) (63.4) (68.4) (73.6) (79.1) (84.8)
Cash Flow—Operations 270.0 282.8 296.2 310.3 325.1 340.8 357.2 374.5

Working Capital 350.0 420.0 441.0 463.1 486.2 510.5 536.0 562.8 -
(Increase) Decrease in W.C. (350.0) (70.0) (21.0) (22.1) (23.2) (24.3) (25.5) (26.8) 562.8
Initial Investment (1,200.0)
Sale of Plant 400.0
 CHAPTER 30
Financial Planning

19. a. Sales increase by 10%, so:

2023 sales = 1.1 × $1,000,000 = $1,100,000

Sales equal 40% of average assets, so average assets must be:

Average assets = $1,100,000 / .40 = $2,750,000

Given the beginning and the average assets, ending assets must be:

Ending assets = (average assets × 2) – beginning assets

Ending assets = ($2,750,000 × 2) – $2,600,000 = $2,900,000

b.
2023 Income Statement (in
thousands)
Sales $1,100
Costs 825
Interest* 25
Pretax profit $ 250
Tax 100
Net income $ 150
Dividends 75
Addition to retained earnings $ 75
*Assumes debt remains constant

Balance Sheet
(in thousands)
Net assets $2,900 Debt $ 500
Equity 2,175
Total $2,900 Total $2,675

External financing need = $2,900,000 – 2,675,000 = $225,000

c. Debt ratio = ($500,000 + 225,000) / $2,900,000 = .25, or 25%

20. Addition to retained earnings = growth rate × (assets – liabilities)

Addition to retained earnings = .10 × ($3,200 – 1,200) = $200

Residual income = net income – addition to retained earnings

Residual income = (1 + .10) × ($500) – $200 = $350

21. a. Required funding = increase in total assets

Required funding = .15 × $3,000 = $450
 Tax rate = taxes / pretax income
Tax rate = $200 / $700 = .2857, or 28.57%

Based on a growth rate of 15% and a tax rate of 28.57%, the projected
income statement for 2020 is:

Income Statement
Sales $1,092.5
Costs 287.5
EBIT 805.0
Taxes 230.0
Net income $ 575.0

Dividends = dividend payout ratio × net income

Dividends = .50 × $575.0 = $287.5

Addition to retained earnings = net income – dividends

Addition to retained earnings = $575.0 – 287.5 = 287.5

External funds needed = required funding – addition to retained

earnings
External funds needed = $450 – 287.5 = $162.5

b. Value of debt = beginning debt + external funds needed

Value of debt = $1,000 + 162.5 = $1,162.5

c. Dividend = net income – required addition to retained earnings

Dividend = $575.00 – [$450 – ($1,100 – 1,000)] = $225.0
 CHAPTER 31
Working Capital Management

3.

10. The comparison of the centralized versus decentralized inventory strategy is

compared below:

Polar Express Railroad ($ in 000's)

Centralized
Carrying costs: Inventory
Average inventory $5,000
Interest rate 6.5%
Annual Interest costs $325
Storage costs $330
Labor costs reduction $0

With an equivalent annual costs, it may pay to pilot the decentralized strategy, given
the non-quantified benefits of quicker repairs and customer satisfaction.