Lecture 3

1 Investment projects
Exercise 1.
Suppose your firm usually forecasts cash flows in nominal terms and discounts at a 15% nominal rate. In this
case, however, you are given project cash flows estimated in real terms.

Real cash flows

0 1 2 3
-100 35 50 30

Assume that inflation is 10% per year.

1. Compute the projects NPV.

Solution to Exercise 1.
• Method 1 Nominal cash flows and Discount rate.

Ct = Xt (1 + i)t

Where
Ct = nominal cash flow in period t
Xt = real cash flow in period t
i = inflation rate.
Nominal cash flows
0 1 2 3
-100 38.50 60.50 39.93

Then
38.50 60.50 39.93
NP V = + + − 100
1.15 1.152 1.153
= $5.50

• Method 2 . Real cash flows and discount rate.

1+r
Real discount rate = −1
1+i
where
r = nominal discount rate.
i = inflation rate.
1.15
Real discount rate = − 1 = 4.55%
1.10
Then
NP V
35 50 30
= + + − 100
1.10455 1.04552 1.04553
= $5.50
Which is the same result as with method 1.

Exercise 2.
Consider an investment project with the following cash flows:

Year (t)
0 1 2 3
Cash flow -5000 2000 2000 2000 2000

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What is the project’s IRR?
Solution to Exercise 2.
The following table gives the NPV for different choices of the discount rate, r:

Discount rate (r)

0 10% 20% 30% 40%
NPV 3000 1339 177 -668 -1302

NPV
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3000

-
r
10% 20% 30%

At the intercept the interest rate is 21.86%.

If the projects opportunity cost of capital is less than 21.86%, the project should be accepted. If not, the project
should be rejected.
Exercise 3.
Consider the following two projects A and B.

Cash flows
Project 0 1 2 IRR
A -5000 3000 3000 13%
B 5000 -3000 -3000 13%

Plot the NPV for interest rates between 10 and 15% for the two projects.
Which is the better project?
Solution to Exercise 3.

6
+1000

-
10% 13% 15%

−1000

The problem is that project A represent a lending opportunity (in which case a high IRR is good), and project B
represent a borrowing opportunity (in which case a low IRR is good).

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Exercise 4.
Consider an investment project with the following cash flows:

Period
0 1 2
Cash Flow -5000 20000 -18000

Determine the IRR of the project.

Solution to Exercise 4.
This project has two IRR’s, y1 = 37% and y2 = 163%. If the opportunity cost of capital is between these two values,
y1 < r < y2 , then we do not know whether to accept or reject the project based on the IRR criteria.

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NPV

-
40% 80% 160%
r

Exercise 5.
Consider the two mutually exclusive investment projects A and B:

Cash flows
Project 0 1 2 IRR
A -2000 2000 3000 82.2%
B -5000 0 10000 41.4%

Suppose that the opportunity cost of capital is r = 10% for both projects. Which project would you choose?
Why?
Solution to Exercise 5.
Then the IRR rule would indicate that project A is preferred to project B since IRRA > IRRB . However, the NPV
rule gives the opposite decision since

N P VA = 2298 < N P VB = 3264

Exercise 6.
Consider the two mutually exclusive investment projects A and B:

Cash flows
Project 0 1 2 IRR
A -2000 2000 3000 82.2%
B -5000 0 10000 41.4%

Suppose that the opportunity cost of capital is r = 10% for both projects. Which project would you choose?
Why?
Use the incremental cash flow method to evaluate the projects.
Solution to Exercise 6.
Then the IRR rule would indicate that project A is preferred to project B since IRRA > IRRB . However, the NPV
rule gives the opposite decision since

N P VA = 2298 < N P VB = 3264

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 Incremental cash flow
Project 0 1 2 IRR
B-A -3000 -2000 7000 23%

Since IRR = 23% > r = 10%, accept project B.

Exercise 7.
Consider the cash flows on the following investment project.
Year (t)
0 1 2 IRR
Cash Flow -5000 5000 1000 17.1%

Suppose that the appropriate cost of capital for cash flows occurring one year in the future is r1 = 10% and
for cash flows occurring two years in the future is r2 = 20%
Use the NPV and IRR methods to evaluate the projects
Solution to Exercise 7.
The IRR method gives no clear decision since r1 < IRR < r2 . However, the NPV method gives us an unambiguous
decision:
5000 1000
NP V = + − 5000 = 240
1.10 1.202
Therefore, the project should be accepted.
Exercise 8.
Suppose your firm must decide which machine to buy to produce widgets. There are two alternatives: machine
A and machine B. The two machines have identical capacity and do exactly the same job. Machine A costs
$100,000, last 4 years, and costs $20,000 per year to operate. Machine B costs $75,000, will last only 3 years,
and costs $35,000 per year to operate. The opportunity cost of capital is 10%.

1. Which machine should your firm purchase?

Solution to Exercise 8.
The only way to evaluate these machines is based on the present value of their costs. The present value of the costs
of machines A and B are:
4
X $20, 000
P VA = + 100, 000
t=1
1.10t
= $163, 397
3
X $35, 000
P VB = + 75, 000
t=1
1, 10t
= $162, 040

The present value of the costs of machine B is less than that of machine A. Does this mean that machine B is preferred
to machine A? No. Machine B lasts only 3 years and therefore will need to be replaced one year earlier than machine
A. To determine which machine is better, we need to compute the equivalent annual annuities for machines A and B.
That is, we need to know what annual cost is equivalent to the present values of A and B.

P VA = 163, 397
 
1 1
= CA −
0.10 0.10 · (1.10)4
→ CA = $51, 547
P VB = $162, 040
 
1 1
= CB −
0.10 0.10 · (1.10)4
→ CB = $65, 159

Therefore, machine A is better than machine B since it has a lower effective annual cost.

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Note: Another way to show the same result is to make the investments comparable. Note that machine A lasts 4
years and machine B lasts 3 year. If we repeat each project enough times to make the horizon comparable, we can
make the decision based on NPV. Here the common horizon is 12 years. If we repeat project A 3 times and project B
4 times, the NPV of the two projects will be comparable.

N P VA
 
1 1
= 163, 397 · 1 + +
1.104 1.108
= 351, 225
N P VB
 
1 1 1
= 162, 040 · 1 + + +
1.103 1.106 1.109
= 443, 971

We get the same result, machine A has the lowest NPV.

Exercise 9.
Suppose that a new machine has been developed that produces your firm’s product more efficiently. The cost
of a new machine is $20,000 and its economic useful life is 3 years. The existing machine will last at most 2
more years. The annual operating costs of the two machines are given below.

Annual operating cost

Machine 1 2 3
Old 10,000 15,000 -
New 4,000 6,000 8,000

The opportunity cost of capital is 10%. When should you replace the existing machine with a new one?
Solution to Exercise 9.
The firm, in essence, has three mutually exclusive alternatives.
• Replace the old machine immediately.
• Replace the old machine in one year.
• Replace the old machine in two years.
The objective should be to minimize the present value of purchasing and operating the firms machine.
The first step in solving this problem is to compute the equivalent annual annuity for the new machine. We do this
by equating the present value of the purchase and operating cost to the present value of an annuity of C dollars for 3
years. That is

4000 6000 8000

PV = + + + 20, 000
1.10 1.102 1.103
= $34, 606
 
1 1
= C −
0.10 0.10 · 1.103
→ C = 13, 915

This means that the firm is indifferent to paying $20,000 at the time the machine is purchased plus the annual operating
expenses, or paying $13,915 per year for the next 3 years. The present value of the two alternatives is exactly the
same.
Since the firm will be required to purchase a new machine every 3 years, it essentially faces the prospect of paying
C = $13, 915 per year forever. The only question that remains is: When will these payments begin? The answer, of
course, depends upon how soon we replace the existing machine.
Immediate Replacement.
If we replace the existing machine immediately, we face the following payment schedule:

t=1 2 3 4 ···
13, 915 13, 915 13, 915 13, 915 ···

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The present value of these payments is:

13, 915
PV = = 139, 150
0.10
Replace after one year.
If we replace the existing machine after one year, we face the following payment schedule:

t=1 2 3 4 ···
10, 000 13, 915 13, 915 13, 915 ···
The present value of these payments is:

10, 000 139, 150

PV = + = 135, 591
1.10 1.10
Replace after two years.
If we replace the existing machine after two years, we face the following payment schedule:

t=1 2 3 4 ···
10, 000 15, 000 13, 915 13, 915 ···
The present value of these payments is:
10, 000 15, 000 139, 150
PV = + +
1.10 1.102 1.102
= $136, 488

So we see that the optimal time to replace the existing machine is after one year.
Note: When the operating costs of the existing machine are strictly increasing through time (i.e. as the machine gets
older), the optimal time to replace the existing machine is as soon as the annual operating cost exceeds the equivalent
annual annuity of a new machine.
Question: How did I know that the new machine would not be replaced early?
Exercise 10.
Suppose your firm is considering the production of a new product. The new product can be produced
on an existing machine that currently has excess capacity. However, the additional use will accelerate the
replacement of the machine by one year. The machine was originally planned to be replaced after 4 years.
New machines have an estimated useful life of 10 years and cost $1 million. What is the appropriate charge
to the new product of the use of excess capacity? Assume a 10% discount rate.
Solution to Exercise 10.
The first step in solving this problem is to compute the equivalent annual annuity of the $1 million original cost of the
new machine.

 
1 1
$1mill = C −
0.10 0.10 · 1.1010
C = $162, 745
This means that the firm is indifferent between paying $1 million at the time the new machine is purchased or paying
$162,745 per year for 10 years.
When the existing machine wears out, you will replace it with a new one. This new machine will then be used for 10
years at which time it too will be replaced. In fact, a new machine will need to be purchased every 10 years.
The annual cost of new machines is $162,745. This perpetuity will begin in year 5 if the new product is not produced
or in year 4 if it is produced.
Don’t produce new product
t = ··· 3 4 5 6 ···
$1mill
162,745 162,745 · · ·
Produce new product
t = ··· 3 4 5 ···
$1mill
162,745 162,745 162,745 · · ·

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The effect of producing the new product is to move up by one year all future machine replacements. The cost of this
is $162,745 in year 4. This can be seen by looking at the difference in the above two annuity streams. Therefore, the
proper cost allocation is:

Cost of excess capacity use

$162, 745
= = $111, 157
1.104

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2 Market valuation
Exercise 11.
You are given the following prices Pt today for receiving risk free payments t periods from now.

t = 1 2 3
Pt = 0.95 0.9 0.95

There are traded securities that offer $1 at any future date, available at these prices.

1. How would you make a lot of money?

Solution to Exercise 11.

1. This data implies an arbitrage opportunity. Note that the price of the risk free security offering $1 in period 3 is
higher than the price of the risk free security offering $1 in period 2. What does this mean? It means you have
to pay less today for receiving money sooner! To make a lot of money, short the risk free security for period 3,
and use $0.9 of the $0.95 proceeds to buy the period 2 risk free security. The $1 you get in period 2 can be
kept as money and used to cover your obligation in period 3. For each of these transactions you get $0.05 now.
To get very rich, do a lot of these transactions.