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Chaptert 10 HW Solutions
Chaptert 10 HW Solutions
Chaptert 10 HW Solutions
Solutions Manual
CHAPTER 10
The Fundamentals of Capital Budgeting
Why are capital investments considered the most important decisions made by a firms
management?
Capital investments are the most important decisions made by a firms management,
because they usually involve large cash outflows and once made are not easily reversed.
These are usually long-term projects that will define the firms line of business and
significantly contribute to the total revenue figure for years to come.
2.
What are the differences between capital projects that are independent, mutually exclusive,
and contingent?
A project is independent if the decision to accept or reject it does not affect the decision
to accept or reject another project. On the other hand, projects are mutually exclusive if
the acceptance of one implies rejection of the other. Contingent projects are those in
which the acceptance of one project is dependent on another project.
Section 10.2
1. What is the NPV of a project?
NPV is simply the difference between the present value of a projects expected future
cash flows and its cost. It is the recommended technique used to value capital
investments, as it takes into account both the timing of the cash flows and their risk.
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Solutions Manual
2. If a firm accepts a project with a $10,000 NPV, what is the effect on the value of the
firm?
If a firm accepts a project with a $10,000 NPV, it will increase its value by $10,000.
3.
Section 10.3
1. What is the payback period?
The payback period is defined as the number of years it takes to recover the projects
initial investment. All other things being equal, the project with the shortest payback
period is usually the optimal investment.
2. Why does the payback period provide a measure of a projects liquidity risk?
The payback period determines how quickly you recover your investment in a project.
Thus, it serves as a good measure of the projects liquidity.
3.
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Section 10.4
1.
What are the major shortcomings of using the ARR method as a capital budgeting
method?
The biggest shortcoming of using ARR as a capital budgeting tool is that it uses
historical, or book value data rather than cash flows and thus disregards the time value of
money principle. In addition, as in the payback method, it fails to establish a rationale
behind picking the appropriate hurdle rate.
Section 10.5
1.
2.
3.
Why should the NPV method be the primary decision tool used in making capital
investment decisions?
Given all the different methods to evaluate capital investment decisions, the NPV method
is the preferred valuation tool as it accounts for both time value of money and the
projects risk. Furthermore, NPV is not sensitive to nonconventional projects, and
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therefore it is superior to the IRR technique and it gives a measure of the value
increase/decrease to the firm by undertaking the project.
Section 10.6
1.
What decision criteria should managers use in selecting projects when there is not
enough money to invest in all available positive-NPV projects?
When a firm does not have enough money to invest in all available positive NPV
projects, managers should identify the bundle of positive NPV projects that creates the
greatest total value for stockholders.
2.
A firm might face capital constraints because it can be difficult for outside investors (new
creditors, bondholders, or stockholders) to accurately assess the risks and returns
associated with the firms projects. This might cause the investors to require returns for
their capital that are so high that they make positive-NPV projects unattractive, because
those projects cannot produce the high returns required by investors.
3.
How can the PI help in choosing projects when a firm faces capital constraints? What are
its limitations?
The basic principle is to select the projects that yield the largest NPV per dollar invested.
The PI tells us the NPV per dollar invested for an individual project. In a single
Copyright 2015 John Wiley & Sons, Inc.
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period, the PI can be used to identify the bundle of projects that yields the largest NPV
per dollar invested. However, as illustrated in Section 12.5, the PI will not necessarily
help identify the most valuable bundle of projects if investments are being compared
across more than one year and the timing of cash flows from early investments affects the
firms ability to make subsequent investments.
Section 10.7
1.
What changes have taken place in the capital budgeting techniques used by U.S.
companies?
Over the years, there has been a shift from using payback and ARR as the primary capital
budgeting tools to using NPV and IRR instead. Managers today understand the
importance of the time value of money and discounting and thus regard ARR as an
inaccurate and obsolete decision tool.
Self-Study Problems
10.1
Solution:
NPV for Otis Forklifts:
Copyright 2015 John Wiley & Sons, Inc.
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Solutions Manual
CFt
t
t 0 (1 k )
n
NPV
(1 0.12)1
(1.12) 2
(1.12) 3
$3,123,450 $874,308 $1,083,296 $1,502,922
$337,075
$3,123,450
NPV
(1 0.12)1
(1.12) 2
(1.12) 3
$4,137,410 $781,461 $1,407,229 $2,039,227
$90,606
$4,137,410
Premium should purchase the Otis forklift since it has a larger NPV.
10.2
Perryman Crafts Corp. management is evaluating two independent capital projects that
together will cost the company $250,000. The two projects will provide the following
cash flows:
Year
1
2
3
4
Project A
$80,750
$93,450
$40,325
$145,655
Project B
$32,450
$76,125
$153,250
$96,110
Which project will be chosen if the companys payback criterion is three years? What if the
company accepts all projects as long as the payback period is less than five years?
Solution:
Payback periods for Perryman projects A and B:
Copyright 2015 John Wiley & Sons, Inc.
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Solutions Manual
Project A
Cumulative
Year
0
1
2
3
4
Cash Flow
$(250,000)
80,750
93,450
40,235
145,655
Cash Flows
$(250,000)
(169,250)
(75,800)
(35,565)
110,090
Project B
Cumulative
Year
0
1
2
3
4
Cash Flow
$(250,000)
32,450
76,125
153,250
96,110
Cash Flows
$(250,000)
(217,550)
(141,425)
11,825
107,935
$35,565
$145,655 per year
3.24 years
= 3
$141, 425
$153, 250 per year
2.92 years
=2
If the payback period is three years, only project B will be chosen. If the payback criterion is
five years, both A and B will be chosen.
10.3
Terrell Corp. management is considering purchasing a machine that will cost $117,250 and
will be depreciated on a straight-line basis over a five-year period. The sales and expenses
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(excluding depreciation) for the next five years are shown in the following table. The
companys tax rate is 34 percent.
Year 1
Year 2
$176,875
$126,488
Year 3
Year 4
Year 5
The
company will accept all projects that provide an accounting rate of return (ARR) of at least
45 percent. Should the company accept this project?
Terrell will accept all projects that provide an accounting rate of return (ARR) of at least 45
percent. Should the company accept the project?
Solution:
Sales
Expenses
Depreciation
EBIT
Taxes (34%)
Net Income
Beginning Book Value
Less: Depreciation
Ending Book Value
Year 1
$123,450
Year 2
$176,87
Year 3
$242,455
Year 4
$255,440
Year 5
$267,125
137,410
23,450
$ (37,410)
12,719
$ (24,691)
117,250
(23,450)
$ 93,800
5
126,488
23,450
$ 26,937
9,159
$ 17,778
93,800
(23,450)
$ 70,350
141,289
23,450
$ 77,716
26,423
$ 51,293
70,350
(23,450)
$ 46,900
143,112
23,450
$ 88,878
30,219
$ 58,659
46,900
(23,450)
$ 23,450
133,556
23,450
$110,119
37,440
$ 72,679
23,450
(23,450)
$
0
= $35,143.6 / $58,625
= 0.599 or 59.9%
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Refer to Problem 9.1. Compute the IRR for each of the two systems. Is the investment
decision different from the one determined by NPV?
Solution:
IRR for two forklift systems:
Otis Forklifts:
First compute the IRR by the trial-and-error approach:
NPV (Otis) = $337,075 > 0
Use a higher discount rate to get NPV = 0!
At k = 15%,
$979, 225 $1, 358,886 $2,111, 497
(1 0.15)1
(1.15) 2
(1.15) 3
$3,123, 450 $851,500 $1,027,513 $1, 388, 344
$143, 907.
(1.15)1
(1.12) 2
(1.12) 3
$4,137, 410 $761,075 $1,334,764 $1,883,856
$157,715
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You are considering a project that has an initial outlay of $1 million. The profitability
index of the project is 2.24. What is the NPV of the project?
Solution:
You can use Equation 9.6 to solve for the NPV:
NPV Initial investment
Initial investment
NPV $1,000,000
2.24
$1,000,000
PI
Therefore:
NPV = $2,240,000
Discussion Questions
10.1
Explain why the cost of capital is referred to as the hurdle rate in capital
budgeting.
Solution
The cost of capital is the minimum required return on any new investment that allows a
firm to break even. Since we are using the cost of capital as a benchmark or hurdle to
Copyright 2015 John Wiley & Sons, Inc.
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compare the return earned by any project, it is sometimes referred to as the hurdle rate.
LO: 1
Level: Basic
10.2
a. Sykes, Inc. management is considering two projects: a plant expansion and a
new computer system for the firms production department. Classify these
projects as independent, mutually exclusive, or contingent projects and explain
your reasoning.
b. A company is building a new plant on the outskirts of Smallesville. The town has
offered to donate the land, and as part of the agreement, the company will have
to build an access road from the main highway to the plant. How will the project
of building the road be classified in the capital budgeting analysis?
c. Management of your firm is currently considering the upgrading of the
operating systems of all the firms computers. One alternative is to choose the
Linux operating system that a local computer services firm has offered to install
and maintain. Microsoft has also put in a bid to install the new Windows
operating system for businesses. How would these projects be classified?
Solution
a. These two projects are independent projects. Accepting or rejecting one will not
influence the decision on the other project. The cash flows of the two projects are
unrelated.
b. This is a contingent project. Acceptance of the road-building project is contingent
on the new plant being a financially viable project. If the new plant will not have
a positive value, then the firm will not even consider this project. However, this
projects cost will have to be considered along with the cost of building the new
Copyright 2015 John Wiley & Sons, Inc.
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Solution
Capital rationing implies that a firm does not have the resources necessary to fund all of
the available projects. In other words, funding needs exceed funding resources. Thus, the
available capital will be allocated to the projects that will benefit the firm and its
shareholders the most. Projects that create the largest increase in shareholder wealth will
be accepted until all the available resources have been allocated.
LO: 1
Level: Basic
10.4
Solution
When projects are mutually exclusive, acceptance of one project precludes the acceptance
of others. Typically, mutually exclusive projects perform the same function and so only
one of them needs to be accepted. A funding or resource constraint can also cause
projects to be mutually exclusive.
LO: 1
Level: Basic
10.5
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appropriate cost of capital is also 12 percent, did the firm make the right
decision. Explain.
b. What is the impact on the firm if it accepts a project with a negative NPV?
Solution
a. We would normally argue that a firm should only accept projects in which the
projects return exceeds the cost of capital. In other words, only if the net present
value exceeds zero should a project be accepted. But in reality, projects with a
zero NPV should also be accepted because the project earns a return that equals
the cost of capital. For some firms like the one above, this could be the situation
because they may not have projects that provide a return greater than the cost of
capital for the firm.
b. When a firm takes on positive NPV projects, the value of the firm increases. By
the same token, when a project undertaken has a negative NPV, the value of the
firm will decrease by the amount of the net present value.
LO: 2
Level: Basic
10.6
Solution
There are several critical weaknesses in the payback period approach of evaluating
capital projects.
The payback period ignores the time value of money by not discounting future
cash flows.
A firm may establish payback criteria with no economic basis for that decision
and thereby run the risk of losing out on good projects.
The method ignores cash flows beyond the payback period, thus leading to nonselection of projects that may produce cash flows well beyond the payback period
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or more cash flows than accepted projects. This leads to a bias against longer-term
projects.
LO: 3
Level: Basic
10.7
What are the strengths and weaknesses of the accounting rate of return approach?
Solution
The biggest advantage of Accounting Rate of Return (ARR) approach is that it is easy to
compute since accounting data is readily available, whereas estimating cash flows is
more difficult. However, the disadvantages outweigh this specific advantage. Similar to
the payback, it does not discount cash flows, but merely averages net income over time.
No economic rationale is used in establishing an ARR cutoff rate. Finally, the ARR uses
net income to evaluate the project and not cash flows or market data. This is a serious
flaw in this approach.
LO: 4
Level: Basic
10.8
Under what circumstances might the IRR and NPV approaches produce conflicting
results?
Solution
IRR and the NPV methods of evaluating capital investment projects might produce
dissimilar results under two circumstances. First, if the projects cash flows are not
conventionalthat is, if the sign of the cash flow changes more than once during the life
of a projectthen multiple IRRs can be obtained as solutions. We would be unable to
identify the correct IRR for decision making. (See Learning by Doing Application 10.3.)
The second situation occurs when two or more projects are mutually exclusive. The
project with the highest IRR may not necessarily be the one with the highest NPV and
thereby be the right choice. There is an important reason for this. IRR assumes that all
cash flows received during the life of a project are reinvested at the IRR, whereas the
Copyright 2015 John Wiley & Sons, Inc.
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NPV method assumes that they are reinvested at the cost of capital. Since the cost of
capital is the better proxy for opportunity cost, NPV uses the better proxy, while the IRR
may use an unrealistically higher rate as proxy.
LO: 5
Level: Intermediate
10.9
The modified IRR (MIRR) alleviates two concerns with using the IRR method for
evaluating capital investments. What are they?
Solution
IRR assumes that the cash flows from a project are reinvested at the projects IRR, while
the NPV assumes that they are invested at the firms cost of capital. The NPV
assumption is correct more often than not. The MIRR assumes that each operating cash
flow is reinvested at the firms cost of capital.
The second appeal of MIRR is that under this method all of the compounded operating
cash flow values are summed up to get the projects terminal value. Since most projects
generate positive total net operating cash flows, MIRR does not suffer from issues
associated with unconventional cash flows.
LO: 5
Level: Basic
10.10 Elkridge Construction Company has an overall (composite) cost of capital of 12
percent. This cost of capital reflects the cost of capital for an Elkridge Construction
project with average risk. However, the firm takes on projects of various risk levels. The
companys experience suggests that low-risk projects have a cost of capital of 10 percent
and high-risk projects have a cost of capital of 15 percent. Which of the following
projects should the company not select to maximize shareholder wealth?
SM 10-15
Project
1. Single-family homes
2. Multifamily residential
3. Commercial
4. Single-family homes
5. Commercial
Solutions Manual
Expected Return
13%
12
18
9
13
Risk
Low
Average
High
Low
High
Solution
Project
1. Single-family homes
2. Multifamily residential
3. Commercial
4. Single-family homes
5. Commercial
LO: 2
Risk
Low
Average
High
Low
High
Required
Expected
Return
10%
12
15
10
15
Return
13%
12
18
9
13
Decision
Accept
Accept / Indifferent
Accept
Reject
Reject
Level: Basic
10.11 High Tech Monopoly Co. has plenty of cash to fund any conceivable positive NPV
project. Can you describe a situation in which capital rationing could still occur?
Solution:
Financial capital is not the only constrainable item within the firm. This might occur, for
example, when human capital is in short supply, as is the case with most high-technology
firms. Even if every positive NPV project could be funded, the firm might not have
enough employees to manage the projects. Therefore, even with ample financial capital,
firms will more than likely still be rationing projects.
LO: 6
Level: Basic
10.12 The profitability index is a tool for measuring a projects benefits relative to its
costs. How might this help to eliminate bias in project selection?
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Solution:
Since the profitability index is a modified pure-return-type measure, it offers a method to
maximize the use of capital that is employed by the firm. This could help eliminate some
types of bias if the measure were to be employed universally. However, it does not
necessarily maximize the use of capital that is not employed, which could in some
circumstances be problematic.
LO: 6
Level: Basic
Net present value: Riggs Corp. management is planning to spend $650,000 on a newmarketing campaign. They believe that this action will result in additional cash flows of
$325,000 over the next three years. If the discount rate is 17.5 percent, what is the NPV
on this project?
Solution:
Initial investment = $650,000
Annual cash flows = $325,000
Length of project = n = 3 years
Required rate of return = k = 17.5%
Net present value = NPV
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NCFt
$325,000 $325,000 $325,000
$650,000
t
(1.175)1
(1.175) 2
(1.175)3
t 0 (1 k )
$650,000 276,596 $235,401 $200,341
$62,337
n
NPV
LO 2
10.2
Net present value: Kingston, Inc. management is considering purchasing a new machine
at a cost of $4,133,250. They expect this equipment to produce cash flows of $814,322,
$863,275, $937,250, $1,017,112, $1,212,960, and $1,225,000 over the next six years. If
the appropriate discount rate is 15 percent, what is the NPV of this investment?
Solution:
Cost of new machine = $4,133,250
Length of project = n = 6 years
Required rate of return = k = 15%
n
NPV
t 0
NCFt
(1 k ) t
(1.15)1
(1.15) 2
(1.15) 3
(1.15) 4
(1.15) 5
(1.15) 6
$4,133,250 $708,106 $652,760 $616257 $581,537 $603,055 $529,601
$4,133,250
$441,933
LO 2
10.3
Net present value: Crescent Industries management is planning to replace some existing
machinery in its plant. The cost of the new equipment and the resulting cash flows are
shown in the accompanying table. If the firm uses an 18 percent discount rate for projects
like this, should management go ahead with the project?
Year
0
1
2
3
Cash Flow
$3,300,000
875,123
966,222
1,145,000
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1,250,399
1,504,445
Solution:
Initial investment = $3,300,000
Length of project = n = 5 years
Required rate of return = k = 18%
NCFt
t
t 0 (1 k )
n
NPV
(1.18)1
(1.18) 2
(1.18) 3
(1.18) 4
(1.18)5
$3,300,000 $741,630 $693,926 $696,882 $644,942 $657,607
$134,986
$3,300,000
Since the NPV is positive, the firm should accept the project.
LO 2
10.4
Solution:
Initial investment = $312,500
Annual cash flows = $121,450
Length of project = n = 7 years
Required rate of return = k = 14%
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NCFt
t
t 0 (1 k )
n
NPV
(1.14)1
(1.14) 2
(1.14)3
(1.14) 4
(1.14)5
$121,450 $121,450
(1.14) 6
(1.14) 7
$312,500 $106,535 $93,452 $81,975 $71,908 $63,077 $55,331 $48,536
$208,315
$312,500
LO 2
10.5
System 1
-15,000
15,000
15,000
15,000
System 2
-45,000
32,000
32,000
32,000
Solution
The NPV of System 1 is $22,969.42 and the NPV of System 2 is $36,001.43. Since the
NPV of the System 2 is larger than the NPV for System 1, and the investments are
mutually exclusive, the firm should take System 2.
LO 2
10.6
Payback: Refer to problem 10.5. What are the payback periods for Production Systems
1 and 2? If the systems are mutually exclusive and the firm always chooses projects with
the lowest payback period, in which system should the firm invest?
Solution
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System 1 has a payback of exactly one year. System 2 has a payback of 1.41 years.
Given the shorter payback period for system 1, the investment should be made in System
1 based on the payback criteria.
LO 3
10.7
Solution:
Cumulative
Year
CF
Cash Flow
0
$(3,768,966) $(3,768,966)
1
979,225
(2,789,741)
2
1,158,886
(1,630,855)
3
1,881,497
250,642
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 2 + ($1,630,855 / $1,881,497) = 2.87 years
LO 3
10.8
Solution:
Cumulative
Year
0
1
2
3
Copyright 2015 John Wiley & Sons, Inc.
CF
$(1,645,276)
212,455
292,333
387,479
Cash Flow
$(1,645,276)
(1,432,821)
(1,140,488)
(753,009)
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5
6
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516,345
645,766
618,325
(236,664)
409,102
1,027,427
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($236,664 / $645,766)
= 4.37 years
LO 3
10.9
Solution:
Cumulative
Year
0
1
2
3
4
CF
$(1,875,000)
586,212
713,277
431,199
318,697
Cash Flow
$(1,875,000)
(1,288,788)
(575,511)
(144,312)
174,385
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 3 + ($144,312 / $318,697)
= 3.45 years
LO
3
10.10 Average accounting rate of return (ARR): Capitol Corp. management is expecting a
project to generate after-tax income of $63,435 in each of the next three years. The
average book value of the projects equipment over that period will be $212,500. If the
firms investment decision on any project is based on an ARR of 37.5 percent, should this
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project be accepted?
Solution:
Annual after-tax income = $63,435
Average after-tax income = ($63,435 +$63,435 + $63,435) / 3 = $63,435
Average book value of equipment = $212,500
Average after - tax income
Average book value
$63,435
29.9%
$212,500
Since the projects ARR is below the acceptance rate of 37.5 percent, the project should be
rejected.
LO 4
10.11 Internal rate of return: Refer to Problem 10.4. What is the IRR that Franklin Mints
management can expect on this project?
Solution:
Initial investment = $312,500
Annual cash flows = $121,450
Length of project = n = 7 years
Required rate of return = k = 14%
To determine the IRR, a trial-and-error approach can be used. Set NPV = 0.
Since the project had a positive NPV of $208,315, try IRR > k.
Try IRR = 25%.
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NCFt
t
t 0 (1 IRR )
n
NPV 0
1
1 (1.25) 7
0 $312,500 $121,450
0.25
NCFt
t
t 0 (1 IRR )
n
NPV 0
1
1 (1.34) 7
0 $312,500 $121,450
0.34
NPV 0
1
1 (1.338) 7
0 $312,500 $121,450
0.338
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project? If the appropriate cost of capital is 12 percent, should Hathaway go ahead with
this project?
Solution:
Initial investment = $7,800,000
Annual cash flows = $1,800,000
Length of project = n = 6 years
Required rate of return = k = 12%
To determine the IRR, a trial-and-error approach can be used. Set NPV = 0.
Try IRR = 12%.
NCFt
t
t 0 (1 IRR )
n
NPV 0
1
1
(1.12) 6
0 $7,800,000 $1,800,000
0.12
NPV 0
1
1 (1.10) 6
0 $7,800,000 $1,800,000
0.10
NPV 0
1
1 (1.102) 6
0 $7,800,000 $1,800,000
0.102
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NPV 0
t 0
NCFt
(1 IRR ) t
1
1 (1.1015) 6
0 $7,800,000 $1,800,000
0.1015
10.13 Profitability index: What is the profitability index, and why is it helpful in the capital
rationing process?
Solution:
The profitability index is computed as the ratio of NPV plus initial investment divided by
initial investment. In the capital rationing process, we can calculate the profitability index
for each potential investment and choose the projects with the largest indexes until we
run out of capital. This follows the basic principle that we need to choose the set of
projects that creates the greatest value given the limited capital available.
LO 6
INTERMEDIATE
10.14 Net present value: Champlain Corp. management is investigating two computer
systems. The Alpha 8300 costs $3,122,300 and will generate cost savings of $1,345,500
in each of the next five years. The Beta 2100 system costs $3,750,000 and will produce
Copyright 2015 John Wiley & Sons, Inc.
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cost savings of $1,125,000 in the first three years and then $2 million for the next two
years. If the companys discount rate for similar projects is 14 percent, what is the NPV
for the two systems? Which one should be chosen based on the NPV?
Solution:
Cost of Alpha 8300 = $3,122,300
Annual cost savings = $1,345,500
Length of project = n = 5 years
Required rate of return = k = 14%
1
1
NCFt
(1.14) 5
NPV
$
3
,
122
,
300
$
1
,
345
,
500
t
0.14
t 0 (1 k )
$3,122,300 $4,619,210
$1,496,910
Cost of Beta 2100 = $3,750,000
Length of project = n = 5 years
Required rate of return = k = 14%
1
1
NCFt
(1.14) 3
NPV
$
3
,
750
,
000
$
1
,
125
,
500
t
0.14
t 0 (1 k )
$2,000,000 $2,000,000
(1.14) 4
(1.14) 5
SM 10-27
Solutions Manual
Year
1
2
3
4
5
Cash Flow
$512,496
(242,637)
814,558
887,225
712,642
Solution:
Cost of equipment = $1,968,450
Length of project = n = 5 years
Required rate of return = k = 15.9%
n
NPV
t 0
NCFt
(1 k ) t
(1.159)1
(1.159) 2
(1.159) 3
(1.159) 4
(1.159) 5
$1,968,450 $442,188 $180,630 $523,205 491,700 340,764
$1,968,450
$351,223
LO 2
10.16 Net present value: Cranjet Industries is expanding its product line and its production
capacity. The costs and expected cash flows of the two independent projects are given in
the following table. The firm uses a discount rate of 16.4 percent for such projects.
a.
Year
0
1
2
3
4
5
Product Line
Production Capacity
Expansion
$(2,575,000)
600,000
875,000
875,000
875,000
875,000
Expansion
$(8,137,250)
2,500,000
2,500,000
2,500,000
3,250,000
3,250,000
Solution:
Copyright 2015 John Wiley & Sons, Inc.
SM 10-28
a.
Solutions Manual
NPV
t 0
NCFt
(1 k ) t
(1.164)1
(1.164) 2
(1.164) 3
(1.164) 4
(1.164) 5
$2,575,000 $515,464 $645,806 $554,816 476,646 409,490
$27,222
$2,575,000
NPV
0.164
(1.164) 4
(1.164) 5
Since they are independent, and both have NPV > 0, both projects should be
accepted.
LO 2
10.17 Net present value: Emporia Mills management is evaluating two alternative heating
systems. Costs and projected energy savings are given in the following table. The firm
uses 11.5 percent to discount such project cash flows. Which system should be chosen?
Year
0
1
2
3
4
System 100
$(1,750,000)
275,223
512,445
648,997
875,000
System 200
$(1,735,000)
750,000
612,500
550,112
384,226
SM 10-29
Solutions Manual
Solution:
Required rate of return = k = 11.5%
System 100:
Cost of System 100 = $1,750,000
NCFt
$275,223 $512,445 $648,997 $875,000
$1,750,000
t
(1.115)1
(1.115) 2
(1.115) 3
(1.115) 4
t 0 (1 k )
$1,750,000 $246,837 $412,190 $468,186 566,120
$56,667
n
NPV
System 200:
Cost of System 200 = $1,735,000
NCFt
$750,000 $612,500 $550,112 $384,226
$1,735,000
t
(1.115)1
(1.115) 2
(1.115) 3
(1.115) 4
t 0 (1 k )
$1,735,000 $672,646 $492,670 $396,850 248,592
$75,758
n
NPV
Since System 200 has a positive NPV, select that system. Reject System 100 as it has
negative NPV.
LO 2
10.18 Payback: Creative Solutions, Inc., has just invested $4,615,300 in new equipment. The
firm uses a payback period criteria of not accepting any project that takes more than four
years to recover its costs. Management anticipates cash flows of $644,386, $812,178,
$943,279, $1,364,997, $2,616,300, and $2,225,375 over the next six years. Does this
investment meet the firms payback criteria?
Solution:
Cumulative
Year
0
1
2
3
Copyright 2015 John Wiley & Sons, Inc.
CF
$(4,615,300)
644,386
812,178
943,279
Cash Flow
$(4,615,300)
(3,970,914)
(3,158,736)
(2,215,457)
SM 10-30
Solutions Manual
4
5
6
1,364,997
2,616,300
2,225,375
(850,460)
1,765,840
3,991,215
$850, 460
$2,616,300
4.33 years
=4
Since the project payback period exceeds the firms target of four years, it should not
have been accepted.
LO 3
10.19 Discounted payback: Timeline Manufacturing Co. management is evaluating two
projects. The company uses payback criteria of three years or less. Project A has a cost of
$912,855, and project Bs cost is $1,175,000. Cash flows from both projects are given in
the following table. What are their discounted payback periods, and which will be
accepted with a discount rate of 8 percent?
Year
1
2
3
4
Project A
$ 86,212
313,562
427,594
285,552
Project B
$586,212
413,277
231,199
Solution:
Project A
Cumulativ
Year
0
1
2
3
4
CF
$(912,855)
86,212
313,562
427,594
285,552
e CF
$(912,855)
(826,643)
(513,081)
(85,487)
200,065
Cumulative
PVCF
$(912,855)
79,826
268,829
339,438
209,889
PVCF
$(912,855)
(833,029)
(564,200)
(224,762)
(14,873)
Cumulative
SM 10-31
Year
0
1
2
3
Solutions Manual
CF
$(1,175,000)
CF
$(1,175,000
PVCF
$(1,175,000)
PVCF
$(1,175,000)
586,212
413,277
231,199
)
(588,788)
(175,511)
55,688
542,789
354,318
183,533
(632,211)
(277,893)
(94,359)
10.20 Payback: Regent Corp. management is evaluating three competing types of equipment.
Costs and cash flow projections for all three are given in the following table. Which
would be the best choice based on payback period?
Year
0
1
2
3
4
5
6
Type 1
$(1,311,450)
212,566
269,825
455,112
285,552
121,396
Type 2
$(1,415,888)
586,212
413,277
331,199
141,442
Type 3
$(1,612,856)
786,212
175,000
175,000
175,000
175,000
175,000
Solution:
Type 1
Cumulativ
Type 2
Cumulativ
Type 3
Cumulative
Year
CF
e CF
CF
e CF
CF
CF
0
1
2
3
4
5
6
$(1,311,450)
212,566
269,825
455,112
285,552
121,396
$(1,311,450)
(1,098,884)
(829,059)
(373,947)
(88,395)
33,001
$(1,415,888)
586,212
413,277
331,199
141,442
$(1,415,888)
(829,676)
(416,399)
(85,200)
56,242
$(1,612,856)
786,212
175,000
175,000
175,000
175,000
175,000
($1,612,856)
(826,644)
(651,644)
(476,644)
(301,644)
(126,644)
48,356
Type 1:
SM 10-32
Solutions Manual
$88,395
$121,396
4.73 years
=4
Type 2:
Payback period = Years before cost recovery +
$85, 200
$141, 442
3.6 years
= 3
Type 3:
Payback period = Years before cost recovery +
$126,644
$175,000
5.72 years
= 5
Cash flows
1
$2,265,433
Years
2
$4,558,721
3
$3,378,911
47
$1,250,000
Solution:
Discount rate = k = 10%
Cumulative
Copyright 2015 John Wiley & Sons, Inc.
Cumulative
SM 10-33
Year
0
Solutions Manual
CF
$(9,365,000)
CF
$(9,365,000
PVCF
$(9,365,000)
PVCF
$(9,365,000)
2,265,433
4,558,721
3,378,911
1,250,000
1,250,000
1,250,000
1,250,000
)
(7,099,567)
(2,540,846)
838,065
2,088,065
3,338,065
4,588,065
5,838,065
2,059,485
3,767,538
2,538,626
853,767
776,152
705,592
641,448
(7,305,515)
(3,537,977)
(999,352)
(145,585)
630,567
1,336,159
1,977,607
1
2
3
4
5
6
7
Discounted PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during
the year)
= 4 + ($145,585 / $776,152)
= 4.19 years
LO 3
10.22 Modified internal rate of return (MIRR): Morningside Bakeries recently purchased
equipment at a cost of $650,000. Management expects the equipment to generate cash flows
of $275,000 in each of the next four years. The cost of capital is 14 percent. What is the
MIRR for this project?
Solution:
PV of costs = $650,000
Length of project = n = 4 years
Cost of capital = k = 14%
Annual cash flows = CFt = $275,000
TV CF1 (1 k ) n 1 CF2 (1 k ) n 2 CFn (1 k ) n n
$275,000(1.14)3 $275,000(1.14) 2 $275,000(1.14)1 $275,000(1.14) 0
$407,425 $357,390 $313,500 $275,000 $1,353,315
Now we can solve for the MIRR using Equation 9.5.
SM 10-34
Solutions Manual
TV
(1 MIRR ) t
$1,353,315
$650,000
(1 MIRR ) 4
$1,353,315
(1 MIRR ) 4
2.0820
$650,000
PVCosts
LO 5
10.23 Modified internal rate of return (MIRR): Management of Sycamore Home Furnishings is
considering acquiring a new machine that can create customized window treatments. The
equipment will cost $263,400 and will generate cash flows of $85,000 over each of the next
six years. If the cost of capital is 12 percent, what is the MIRR on this project?
Solution:
PV of costs = $263,400
Length of project = n = 6 years
Cost of capital = k = 12%
Annual cash flows = CFt = $85,000
TV CF1 (1 k ) n 1 CF2 (1 k ) n 2 CFn (1 k ) n n
$85,000(1.12)5 $85,000(1.12) 4 $85,000(1.12)3 $85,000(1.12) 2
$85,000(1.12)1 $85,000(1.12)0
$149,799 $133,749 $119,419 $106,624 $95,200 $85,000
$689,791
Now we can solve for the MIRR using Equation 9.5.
SM 10-35
Solutions Manual
TV
(1 MIRR) t
$689,791
$263, 400
(1 MIRR)6
$689,791
(1 MIRR)6
2.6188
$263, 400
PVCosts
Cash Flow
$23,500,000
$72,000,000
$80,000,000
Years
14
57
810
Cash Flow
$23,500,000
$72,000,000
$80,000,000
Solution:
Initial investment =
Length of project =
$161,000,000
n = 10 years
SM 10-36
Solutions Manual
NCFt
t
t 0 (1 IRR )
n
NPV 0
1
1 (1.22) 4
0 $161,000,000 $23,500,000
0.22
1
1 (1.22) 3
1
$72,000,000
0.22 (1.22) 4
1
1 (1.22) 3
1
$80,000,000
0.22 (1.22) 7
NPV 0
1
1 (1.23) 4
0 $161,000,000 $23,500,000
0.23
1
1 (1.23) 3
1
$72,000,000
0.23 (1.23) 4
1
1 (1.23) 3
1
$80,000,000
0.23 (1.23) 7
NCFt
t
t 0 (1 IRR )
n
NPV 0
1
1 (1.227) 4
0 $161,000,000 $23,500,000
0.227
1 (1.227) 3
1
$72,000,000
0.227 (1.227) 4
1 (1.227) 3
1
$80,000,000
0.227 (1.227) 7
SM 10-37
Solutions Manual
The IRR of the project is between 22 and 23 percent. Using a financial calculator, we find
that the IRR is 22.65 percent.
LO 5
10.25 Internal rate of return: Refer to problem 10.5. Compute the IRR for both production
System 1 and production System 2. Which has the higher IRR? Which production
system has the higher NVP? Explain why the IRR and NPV rankings of Systems 1 and 2
are different?
Solution
The IRR of system 1 is 83.93 percent and the IRR of system 2 is 50.07 percent. The
NPV of system 1 is $22,969.42 and the NPV of system 2 is $36,001.43. System 1
delivers a higher IRR because it requires a lower initial investment and the cost is
recovered the first year. Thus, even with lower cash inflows in the years after startup,
system 1is able to deliver a higher return on the initial investment. System 2 has a higher
initial investment but delivers a higher net cash flow for the firm.
LO 5
Golf Belts
-$1,000
1,000
500
Golf Hats
-$500
500
300
SM 10-38
Solutions Manual
500
300
NPV
IRR
$697.97
54%
$427.87
61%
Solution
The IRRs and NPVs of the belt and hat lines disagree because of the differences in the
scale of the project. Golf hats deliver a higher IRR because they require a lower initial
investment. Thus, even with lower cash inflows in the years after startup, the golf hat
project is able to deliver a higher return on the initial investment. While the golf belts
project does cost more, it delivers a higher net cash flow for Ancalas investors. This
NPV factors in the initial cost of the project, and reflects the total net cash flow for the
firms shareholders.
The CFOs decision to choose the golf belts project is the right choice because it yields
the higher net cash flows for Ancalas investors.
LO 5
10.27 Internal rate of return: Compute the IRR on the following cash flow streams:
a.
b.
c.
LO 5
Solution:
a.
SM 10-39
Solutions Manual
NCFt
t
t 0 (1 IRR )
$37,450
0 $25,000
(1.07) 6
$25,000 $24,955 $45
NPV 0
NPV 0
The IRR of the project is approximately 6.97 percent. Using a financial calculator,
we find that the IRR is 6.968 percent.
b.
NCFt
t
t 0 (1 IRR )
$1,650,000
0 $1,000,000
(1.12) 4
$1,000,000 $1,048,605 $48,605
NPV 0
NPV 0
NCFt
t
t 0 (1 IRR )
$1,650,000
0 $1,000,000
(1.133) 4
$1,000,000 $1,001,300 $1,300
NPV 0
SM 10-40
Solutions Manual
The IRR of the project is approximately 13.3 percent. Using a financial calculator,
we find that the IRR is 13.337 percent.
c.
NCFt
t
t 0 (1 IRR )
$1,650,000 $1,250,000
0 $2,000,000
(1.15) 2
(1.15) 4
$2,000,000 $1,247,637 $714,692 $37,671
NPV 0
(1.14) 2
(1.14) 4
$2,000,000 $1,269,621 $740,100 $9,721
n
NPV 0
The IRR of the project is between 14 and 15 percent. Using a financial calculator,
we find that the IRR is 14.202 percent.
10.28 Internal rate of return: Compute the IRR for the following project cash flows:
a.
An initial outlay of $3,125,000 followed by annual cash flows of $565,325 for the
next eight years.
b.
An initial investment of $33,750 followed by annual cash flows of $9,430 for the
next five years.
c.
An initial outlay of $10,000 followed by annual cash flows of $2,500 for the next
seven years.
Solution:
a.
SM 10-41
Solutions Manual
1
1
NCFt
(1.08) 8
NPV
$
3
,
125
,
000
$
565
,
325
t
0.08
t 0 (1 k )
$3,125,000 $3,248,719
$123,719
Try a higher rate, IRR = 9%.
1
1
NCFt
(1.09) 8
NPV
$
3
,
125
,
000
$
565
,
325
t
0.09
t 0 (1 k )
$3,125,000 $3,128,972
$3,972
The IRR of the project is approximately 9 percent. Using a financial calculator,
we find that the IRR is 9.034 percent.
b.
1
1
NCFt
(1.12) 5
NPV
$
33
,
750
$
9
,
430
t
0.12
t 0 (1 k )
$33,750 $33,993
$243
Try IRR = 12.3%.
SM 10-42
Solutions Manual
1
1
NCFt
(1.123) 5
NPV
$
33
,
750
$
9
,
430
t
0.123
t 0 (1 k )
$33,750 $33742
$8 0
The IRR of the project is approximately 12.3 percent. Using a financial calculator,
we find that the IRR is 12.29 percent.
c.
1
1
NCFt
(1.16) 7
NPV
$
10
,
000
$
2
,
500
t
0.16
t 0 (1 k )
$10,000 $10,096
$96
Try IRR = 16.3%.
1
1
NCFt
(1.163) 7
NPV
$10,000 $2,500
t
0.163
t 0 (1 k )
$10,000 $10,008
$8 0
The IRR of the project is approximately 16.3 percent. Using a financial calculator,
we find that the IRR is 16.327 percent.
LO 5
SM 10-43
9.29
Solutions Manual
Profitability index: Suppose that you could invest in the following projects but have only
$30,000 to invest. How would you make your decision and in which projects would you
invest?
Project
Cost
NPV
$ 8,000
$4,000
11,000
7,000
9,000
5,000
7,000
4,000
Solution:
One would compute the Profitability index for each of the projects as follows:
PI
NPV+Initial investment
Initial investment
PI A
PI B
PI C
$5,000 $9,000
1.56
$9,000
PI D
With $30,000, you should invest in B, D, and C. The total cost is $27,000, and the total
NPV is $16,000.
LO 6
Copyright 2015 John Wiley & Sons, Inc.
SM 10-44
Solutions Manual
10.30 Profitability index: Suppose that you could invest in the same projects as in the previous
problem, but have only $25,000 to invest. Which projects would you chose?
Solution:
The profitability indexes of the projects are:
A: 1.50; B: 1.64; C: 1.56; D: 1.57
With $25,000, you cannot invest in all of B, D, and C, since the total cost is $27,000. You
may think that you should then invest in only B and D, since they have the highest
profitability indexes. This will yield a total NPV of $11,000, and you are left with $7,000
of idle capital.
If you give up project B, however, which has the highest profitability index and
highest cost, and invest instead in A, C, and D, which require less capital, you will get a
total NPV of $13,000, and you are left with less idle capital ($1,000). From this example
you can see that capital rationing with indivisible projects are sometimes complicated and
require a careful thought of all possibilities (or linear/integer programming).
LO 6
ADVANCED
10.31 Management of Draconian Measures, Inc., is evaluating two independent projects. The
company uses a 13.8 percent discount rate for such projects. The costs and cash flows for
the projects are shown in the following table. What are their NPVs?
Year
Copyright 2015 John Wiley & Sons, Inc.
Project 1
Project 2
SM 10-45
0
1
2
3
4
5
6
7
$(8,425,375)
3,225,997
1,775,882
1,375,112
1,176,558
1,212,645
1,582,156
1,365,882
Solutions Manual
$(11,368,000)
2,112,589
3,787,552
3,125,650
4,115,899
4,556,424
Solution:
Project 1:
Cost of Project 1 = $8,425,375
Length of project = n = 7 years
Required rate of return = k = 13.8%
n
NPV
t 0
NCFt
(1 k ) t
(1.138)1
(1.138) 2
(1.138) 3
(1.138) 4
(1.138) 5
$1,582,156 $1,365,882
(1.138) 6
(1.138) 7
$8,425,375 $2,834,795 $1,371,291 $933,064 701,527 $635,364 $728,443
$8,425,375
$552,608
$668,283
NPV
t 0
NCFt
(1 k ) t
(1.138)1
(1.138) 2
(1.138) 3
(1.138) 4
(1.138) 5
$11,368,000 $1,856,405 $2,924,651 $2,120,868 $2,454,119 $2,387,332
$11,368,000
$375,375
SM 10-46
Solutions Manual
LO 2
b.
Does the IRR criterion suggest a different decision than the NPV criterion?
c.
Explain how you would expect the management of Draconian Measures to decide
which project(s) to invest in.
Solution:
a.
Project 1:
At the required rate of return of 13.8 percent, Project 1 has a NPV of $(668,283).
To find the IRR, try lower rates.
Try IRR = 11%.
n
NPV
t 0
NCFt
(1 k ) t
(1.11)1
(1.11) 2
(1.11) 3
(1.11) 4
(1.11) 5
$1,582,156 $1,365,882
(1.11) 6
(1.11) 7
$8,425,375 $2,906,304 $1,441,346 $1,005,470 $775,035 $719,646
$8,425,375
$845,885 $657,889
$73,801
NPV
t 0
NCFt
(1 k ) t
(1.107)1
(1.107) 2
(1.107) 3
(1.107) 4
(1.107) 5
$1,582,156 $1,365,882
(1.107) 6
(1.107) 7
$8,425,375 $2,914,180 $1,449,168 $1,013,667 $783,471 $729,450
$8,425,375
$859,733 $670,471
$5,235
Copyright 2015 John Wiley & Sons, Inc.
SM 10-47
Solutions Manual
The IRR of the project is approximately 10.7 percent. Using a financial calculator,
we find that the IRR is 10.677 percent.
Project 2:
At the required rate of return of 13.8 percent, Project 2 has a NPV of $ 375,375.
To find the IRR, try higher rates.
Try IRR = 15%.
NCFt
t
t 0 (1 IRR )
$2,112,589 $3,787,552 $3,125,650 $4,115,899 $4,556,424
0 $11,368,000
(1.15)1
(1.15) 2
(1.15) 3
(1.15) 4
(1.15) 5
$11,368,000 $1,837 ,034 $2 ,863,933 $ 2,055,166 $ 2 ,353,279 $ 2 ,265,348
n
NPV 0
$6,760
(1.151)1
(1.151) 2
(1.151) 3
(1.151) 4
(1.151) 5
$11,368,000 $1,835,438 $2 ,858,959 $ 2 ,049 ,814 $2,345,111 $ 2 ,255,524
n
NPV 0
$23,154
The IRR of the project is between 15 and 15.1 percent. Using a financial
calculator, we find that the IRR is 15.023 percent.
b.
Based on the IRR, Project 1 will be rejected and Project 2 will be accepted. These
decisions are identical to those based on NPV. (Given that Project 1 had a
negative NPV, the IRR will always be less than the required rate of return 13.8%.)
c.
Management would use the decision spelled out by NPV, although in this case the
IRR has come up with the same decision.
LO 5
SM 10-48
Solutions Manual
10.33 Management of Dravid, Inc., is currently evaluating three projects that are independent.
The cost of funds can be either 13.6 percent or 14.8 percent depending on their financing
plan. All three projects cost the same at $500,000. Expected cash flow streams are shown
in the following table. Which projects would be accepted at a discount rate of 14.8
percent? What if the discount rate was 13.6 percent?
Year
1
2
3
4
Project 1
$0
125,000
150,000
375,000
Project 2
$0
0
500,000
500,000
Project 3
$245,125
212,336
112,500
74,000
Solution:
Cost of projects = $500,000
Length of project = n = 4 years
Required rate of return = k = 14.8%
Project 1:
NCFt
$0
$125,000 $150,000 $375,000
$500,000
t
1
(1.148)
(1.148) 2
(1.148) 3
(1.148) 4
t 0 (1 k )
$500,000 $0 $94,848 $99,144 $ 215,906
$90,103
n
NPV
Project 2:
NCFt
$0
$0
$500,000 $500,000
$500,000
t
1
2
(1.148) (1.148)
(1.148) 3
(1.148) 4
t 0 (1 k )
$500,000 $0 $0 $330,479 $ 287,874
$118,353
n
NPV
Project 3:
SM 10-49
Solutions Manual
NCFt
$245,125 $212,336 $112,500 $74,000
$500,000
t
(1.148)1
(1.148) 2
(1.148) 3 (1.148) 4
t 0 (1 k )
$500,000 $213,524 $161,116 $ 74,358 $ 42,605
$8,397
n
NPV
At a discount rate of 14.8 percent, only project 2 will be accepted. At a discount rate of
13.6 percent, the NPVs of the three projects are -$75,645, $141,295, and $1,491
respectively. Both projects 2 and 3 have positive NPVs and will be accepted.
Year
0
1
2
3
4
NPV
Project 1
$(500,000)
125,000
150,000
375,000
PVCF
$(500,000)
96,862
102,319
225,175
(75,645)
Project 2
$(500,000)
500,000
500,000
PVCF
$(500,000)
341,063
300,232
141,295
Project 3
$(500,000)
245,125
212,336
112,500
74,000
PVCF
$(500,000)
215,779
164,538
76,739
44,434
1,491
LO 2
10.34 Management of Intrepid, Inc., is considering investing in three independent projects. The
costs and the cash flows are given in the following table. The appropriate cost of capital
is 14.5 percent. Compute the project IRRs and identify the projects that should be
accepted.
Year
0
1
2
3
4
Project 1
$(275,000)
63,000
85,000
85,000
100,000
Project 2
$(312,500)
153,250
167,500
112,000
Project 3
$(500,000)
212,000
212,000
212,000
212,000
Solution:
Project 1:
Cost of Project 1 = $275,000
Length of project = n = 4 years
Required rate of return = k = 14.5%
Copyright 2015 John Wiley & Sons, Inc.
SM 10-50
NPV
t 0
Solutions Manual
NCFt
(1 k ) t
At the required rate of return of 14.5 percent, Project 1 has a NPV of $(40,338). To find
the IRR, try lower rates.
Try IRR = 7.6%.
NCFt
t
t 0 (1 IRR )
$63,000 $85,000 $85,000 $100,000
0 $275,000
NPV 0
The IRR of the project is approximately 7.6 percent. Using a financial calculator, we find
that the IRR is 7.57 percent.
Project 2:
Cost of Project 2 = $312,500
Length of project = n = 3 years
Required rate of return = k = 14.5%
NCFt
$153,250 $167,500 $112,000
$312,500
t
(1.145)1
(1.145) 2
(1.145) 3
t 0 (1 k )
$312,500 $ 133,843 $127,763 $ 74,611
$23,717
n
NPV
At the required rate of return of 14.5 percent, Project 2 has a NPV of $23,717. To find the
IRR, try higher rates.
Try IRR =19%.
SM 10-51
Solutions Manual
NCFt
t
t 0 (1 IRR )
$153,250 $167,500 $112,000
0 $312,500
(1.19)1
(1.19) 2
(1.19) 3
$312,500 $128,782 $118,283 $66,463
$1,027
n
NPV 0
Try IRR=19.2%.
NCFt
t
t 0 (1 IRR )
$153,250 $167,500 $112,000
0 $312,500
(1.192)1
(1.192) 2
(1.192) 3
$312,500 $128,565 $117,886 $ 66,129
$80 0
n
NPV 0
The IRR of the project is approximately 19.2 percent. Using a financial calculator, we
find that the IRR is 19.22 percent.
Project 3:
Cost of Project 3 = $500,000
Length of project = n = 4 years
Required rate of return = k = 14.5%
1
1
NCFt
(1.145) 4
NPV
$
500
,
000
$
212
,
000
t
0.145
t 0 (1 k )
$500,000 $611,429
$111,429
At the required rate of return of 14.5 percent, Project 3 has a NPV of $111,429. To find
the IRR, try higher rates.
Try IRR =25%.
SM 10-52
Solutions Manual
NCFt
t
t 0 (1 IRR )
n
NPV 0
1
1 (1.25) 4
0 $500,000 $212,000
0.25
$500,000 $500,659
$659
Try IRR=25.1%.
n
NPV 0
t 0
NCFt
(1 IRR ) t
1
1 (1.251) 4
0 $500,000 $212,000
0.251
$500,000 $500,659
$231 0
The IRR of the project is approximately 25.1 percent. Using a financial calculator, we
find that the IRR is 25.07 percent.
Only Projects 2 and 3 will be accepted as the IRRs exceed the required rate of return of
14.5 percent.
10.35 Jekyll & Hyde Corp. management is evaluating two mutually exclusive projects. The cost
of capital is 15 percent. Costs and cash flows for each project are given in the following
table. Which project should be accepted?
Year
0
1
2
3
4
5
Project 1
$(1,250,000)
250,000
350,000
450,000
500,000
750,000
Project 2
$(1,250,000)
350,000
350,000
350,000
350,000
350,000
SM 10-53
Solutions Manual
Solution:
Project 1:
Cost of project = $1,250,000
Length of project = n = 5 years
Required rate of return = k = 15%
n
NPV
t 0
NCFt
(1 k ) t
(1.15)1
(1.15) 2
(1.15) 3
(1.15) 4
(1.15) 5
$1,250,000 $217,391 $264,650 $ 295,882 $ 285,877 $372,883
$1,250,000
$186,683
NPV 0
t 0
NCFt
(1 k ) t
(1.20)1
(1.20) 2
(1.20) 3
(1.20) 4
(1.20) 5
$1,250,000 $208,333 $243,056 $ 260,417 $ 241,127 $301,408
$4,340
0 $1,250,000
(1.201)1
(1.201) 2
(1.201) 3
(1.201) 4
(1.201) 5
$1,250,000 $208,160 $242,651 $ 259,767 $ 240,324 $300,155
$1,057 0
n
NPV 0
The IRR of the project is approximately 20.1 percent. Using a financial calculator, we
find that the IRR is 20.132 percent.
SM 10-54
Solutions Manual
Project 2:
Cost of project = $1,250,000
Length of project = n = 5 years
Required rate of return = k = 15%
1
1
NCFt
(1.15) 5
NPV
$1,250,000 $350,000
t
0.15
t 0 (1 k )
$1,250,000 $1,173,254
$76,746
At the required rate of return of 15 percent, Project 2 has an NPV of $(76,746). Based on
the negative NPV, Project 2 should be rejected.
To find the IRR, try lower rates.
Try IRR = 12%.
n
NPV 0
t 0
NCFt
(1 IRR ) t
1
1 (1.12) 5
0 $1,250,000 $350,000
0.12
$1,250,000 $1,261,672
$11,672
NPV 0
1
1 (1.124) 5
0 $1,250,000 $350,000
0.124
$1,250,000 $1,249,269
$731 0
SM 10-55
Solutions Manual
The IRR of the project is approximately 12.4 percent. Using a financial calculator, we
find that the IRR is 12.376 percent.
Given a required rate of return of 15 percent, Project 1 will be accepted as the IRR of
20.1 percent exceeds the required rate of return. Project 2 will be rejected.
LO 5
Project 1
$(475,000)
300,000
110,000
125,000
140,000
Project 2
$(500,000)
117,500
181,300
244,112
278,955
Solution:
Project 1:
Cost of project = $475,000
Length of project = n = 4 years
Required rate of return = k = 17%
n
NPV
t 0
NCFt
(1 k ) t
(1.17)1
(1.17) 2
(1.17) 3
(1.17) 4
$475,000 $256,410 $80,356 $ 78,046 $ 74,711
$14,524
$475,000
At the required rate of return of 17 percent, Project 1 has an NPV of $14,524. To find the
IRR, try higher rates.
Try IRR = 19%.
Copyright 2015 John Wiley & Sons, Inc.
SM 10-56
NPV
t 0
Solutions Manual
NCFt
(1 k ) t
(1.19)1
(1.19) 2
(1.19) 3
(1.19) 4
$475,000 $252,101 $77,678 $74,177 $ 69,814
$1,230
$475,000
NPV
t 0
NCFt
(1 k ) t
(1.188)1
(1.188) 2
(1.188) 3
(1.188) 4
$475,000 $252,525 $77,940 $ 74,552 $ 70,285
$302 0
$475,000
The IRR of the project is approximately 18.8 percent. Using a financial calculator, we
find that the IRR is 18.839 percent.
Project 2:
Cost of project = $500,000
Length of project = n = 4 years
Required rate of return = k = 17%
n
NPV
t 0
NCFt
(1 k ) t
(1.17)1
(1.17) 2
(1.17) 3
(1.17) 4
$475,000 $100,427 $132,442 $152,416 $148,864
$34,150
$500,000
At the required rate of return of 17 percent, Project 2 has an NPV of $34,150. To find the
IRR, try higher rates.
Try IRR = 20%.
SM 10-57
Solutions Manual
NCFt
t
t 0 (1 IRR )
$117,500 $181,300 $244,112 $278,955
0 $500,000
(1.20)1
(1.20) 2
(1.20) 3
(1.20) 4
$475,000 $97,917 $125,903 $141,269 $134,527
$385 0
n
NPV 0
The IRR of the project is approximately 20 percent. Using a financial calculator, we find
that the IRR is 19.965 percent.
Both projects can be accepted since their IRRs exceed the cost of capital of 17 percent.
LO 5
10.37 Compute the IRR for each of the following projects:
Year
0
1
2
3
4
5
Project 1
$(10,000)
4,750
3,300
3,600
2,100
Project 2
$(10,000)
1,650
3,890
5,100
2,750
800
Project 3
$(10,000)
800
1,200
2,875
3,400
6,600
Solution:
Project 1:
Cost of project = $10,000
Length of project = n = 4 years
NCFt
t
t 0 (1 IRR )
$4,750 $3,300 $3,600 $2,100
0 $10,000
NPV 0
$13 0
The IRR of the project is approximately 16 percent. Using a financial calculator, we find
that the IRR is 16.076 percent.
SM 10-58
Solutions Manual
Project 2:
Cost of project = $10,000
Length of project = n = 5 years
NCFt
t
t 0 (1 IRR )
$1,650
$3,890
$5,100
$2,750
$800
0 $10,000
1
2
3
4
(1.137) (1.137)
(1.137)
(1.137)
(1.137) 5
$10,000 $1,451 $3,009 $3,470 $1,645 $421
n
NPV 0
$4 0
The IRR of the project is approximately 13.7 percent. Using a financial calculator, we
find that the IRR is 13.685 percent.
Project 3:
Cost of project = $10,000
Length of project = n = 5 years
NCFt
t
t 0 (1 IRR )
$800
$1,200
$2,875
$3,400
$6,600
0 $10,000
1
2
3
4
(1.109) (1.109)
(1.109)
(1.109)
(1.109) 5
$10,000 $721 $976 $ 2,108 $ 2,248 $3,934
n
NPV 0
$13 0
The IRR of the project is approximately 10.9 percent. Using a financial calculator, we
find that the IRR is 10.862 percent.
LO 5
9.38
Primus Corp. management is planning to convert an existing warehouse into a new plant
that will increase its production capacity by 45 percent. The cost of this project will be
$7,125,000. It will result in additional cash flows of $1,875,000 for the next eight years.
The discount rate is 12 percent.
a.
b.
SM 10-59
c.
Solutions Manual
Solution:
a.
Year
0
1
2
3
4
5
6
7
8
Project 1
Cumulative CF
$(7,125,000)
$(7,125,000)
1,875,000
(5,250,000)
1,875,000
(3,375,000)
1,875,000
(1,500,000)
1,875,000
375,000
1,875,000
2,250,000
1,875,000
4,125,000
1,875,000
6,000,000
1,875,000
7,875,000
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the
year)
= 3 + ($1,500,000 / $1,875,000) = 3.80 years
b.
NPV
t 0
NCFt
(1 k ) t
1
1 (1.12) 8
$7,125,000 $1,875,000
0.12
$7,125,000 $9,314,325
$2,189,325
c.
SM 10-60
NPV 0
t 0
Solutions Manual
NCFt
(1 k ) t
1
1 (1.20) 8
0 $7,125,000 $1,875,000
0.20
$7,125,000 $7,194,675
$69,675
NPV 0
1
1 (1.203) 8
0 $7,125,000 $1,875,000
0.203
$7,125,000 $7,130,832
$5,832
The IRR of the project is approximately 20.3 percent. Using a financial calculator, we
find that the IRR is 20.328 percent.
LO 2, LO 3, LO 5
10.39 Quasar Tech Co. management is investing $6 million in new machinery that will produce
the next-generation routers. Sales to its customers will amount to $1,750,000 for the next
three years and then increase to $2.4 million for three more years. The project is expected
to last six years and operating costs, excluding depreciation, will be $898,620 annually.
The machinery will be depreciated to a salvage value of $0 over 6 years using the
straight-line method. The companys tax rate is 30 percent, and the cost of capital is 16
percent.
a.
b.
c.
d.
SM 10-61
Solutions Manual
Solution:
a.
Project 1
Year
0
1
2
3
4
5
6
Net Income
Depreciation
$(104,034)
$(104,034)
$(104,034)
350,966
350,966
350,966
$1,000,000
$1,000,000
$1,000,000
$1,000,000
$1,000,000
$1,000,000
Cash Flows
$(6,000,000)
895,966
895,966
895,966
1,350,966
1,350,966
1,350,966
Cumulative
CF
$(6,000,000)
(5,104,034)
(4,208,068)
(3,312,102)
(1,961,136)
(610,170)
740,796
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the
year)
= 5 + ($610,170 / $1,350,966) = 5.45 years
b.
Sales
Expenses
Depreciation
EBIT
Taxes (30%)
Net income
Beginning BV
Less:
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
$ 1,750,000 $ 1,750,000 $ 1,750,000 $ 2,400,000 $ 2,400,000 $ 2,400,000
898,620
898,620
898,620
898,620
898,620
898,620
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
$(1,48,620) $(1,48,620) $(1,48,620) $ 501,380 $ 501,380 $ 501,380
44,586
44,586
44,586
(150,414)
(150,414)
(150,414)
$ (104,034) $ (104,034) $ (104,034)
$ 350,966
$ 350,966
$ 350,966
6,000,000
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
Depreciation
Ending BV
4.1%
$3,000,000
c.
SM 10-62
Solutions Manual
NPV
1
1
1 (1.16) 3
1 (1.16) 3
1
$1,350,966
$6,000,000 $895,966
0.16
0.16 (1.16) 3
NPV 0
1
1
1
(1.03)
(1.03) 3
0 $6,000,000 $895,966
$1,350,966
0.03
0.03 (1.03) 3
NPV 0
t 0
NCFt
(1 IRR ) t
1
1 (1.031) 3
0 $6,000,000 $895,966
0.031
1 (1.031) 3
1
$1,350,966
0.031 (1.031) 3
SM 10-63
Solutions Manual
b.
c.
d.
Solution:
a.
Year
0
1
2
3
4
5
CF
$(3,250,000)
1,400,000
1,400,000
1,400,000
1,400,000
1,400,000
Cumulative
CF
$(3,250,000)
(1,850,000)
(450,000)
950,000
2,350,000
3,750,000
PVCF
$(3,250,000)
1,196,581
1,022,719
874,119
747,110
638,556
Cumulative
PVCF
$(3,250,000)
(2,053,419)
(1,030,700)
(156,581)
590,529
1,229,085
Discount payback period = Years before recovery + (Remaining cost / Next years CF)
= 3 + ($156,581 / $747,110) = 3.21 years
b.
Net income
Beginning BV
Less:
Depreciation
Ending BV
Year 1
$ 750,000
3,250,000
650,000
Year 2
$ 750,000
2,600,000
650,000
Year 3
$ 750,000
1,950,000
650,000
Year 4
$ 750,000
1,300,000
650,000
Year 5
$ 750,000
650,000
650,000
$2,600,000
$1,950,000
$1,300,000
$ 650,000
SM 10-64
Solutions Manual
46.2%
$1,625,000
c.
1
1
NCFt
(1.17) 5
NPV
$
3
,
250
,
000
$
1
,
400
,
000
t
0.17
t 0 (1 k )
$3,250,000 $4,479,085
$1,229,085
d.
NPV 0
t 0
NCFt
(1 IRR ) t
1
1 (1.30) 5
0 $3,250,000 $1,400,000
0.30
$3,250,000 $3,409,798
$159,798
Try IRR = 32.5%.
NCFt
t
t 0 (1 IRR )
n
NPV 0
1
1 (1.325) 5
0 $3,250,000 $1,400,000
0.325
$3,250,000 $3,252,904
$2,904 0
SM 10-65
Solutions Manual
The IRR of the project is approximately 32.5 percent. Using a financial calculator, we
find that the IRR is 32.548 percent.
LO 2, LO 3, LO 4, LO 5
10.41 Trident Corp. management is evaluating two independent projects. The costs and
expected cash flows are given in the following table. The cost of capital is 10 percent.
Year
0
1
2
3
4
5
A
$(312,500)
121,450
121,450
121,450
121,450
121,450
B
$(395,000)
153,552
158,711
166,220
132,000
122,000
a.
b.
c.
d.
If you are the decision maker for the firm, which project or projects will be
accepted? Explain your reasoning.
Solution:
a.
Project A:
Cost of this project = $312,500
Annual cash flows = $121,450
Required rate of return = k = 10%
Length of project = n = 5 years
1
1
NCFt
(1.10) 5
NPV
312,500 $121,450
t
0.10
t 0 (1 k )
$312,500 460,391
$147,891
Copyright 2015 John Wiley & Sons, Inc.
SM 10-66
Solutions Manual
Project B:
Cost of this project = $395,000
Required rate of return = k = 10%
Length of project = n = 5 years
n
NPV
t 0
NCFt
(1 k ) t
(1.10)1
(1.10) 2
(1.10) 3
(1.10) 4
(1.10) 5
395,000 $139,593 $131,166 $124,884 90,158 75,752
$395,000
$166,553
b.
Project A:
Since NPV > 0, to compute the IRR, try rates higher than 10 percent.
Try IRR = 27%.
n
NPV 0
t 0
NCFt
(1 IRR ) t
1
1 (1.27) 5
0 312,500 $121,450
0.27
$312,500 313,666
$1,166
NPV 0
t 0
NCFt
(1 IRR ) t
1
1 (1.272) 5
0 312,500 $121,450
0.272
$312,500 312,418
$82 0
The IRR of Project A is approximately 27.2 percent. Using a financial calculator,
we find that the IRR is 27.187 percent.
Project B:
Copyright 2015 John Wiley & Sons, Inc.
SM 10-67
Solutions Manual
Since NPV > 0, to compute the IRR, try rates higher than 10 percent.
Try IRR = 26%.
NCFt
t
t 0 (1 IRR )
$153,552 $158,711 $166,220 $132,000 $122,000
0 $395,000
(1.26)1
(1.26) 2
(1.26) 3
(1.26) 4
(1.26) 5
$395,000 $121,867 $99,969 $83,094 $52,371 $38,416
$717
n
NPV 0
(1.261)1
(1.261) 2
(1.261) 3
(1.261) 4
(1.261) 5
$395,000 $121,770 $99,811 $82,897 $52,205 $38,263
n
NPV 0
$54 0
The IRR of Project B is approximately 26.1 percent. Using a financial calculator, we find
that the IRR is 26.093 percent.
c.
Since both projects have positive NPVs and they are independent projects, both
should be accepted under the NPV decision criteria. Under the IRR decision
criteria, since both projects have IRRs greater than the cost of capital, both will be
accepted. Thus, there is no conflict between the NPV and IRR decisions.
d.
LO 2, LO 5
10.42 Management of Tyler, Inc., is considering switching to a new production technology. The
cost of the required equipment will be $4 million. The discount rate is 12 percent. The
cash flows that management expects the new technology to generate are as follows.
Years
CF
SM 10-68
Solutions Manual
1-2
35
69
0
$845,000
$1,450,000
a.
Compute the payback and discounted payback periods for the project.
b.
What is the NPV for the project? Should the firm go ahead with the project?
c.
What is the IRR, and what would be the decision based on the IRR?
Solution:
a.
Year
0
1
2
3
4
5
6
7
8
9
Cash Flows
$(4,000,000)
--845,000
845,000
845,000
1,450,000
1,450,000
1,450,000
1,450,000
PVCF
$(4,000,000)
--601,454
537,013
479,476
734,615
655,906
585,631
522,885
Cumulative
Cumulative
CF
$(4,000,000)
(4,000,000)
(4,000,000)
(3,155,000)
(2,310,000)
(1,465,000)
(15,000)
1,435,000
2,885,000
4,335,000
PVCF
$(4,000,000)
(4,000,000)
(4,000,000)
(3,398,546)
(2,861,533)
(2,382,057)
(1,647,442)
(991,536)
(405,905)
116,979
$15,000
$1, 450,000
6.01 years
= 6
$405,905
$522,885
8.8 years
=8
b.
SM 10-69
Solutions Manual
1
1
NCFt
1
(1.12) 3
NPV
$
4
,
000
,
000
$
845
,
000
t
0.12 (1.12) 2
t 0 (1 k )
1
1 (1.12) 4
$1,450,000
0.12
1
(1.12) 5
Given a positive NPV, to compute the IRR, one should try rates higher than 12
percent.
Try IRR = 12.5%.
NCFt
1
(1.125)
NPV
$4,000,000 0 0 $845,000
t
0.125 (1.125) 2
t 0 (1 k )
1
1 (1.125) 4
$1,450,000
0.125
1
(1.125) 5
10.43 You are analyzing two proposed capital investments with the following cash flows:
SM 10-70
Solutions Manual
Year
0
Project X
$(20,000)
Project Y
$(20,000)
13,000
7,000
6,000
7,000
6,000
7,000
2,000
7,000
The cost of capital for both projects is 10 percent. Calculate the profitability index (PI)
for each project. Which project, or projects, should be accepted if you have unlimited
funds to invest? Which project should be accepted if they are mutually exclusive?
Solution:
The PI calculations are as follows:
The NPV is needed first:
$2,650.78
(1.1)1
(1.1) 2
(1.1) 3
(1.1) 4
$7,000 $7,000 $7,000 $7,000
NPVy $20,000
$2,189.06
(1.1)1
(1.1) 2
(1.1) 3
(1.1) 4
NPVx $20,000
PI x
1.1325
Initial Investment
$20, 000
PI y
1.1095
Initial Investment
$20, 000
Both methods rank Project X over Project Y. Therefore, both should be accepted if they are
independent and sufficient resources are available. If the projects are mutually exclusive, we
should choose the project with the higher PI at r = 10%, which in this case is Project X.
LO 6
Copyright 2015 John Wiley & Sons, Inc.
SM 10-71
Solutions Manual
CFA Problems
10.44 Given the following cash flows for a capital project, calculate the NPV and IRR. The
required rate of return is 8 percent.
CASH FLOW
0
50,000
Year
1
2
15,000 15,000
NPV
IRR
a.
$1,905
10.9%
b.
$1,905
26.0%
c.
$3,379
10.9%
d.
$3,379
26.0%
3
20,000
4
10,000
5
5,000
SOLUTION:
c is correct.
NPV 50, 000
1.08
1.082
1.083
1.084
1.085
Year
CASH FLOW
0
50,000
1
15,000
2
15,000
3
20,000
4
10,000
5
5,000
SM 10-72
Solutions Manual
b.
c.
d.
SOLUTION:
c is correct.
YEAR
CASH FLOW
CUMULATIVE CASH
0
$50,000
1
$15,000
2
$15,000
3
$20,000
4
$10,000
5
$5,000
FLOW
DISCOUNTED CASH
50,000
35,000
20,000
10,000
15,000
FLOW
50,000
13,888.89
12,860.08
15,876.64
7,350.30
3,402.92
$3,378.8
CUMULATIVE DCF
$50,000
$36,111.11
$23,251.03
$7,374.38
$24.09
As the table shows, the cumulative cash flow offsets the initial investment in
exactly three years. The payback period is 3.00 years. The discounted payback
period is between four and five years. The discounted payback period is 4 years
plus 24.09/3,402.92 = 0.007 of the fifth year cash flow, or 4.007 = 4.01 years. The
discounted payback period is 4.01 3.00 = 1.01 years longer than the payback
period.
LO 3
10.46 An investment of $100 generates after-tax cash flows of $40 in Year 1, $80 in Year 2, and
$120 in Year 3. The required rate of return is 20 percent. The net present value is closest
to
a.
$42.22
b.
$58.33
c.
$68.52
d.
$98.95
SM 10-73
Solutions Manual
SOLUTION:
b is correct.
NCFt
40
80
120
$100
t
2
1.20 1.20 1.20 3 = $58.33
t 0 (1 k )
n
NPV
LO 2
28.19 percent
b.
28.39 percent
c.
28.59 percent
d.
28.79 percent
SOLUTION:
d is correct. The IRR can be found using a financial calculator or with trial and
error. Using trial and error, the total PV is equal to zero if the discount rate is 28.79
percent.
YEA
R
0
1
2
Total
CASH FLOW
150,000
100,000
120,000
PRESENT VALUE
28.19%
28.39%
28.59%
28.79%
150,000
78,009
73,025
1,034
150,000
77,767
72,572
338
150,000
77,646
72,346
8
150,000
77,888
72,798
686
SM 10-74
Solutions Manual
the annual after-tax cash flows by $5. How will the enhancement affect the projects NPV
profile? The vertical intercept of the NPV profile of the project shifts:
a. up and the horizontal intercept shifts left.
b. up and the horizontal intercept shifts right.
c. down and the horizontal intercept shifts left.
d. down and the horizontal intercept shifts right.
SOLUTION:
a is correct. The vertical intercept changes from $60 to $65, and the horizontal intercept
changes from 21.86 percent to 20.68 percent.
LO 2
Testco Corporation is considering adding a new product line. The cost of the factory and
equipment to produce this product is $1,780,000. Company management expects net cash
flows from the sale of this product to be $450,000 in each of the next eight years. If Testco
uses a discount rate of 12 percent for projects like this, what is the net present value of this
project? What is the internal rate of return? (LO 2 & 5)
Solution:
Investment = $1,780,000
Annual net cash flow = NCF = $450,000
Discount rate = k = 12%
Length of project = n = 8 years
1
1
NCFt
(1.12)8
NPV=
$1,
780,
000
$450,
000
t
0.12
t 0 (1 k )
SM 10-75
Solutions Manual
1
1
NCFt
(1.20)8
NPV 0
$1,500, 000 $450, 000
t
0.20
t 0 (1 IRR)
$53, 278
Try IRR = 19%
NCFt
$1, 780, 000 $450, 000
t
t 0 (1 IRR)
$1, 780, 000 $1, 779, 465
n
NPV 0
1
(1.19)8
0.19
$535 0
The IRR is approximately 19 percent. Using the financial calculator, we find that the
IRR is 18.99 percent.
SM 10-76
10.2
Solutions Manual
Flowers Unlimited is considering purchasing an additional delivery truck which will have a
seven year useful life. The new truck will cost $42,000. Cost savings with this truck are
expected to be $12,800 for the first two years, $8,900 for the following two years, and $5,000
for the last 3 years of the trucks useful life. What is the payback period for this project?
What is the discounted payback period for this project with a discount rate of 10 percent?
(LO 3)
Solution:
Discount rate = k = 10%
Year
0
1
2
3
4
5
6
7
NCF
$(42,000)
12,800
12,800
8,900
8,900
5,000
5,000
5,000
Cumulative
NCF
$(42,000)
(29,200)
(16,400)
(7,500)
1,400
6,400
11,400
16,400
PV(NCF)
$(42,000)
11,636
10,579
6,687
6,079
3,105
2,822
2,566
Cumulative
PV(NCF)
$(42,000)
(30,364)
(19,785)
(13,098)
(7,019)
(3,914)
(1,092)
1,474
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 3 + ($7,500 / $8,900)
= 3.84 years
Discounted PB = Years before cost recovery + (Remaining cost to recover/ PV Cash flow
during the year)
= 6 + ($1,092 / $2,566)
= 6.43 years
10.3
What is the average accounting rate of return (ARR) on a piece of equipment that will cost
$1.2 million and that will result in pretax cost savings of $380,000 for the first three years
and then $280,000 for the following three years? Assume that the machinery will be
depreciated to a salvage value of 0 over 6 years using the straight-line method and the
companys tax rate is 32 percent. If the acceptance decision is based on the project
exceeding an ARR of 20 percent, should this machinery be purchased? (LO 4)
Solution:
Cost savings
Depreciation
EBIT
Taxes (32%)
Net income
Beg. book value
Less:Depreciatio
n
Year 1
$ 380,000
200,000
$ 180,000
57,600
$ 122,400
Year 2
$ 380,000
200,000
$ 180,000
57,600
$ 122,400
Year 3
$ 380,000
200,000
$ 180,000
57,600
$ 122,400
Year 4
$ 280,000
200,000
$ 80,000
25,600
$ 54,400
Year 5
$ 280,000
200,000
$ 80,000
25,600
$ 54,400
Year 6
$ 280,000
200,000
$ 80,000
25,600
$ 54,400
5,000,000
200,000
4,000,000
200,000
3,000,000
200,000
2,000,000
200,000
1,000,000
200,000
1,200,000
200,000
SM 10-77
$
1,000,000
$ 800,000
Solutions Manual
$ 600,000
$ 400,000
$ 200,000
14.7%
$600, 000
Since the projects ARR is below the acceptance rate of 20 percent, the machinery should not
be purchased.
Accounting rate of return
10.4
What do we know about that projects IRR if we know that it has a positive NPV? (LO 2
& 5)
Solution:
If a project has a positive NPV, the IRR of that project is greater than the required rate of
return. Since the IRR is the discount rate that makes the NPV equal zero, a positive NPV
results from the projects IRR being greater than the required rate of return.
10.5
West Street Automotive is considering adding state safety inspections to their service
offerings. The equipment necessary to perform these inspections will cost $557,000 and will
generate cash flows of $195,000 over each of the next five years. If the cost of capital is 14
percent, what is the MIRR on this project? (LO 5)
Solution:
Investment (cost) = $557,000
Annual net cash flow = NCFt = $195,000
Length of project = n = 5 years
Cost of capital = k = 14%
TV = NCF1 (1 k ) n 1 NCF2 (1 k ) n 2 L L NCFn (1 k ) n n
$195, 000 (1.14) 4 $195, 000 (1.14)3 $195, 000 (1.14)2 $195, 000 1.14 $195, 000
$329,347 $288,901 $253, 422 $222,300 $195, 000
$1, 288, 970
Solve for the MIRR:
SM 10-78
Solutions Manual
TV
(1 MIRR) n
$1, 288,970
$557, 000
(1 MIRR)5
$1, 288,970
(1 MIRR) 5
2.3141
$557, 000
PVCost
You are chairperson of the investment committee at your fi rm. Five projects have been
submitted to your committee for approval this month. The investment required and the
project profitability index for each of these projects are presented in the following table: (LO
6)
If you have $500,000 available for investments, which of these projects would you
approve? Assume that you do not have to worry about having enough resources for future
investments when making this decision.
Solution:
Definitely accept projects A, B, and C. They all have a positive NPV. Project D just
returns the opportunity cost of capital, so you would be indifferent with regards to
accepting this project. Do not accept project E; it has a negative NPV.
SM 10-79