CHAPTER 9

NET PRESENT VALUE AND OTHER

INVESTMENT CRITERIA
Solutions to Questions and Problems
! To calculate the payback period, we need to find the time that the project has
recovered its initial investment. After three years, the project has created:
$1,6 ! 1," ! #,$ % $&,'
in cash flows. The project still needs to create another:
$6,( ) &,' % $6
in cash flows. *urin+ the fourth year, the cash flows from the project will be $1,(.
,o, the payback period will be $ years, plus what we still need to make divided by
what we will make durin+ the fourth year. The payback period is:
-ayback % $ ! .$6 / $1,(0 % $.($ years
"! To calculate the payback period, we need to find the time that the project has
recovered its initial investment. The cash flows in this problem are an annuity, so the
calculation is simpler. 1f the initial cost is $#,(, the payback period is:
-ayback % $ ! .$1& / $26&0 % $.1( years
There is a shortcut to calculate the future cash flows are an annuity. 3ust divide the
initial cost by the annual cash flow. 4or the $#,( cost, the payback period is:
-ayback % $#,( / $26& % $.1( years
4or an initial cost of $$,6, the payback period is:
-ayback % $$,6 / $26& % (.21 years
The payback period for an initial cost of $6,& is a little trickier. 5otice that the
total cash inflows after ei+ht years will be:
Total cash inflows % '.$26&0 % $6,1#
1f the initial cost is $6,&, the project never pays back. 5otice that if you use the
shortcut for annuity cash flows, you +et:
-ayback % $6,& / $26& % '.& years
This answer does not make sense since the cash flows stop after ei+ht years, so
a+ain, we must conclude the payback period is never.
#! -roject A has cash flows of $1", in 6ear 1, so the cash flows are short by $#1,
of recapturin+ the initial investment, so the payback for -roject A is:
-ayback % 1 ! .$#1, / $#&,0 % 1.'( years
-roject 7 has cash flows of:
8ash flows % $1(, ! 12, ! #(, % $&&,
durin+ this first three years. The cash flows are still short by $&, of recapturin+
the initial investment, so the payback for -roject 7 is:
7: -ayback % $ ! .$&, / $#2,0 % $.1" years
9sin+ the payback criterion and a cutoff of $ years, accept project A and reject
project 7.
$! :hen we use discounted payback, we need to find the value of all cash flows today.
The value today of the project cash flows for the first four years is:
;alue today of 6ear 1 cash flow % $(,#/1.1( %
$$,6'(.#1
;alue today of 6ear # cash flow % $&,$/1.1(
#
% $(,2'.1'
;alue today of 6ear $ cash flow % $6,1/1.1(
$
% $(,112.$$
;alue today of 6ear ( cash flow % $2,(/1.1(
(
% $(,$'1.$"
To find the discounted payback, we use these values to find the payback period. The
discounted first year cash flow is $$,6'(.#1, so the discounted payback for a $2,
initial cost is:
*iscounted payback % 1 ! .$2, ) $,6'(.#10/$(,2'.1' % 1.'1 years
4or an initial cost of $1,, the discounted payback is:
*iscounted payback % # ! .$1, ) $,6'(.#1 ) (,2'.1'0/$(,112.$$ % #.&( years
5otice the calculation of discounted payback. :e know the payback period is
between two and three years, so we subtract the discounted values of the 6ear 1 and
6ear # cash flows from the initial cost. This is the numerator, which is the discounted
amount we still need to make to recover our initial investment. :e divide this
amount by the discounted amount we will earn in 6ear $ to +et the fractional portion
of the discounted payback.
1f the initial cost is $1$,, the discounted payback is:
*iscounted payback % $ ! .$1$, ) $,6'(.#1 ) (,2'.1' ) (,112.$$0 / $(,$'1.$" %
$.#6 years
%! < % =: $ ! .$#,1 / $(,$0 % $.(" years
discounted payback % re+ular payback % $.(" years
< % &=: $(,$/1.& ! $(,$/1.&
#
! $(,$/1.&
$
% $11,2"."2
$(,$/1.&
(
% $$,&$2.6#
discounted payback % $ ! .$1&, ) 11,2"."20 / $$,&$2.6# % $."$ years
< % 1"=: $(,$.-;14A
1"=,6
0 % $1(,66#.(
The project never pays back.
&! >ur definition of AA< is the avera+e net income divided by the avera+e book value.
The avera+e net income for this project is:
Avera+e net income % .$1,"$',# ! #,#1,6 ! 1,'26, ! 1,$#",&0 / ( %
$1,'$6,$#&
And the avera+e book value is:
Avera+e book value % .$1&,, ! 0 / # % $2,&,
,o, the AA< for this project is:
AA< % Avera+e net income / Avera+e book value % $1,'$6,$#& / $2,&, % .#(('
or #(.('=
'! The 1<< is the interest rate that makes the 5-; of the project e?ual to @ero. ,o, the
e?uation that defines the 1<< for this project is:
% ) $$(, ! $16,/.1!1<<0 ! $1',/.1!1<<0
#
! $1&,/.1!1<<0
$

9sin+ a spreadsheet, financial calculator, or trial and error to find the root of the
e?uation, we find that:
1<< % #."2=
,ince the 1<< is +reater than the re?uired return we would accept the project.
(! The 5-; of a project is the -; of the outflows minus the -; of the inflows. The
e?uation for the 5-; of this project at an 11 percent re?uired return is:
5-; % ) $$(, ! $16,/1.11 ! $1',/1.11
#
! $1&,/1.11
$
% $&,""1.("
At an 11 percent re?uired return, the 5-; is positive, so we would accept the
project.
The e?uation for the 5-; of the project at a $ percent re?uired return is:
5-; % ) $$(, ! $16,/1.$ ! $1',/1.$
#
! $1&,/1.$
$
% )$(,#1$."$
At a $ percent re?uired return, the 5-; is ne+ative, so we would reject the project.
)! The 5-; of a project is the -; of the outflows minus the -; of the inflows. ,ince
the cash inflows are an annuity, the e?uation for the 5-; of this project at an '
percent re?uired return is:
5-; % )$1$', ! $#',&.-;14A
'=, "
0 % $(,$6.$1
At an ' percent re?uired return, the 5-; is positive, so we would accept the project.
The e?uation for the 5-; of the project at a # percent re?uired return is:
5-; % )$1$', ! $#',&.-;14A
#=, "
0 % )$#$,112.(&
At a # percent re?uired return, the 5-; is ne+ative, so we would reject the project.
:e would be indifferent to the project if the re?uired return was e?ual to the 1<< of
the project, since at that re?uired return the 5-; is @ero. The 1<< of the project is:
% )$1$', ! $#',&.-;14A
1<<, "
0
1<< % 1(.&"=
*! The 1<< is the interest rate that makes the 5-; of the project e?ual to @ero. ,o, the
e?uation that defines the 1<< for this project is:
% )$1",& ! $",'/.1!1<<0 ! $1,$/.1!1<<0
#
! $',6/.1!1<<0
$

9sin+ a spreadsheet, financial calculator, or trial and error to find the root of the
e?uation, we find that:
1<< % ##.6(=
! The 5-; of a project is the -; of the outflows minus the -; of the inflows. At a
@ero discount rate .and only at a @ero discount rate0, the cash flows can be added
to+ether across time. ,o, the 5-; of the project at a @ero percent re?uired return is:
5-; % )$1",& ! ",' ! 1,$ ! ',6 % $",#
The 5-; at a 1 percent re?uired return is:
5-; % )$1",& ! $",'/1.1 ! $1,$/1.1
#
! $',6/1.1
$
% $(,$'#.2"
The 5-; at a # percent re?uired return is:
5-; % )$1",& ! $",'/1.# ! $1,$/1.#
#
! $',6/1.#
$
% $2"6.$
And the 5-; at a $ percent re?uired return is:
5-; % )$1",& ! $",'/1.$ ! $1,$/1.$
#
! $',6/1.$
$
% )$1,"&#.((

5otice that as the re?uired return increases, the 5-; of the project decreases. This
will always be true for projects with conventional cash flows. 8onventional cash
flows are ne+ative at the be+innin+ of the project and positive throu+hout the rest of
the project.
"! a. The 1<< is the interest rate that makes the 5-; of the project e?ual to @ero. The
e?uation for the 1<< of -roject A is:
% )$($, ! $#$,/.1!1<<0 ! $12,"/.1!1<<0
#
! $1#,(/.1!1<<0
$
! $",(/
.1!1<<0
(

9sin+ a spreadsheet, financial calculator, or trial and error to find the root of the
e?uation, we find that:
1<< % #.((=
The e?uation for the 1<< of -roject 7 is:
% )$($, ! $2,/.1!1<<0 ! $1$,'/.1!1<<0
#
! $#(,/.1!1<<0
$
! $#6,/
.1!1<<0
(
9sin+ a spreadsheet, financial calculator, or trial and error to find the root of the
e?uation, we find that:
1<< % 1'.'(=
ABaminin+ the 1<<s of the projects, we see that the 1<<
A
is +reater than the
1<<
7
, so 1<< decision rule implies acceptin+ project A. This may not be a
correct decisionC however, because the 1<< criterion has a rankin+ problem for
mutually eBclusive projects. To see if the 1<< decision rule is correct or not, we
need to evaluate the project 5-;s.
b. The 5-; of -roject A is:
5-;
A
% )$($, ! $#$,/1.11! $12,"/1.11
#
! $1#,(/1.11
$
!
$",(/1.11
(

5-;
A
% $2,&2.61
And the 5-; of -roject 7 is:
5-;
7
% )$($, ! $2,/1.11 ! $1$,'/1.11
#
! $#(,/1.11
$
!
$#6,/1.11
(

5-;
7
% $",1'#.#"
The 5-;
7
is +reater than the 5-;
A
, so we should accept -roject 7.
c. To find the crossover rate, we subtract the cash flows from one project from the
cash flows of the other project. Dere, we will subtract the cash flows for -roject
7 from the cash flows of -roject A. >nce we find these differential cash flows,
we find the 1<<. The e?uation for the crossover rate is:
8rossover rate: % $16,/.1!<0 ! $(,1/.1!<0
#
) $11,6/.1!<0
$
)
$16,6/.1!<0
(

9sin+ a spreadsheet, financial calculator, or trial and error to find the root of the
e?uation, we find that:
< % 1&.$=
At discount rates above 1&.$= choose project AC for discount rates below
1&.$= choose project 7C indifferent between A and 7 at a discount rate of
1&.$=.
#! The 1<< is the interest rate that makes the 5-; of the project e?ual to @ero. The
e?uation to calculate the 1<< of -roject E is:
% )$1&, ! $',1&/.1!1<<0 ! $&,&/.1!1<<0
#
! $6,'/.1!1<<0
$

9sin+ a spreadsheet, financial calculator, or trial and error to find the root of the
e?uation, we find that:
1<< % 16.&2=
4or -roject 6, the e?uation to find the 1<< is:
% )$1&, ! $2,2/.1!1<<0 ! $&,1&/.1!1<<0
#
! $2,#&/.1!1<<0
$

9sin+ a spreadsheet, financial calculator, or trial and error to find the root of the
e?uation, we find that:
1<< % 16.(&=
To find the crossover rate, we subtract the cash flows from one project from the cash
flows of the other project, and find the 1<< of the differential cash flows. :e will
subtract the cash flows from -roject 6 from the cash flows from -roject E. 1t is
irrelevant which cash flows we subtract from the other. ,ubtractin+ the cash flows,
the e?uation to calculate the 1<< for these differential cash flows is:
8rossover rate: % $(&/.1!<0 ) $1/.1!<0
#
) $(&/.1!<0
$

9sin+ a spreadsheet, financial calculator, or trial and error to find the root of the
e?uation, we find that:
< % 11.2$=
The table below shows the 5-; of each project for different re?uired returns. 5otice
that -roject 6 always has a hi+her 5-; for discount rates below 11.2$ percent, and
always has a lower 5-; for discount rates above 11.2$ percent.
< $5-;
E
$5-;
6
= $&,. $&,1.
&= $$,#16.& $$,#62.$6
1= $1,6"1.&" $1,2$.#$
1&= $$26.&" $$&6.2'
#= )$266.# )$'11.$(
#&= )$1,266.( )$1,'$#.
$! a. The e?uation for the 5-; of the project is:
5-; % )$(&,, ! $2',,/1.1 ) $1(,,/1.1
#
% $1$,('#,1(#.'6
The 5-; is +reater than , so we would accept the project.
b. The e?uation for the 1<< of the project is:
% )$(&,, ! $2',,/.1!1<<0 ) $1(,,/.1!1<<0
#

4rom *escartes rule of si+ns, we know there are potentially two 1<<s since the cash
flows chan+e si+ns twice. 4rom trial and error, the two 1<<s are:
1<< % &$.=, )2".62=
:hen there are multiple 1<<s, the 1<< decision rule is ambi+uous. 7oth 1<<s
are correct, that is, both interest rates make the 5-; of the project e?ual to @ero.
1f we are evaluatin+ whether or not to accept this project, we would not want to
use the 1<< to make our decision.
%! The profitability indeB is defined as the -; of the cash inflows divided by the -; of
the cash outflows. The e?uation for the profitability indeB at a re?uired return of 1
percent is:
-1 % F$2,$/1.1 ! $6,"/1.1
#
! $&,2/1.1
$
G / $1(, % 1.1'2
The e?uation for the profitability indeB at a re?uired return of 1& percent is:
-1 % F$2,$/1.1& ! $6,"/1.1&
#
! $&,2/1.1&
$
G / $1(, % 1."(
The e?uation for the profitability indeB at a re?uired return of ## percent is:
-1 % F$2,$/1.## ! $6,"/1.##
#
! $&,2/1.##
$
G / $1(, % ."'$
:e would accept the project if the re?uired return were 1 percent or 1& percent
since the -1 is +reater than one. :e would reject the project if the re?uired return
were ## percent since the -1 is less than one.
&! a. The profitability indeB is the -; of the future cash flows divided by the initial
investment. The cash flows for both projects are an annuity, so:
-1
1
% $#2,.-;14A
1=,$
0 / $&$, % 1.#62
-1
11
% $",1.-;14A
1=,$
0 / $16, % 1.(1(
The profitability indeB decision rule implies that we accept project 11, since -1
11
is +reater than the -1
1
.
b. The 5-; of each project is:
5-;
1
% )$&$, ! $#2,.-;14A
1=,$
0 % $1(,1(&.
5-;
11
% )$16, ! $",1.-;14A
1=,$
0 % $6,6$.$&
The 5-; decision rule implies acceptin+ -roject 1, since the 5-;
1
is +reater
than the 5-;
11
.
c. 9sin+ the profitability indeB to compare mutually eBclusive projects can be
ambi+uous when the ma+nitude of the cash flows for the two projects are of different
scale. 1n this problem, project 1 is rou+hly $ times as lar+e as project 11 and produces a
lar+er 5-;, yet the profitability indeB criterion implies that project 11 is more acceptable.