Problems

Problem 8-6
Problem 8-7
Problem 8-11
Problem 8-12
Problem 8-13
Problem 8-15
Problem 8-16
NPV for 8-16
Problem 8-17
NPV for 8-17
Problem 8-18
Problem 8-19
Problem 8-20
Problem 8-21
Problem 8-24
Problem 8-25
Problem 8-28
Problem 8-30
Problem 8-6

You have been offered a unique investment opportunity. If you invest $10,000 today, you w
$500 one year from now, $1500 two years from now, and $10,000 ten years from now.
a. What is the NPV of the opportunity if the cost of capital is 6% per year? Should you
opportunity?

b. What is the NPV of the opportunity if the cost of capital is 2% per year? Should you

Year 0 1
Cash flow ($10,000) $500

a. Present value with 6% cost of capital ($10,000.00) $471.70

NPV with 6% cost of capital ($2,609.36)
b. Present value with 2% cost of capital ($10,000.00) $490.20
NPV with 2% cost of capital $135.43
st $10,000 today, you will receive
en years from now.
% per year? Should you take the

% per year? Should you take it now?

2 10
$1,500 $10,000

$1,334.99 $5,583.95

$1,441.75 $8,203.48
Problem 8-7

Marian Plunket owns her own business and is considering an investment. If she undertakes
investment, it will pay $4000 at the end of each of the next three years. The opportunity req
initial investment of $1000 plus an additional investment at the end of the second year of $
is the NPV of this opportunity if the cost of capital is 2% per year? Should Marian take it?

Year 0 1
Cash flow ($1,000) $4,000

Present value with 2% cost of capital ($1,000.00) $3,921.57

NPV with 2% cost of capital $5,729.69
 stment. If she undertakes the
years. The opportunity requires an
d of the second year of $5000. What
? Should Marian take it?

2 3
($1,000) $4,000

($961.17) $3,769.29
Problem 8-11

FastTrack Bikes, Inc., is thinking of developing a new composite road bike. Development will take six years and the cost is $200,000 per year.
Once in production, the bike is expected to make $300,000 per year for 10 years. The cash inflows begin at the end of year 7. Assuming the
cost of capital is 10%:

a. Calculate the NPV of this investment opportunity. Should the company make the investment?
b. Calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the
decision unchanged.
c. How long must development last to change the decision?

Annual development cost (200,000)

Number of years to develop 6
Cash flows in production 300,000
Number of years in production 10
Cost of capital 10.00%
PV of development costs (871,052)
PV of production inflows 1,040,534
a. NPV 169,482
Yes, they should invest
0 1 2 3 4 5
b. Cash flows for IRR: 0 (200000) (200000) (200000) (200000) (200000)
IRR 12.66%
The decision will change if the cost of capital
deviates by more than 2.66%

c. Annual development cost (200,000)

This answer is the result of Excel's Goal
Number of years to develop 6.85 Seek function (Data, What-if analysis). If
you change the numbers in part a, above,
Cash flows in production 300,000 you will need to re-do the goal seek.
Number of years in production 10 Set cell e35 = 0, by changing cell e29.
Notice the solutions manual shows how to
Cost of capital 10.00% do this using logs.
PV of development costs (959,247)
PV of production inflows 959,247
 NPV 0.00
Number of years of development to break even: 6.85

Assuming the cost of capital is 14%:

a. Calculate the NPV of this investment opportunity. Should the company make the investment?
b. How much must this cost of capital estimate deviate to change the decision?
c. How long must development last to change the decision?

Annual development cost (200,000)

Number of years to develop 6
Cash flows in production 300,000
Number of years in production 10
Cost of capital 14.00%
PV of development costs (777,734)
PV of production inflows 712,918
a. NPV (64,816)
No, they should not invest
0 1 2 3 4 5
b. Cash flows for IRR: 0 (200000) (200000) (200000) (200000) (200000)
IRR 12.66%
The decision will change if the cost of capital
deviates by more than -1.34%
This answer is the result of
c. Annual development cost (200,000) Excel's Goal Seek function. If
you change the numbers in part
Number of years to develop 5.65 a., above, you will need to re-do
Cash flows in production 300,000.00 the goal seek. Set cell e68=0, by
changing cell e62.
Number of years in production 10.000
Cost of capital 14.00%
The goal seek function
PV of development costs (746,801) changes the values in cell
E63, which changes the
PV of production inflows 746,801 values in cells E67, E68, and
NPV 0 E69 until cell E69 (the NPV)
equals zero.
Number of years in development to break even: 5.65
Problem 8-12

OpenSeas, Inc. is evaluating the purchase of a new cruise ship. The ship would cost $500 million, but would operate for 20 years. OpenSeas
expects annual cash flows from operating the ship to be $70 million and its cost of capital is 12%.

a. Prepare an NPV profile of the purchase.

b. Identify the IRR on the graph.
c. Should OpenSeas go ahead with the purchase?
d. How far off could OpenSeas' cost of capital estimate be before your purchase decision would change?

Initial cost: (500,000,000)

Number of years of operation: 20
Cash flows in operation: 70,000,000
Cost of capital 12.00%

a.

NPV Profile of cruise ship investment

1,000,000,000

800,000,000

600,000,000
NPV

400,000,000

200,000,000

0
0.00%
0.75%
1.50%
2.25%
3.00%
3.75%
4.50%
5.25%
6.00%
6.75%
7.50%
8.25%
9.00%
9.75%
10.50%
11.25%
12.00%
12.75%
13.50%
14.25%
15.00%
15.75%
16.50%
17.25%
18.00%
18.75%
19.50%
(200,000,000)

(400,000,000) Cost of capital

b. The IRR is the point at which the NPV profile crosses the x-axis. In this case, it falls very close to 13%. Using Excel, we can solve for the
actual IRR, which is:
IRR: 12.72%

c. Yes, because at a 12% discount rate, the NPV is positive.

d. The cost of capital estimate can be off by the difference between the cost of capital and the IRR, which is 0.72%

Discount rate NPV

0.00% 900,000,000
0.25% 863,914,180
0.50% 829,119,340
0.75% 795,561,379
1.00% 763,188,708
1.25% 731,952,129
1.50% 701,804,715
1.75% 672,701,691
2.00% 644,600,334
2.25% 617,459,866
2.50% 591,241,360
2.75% 565,907,649
3.00% 541,423,240
3.25% 517,754,230
3.50% 494,868,231
3.75% 472,734,295
4.00% 451,322,844
4.25% 430,605,607
 4.50% 410,555,552
4.75% 391,146,831
5.00% 372,354,724
5.25% 354,155,581
5.50% 336,526,774
5.75% 319,446,651
6.00% 302,894,485
6.25% 286,850,437
6.50% 271,295,507
6.75% 256,211,503
7.00% 241,580,997
7.25% 227,387,294
7.50% 213,614,395
7.75% 200,246,969
8.00% 187,270,319
8.25% 174,670,353
8.50% 162,433,563
8.75% 150,546,987
9.00% 138,998,197
9.25% 127,775,265
9.50% 116,866,748
9.75% 106,261,661
10.00% 95,949,460
10.25% 85,920,022
10.50% 76,163,624
10.75% 66,670,929
11.00% 57,432,968
11.25% 48,441,122
11.50% 39,687,110
11.75% 31,162,971
12.00% 22,861,054
12.25% 14,774,000
12.50% 6,894,735
12.75% (783,546)
13.00% (8,267,390)
13.25% (15,563,094)
13.50% (22,676,722)
13.75% (29,614,105)
14.00% (36,380,861)
14.25% (42,982,397)
14.50% (49,423,918)
14.75% (55,710,441)
15.00% (61,846,797)
15.25% (67,837,639)
15.50% (73,687,454)
15.75% (79,400,564)
16.00% (84,981,137)
16.25% (90,433,190)
16.50% (95,760,597)
16.75% (100,967,094)
17.00% (106,056,286)
17.25% (111,031,651)
17.50% (115,896,542)
17.75% (120,654,198)
18.00% (125,307,745)
18.25% (129,860,200)
18.50% (134,314,476)
18.75% (138,673,387)
19.00% (142,939,650)
19.25% (147,115,891)
19.50% (151,204,646)
19.75% (155,208,365)
20.00% (159,129,419)
Problem 8-13

You are CEO of Rivet Networks, maker of ultra-high performance network cards for gaming computers, and you are considering whether to
launch a new product. The product, the Killer X3000, will cost $900,000 to develop up front (year 0), and you expect revenues the first year
of $800,000, growing to $1.5 million the second year, and then declining by 40% per year for the next 3 years before the product is fully
obsolete. In years 1 through 5, you will have fixed costs associated with the product of $100,000 per year, and variable costs equal to 50% of
revenues
a. What are the cash flows for the project in years 0 through 5?
b. Plot the NPV profile for this investment from 0% to 40% in 10% increments.
c. What is the project’s NPV if the project’s cost of capital is 10%?
d. Use the NPV profile to estimate the cost of capital at which the project would become unprofitable; that is, estimate the project’s IRR.

Cost of Capital 10.0%

0 1 2 3 4 5
Revenues 800,000 1,500,000 900,000 540,000 324,000
yoy growth 87.5% (40.0%) (40.0%) (40.0%)
Variable Costs (400,000) (750,000) (450,000) (270,000) (162,000)
% sales 50.0% 50.0% 50.0% 50.0% 50.0%
Fixed Costs (100,000) (100,000) (100,000) (100,000) (100,000)
Investment (900,000)
Total Cash Flow (900,000) 300,000 650,000 350,000 170,000 62,000
Discount Factor 1.000 0.909 0.826 0.751 0.683 0.621
PV (900,000) 272,727 537,190 262,960 116,112 38,497
NPV 327,487
IRR 26.62%

Discount rate 327,487

0% 632,000
5% 466,065
10% 327,487
15% 210,517
20% 110,835
25% 25,148
30% (49,087)
35% (113,862)
40% (170,750)
Problem 8-15

Does the IRR rule agree with the NPV rule in Problem 8?

Timeline: 0 1 2 3
Cash flows: -8 5 5 5

Cost of capital: 8.00%

IRR: 39.45%

The IRR rule says to take the contract. The IRR rule agrees with the NPV rule.
Problem 8-16

How many IRRs are there in part (a) of Problem 10? Does the IRR rule give the right answ

Year
0

Advance payment for book $10,000,000

Annual speaking fees foregone
Cash Flow $10,000,000
Cost of capital 10.00%
NPV of book deal ($9,894,816)

IRR 60.74%
There is 1
Click here for NPV graph.
There is one IRR. However, the inflows occur before the outflows, so the rule only work
cost of capital.

Problem 8-17

How many IRRs are there in part (b) of Problem 10? Does the IRR rule work in this case?

Yea
0

Advance payment for book $10,000,000

Annual speaking fees foregone
Royalties when book is complete
Cash Flows $19,391,435
Growth rate in royalties -30.00%
Cost of capital 10.00%
PV of royalties $9,391,435.01
NPV of book deal ($503,380.92)
There are 2
Click here for NPV graph.
IRR may give the wrong answer, since there is more than one IRR.

NPV for 8-15

Discount rate ($9,894,815.93)
0.0% (14000000.00)
2.0% (13071066.18)
4.0% (12200728.27)
6.0% (11384095.60)
8.0% (10616775.90)
10.0% (9894815.93)
12.0% (9214650.15)
14.0% (8573056.22)
16.0% (7967116.32)
18.0% (7394183.44)
20.0% (6851851.85)
22.0% (6337931.37)
24.0% (5850424.62)
26.0% (5387507.15)
28.0% (4947509.77)
30.0% (4528903.05)
32.0% (4130283.55)
34.0% (3750361.58)
36.0% (3387950.34)
38.0% (3041956.23)
40.0% (2711370.26)
42.0% (2395260.27)
44.0% (2092764.06)
46.0% (1803083.16)
48.0% (1525477.27)
50.0% (1259259.26)
52.0% (1003790.64)
54.0% (758477.48)
56.0% (522766.74)
58.0% (296142.90)
60.0% (78125.00)
62.0% 131736.17
64.0% 333860.51
66.0% 528640.91
68.0% 716445.31
70.0% 897618.56
72.0% 1072484.18
74.0% 1241345.90
76.0% 1404489.11
78.0% 1562182.17
80.0% 1714677.64
82.0% 1862213.38
84.0% 2005013.56
86.0% 2143289.61
88.0% 2277241.07
90.0% 2407056.42
92.0% 2532913.77
94.0% 2654981.58
96.0% 2773419.24
98.0% 2888377.71
? Does the IRR rule give the right answer in this case?

Year
1 2 3

$8,000,000 $8,000,000 $8,000,000

($8,000,000) ($8,000,000) ($8,000,000)

IRR.

efore the outflows, so the rule only works if you accept when the IRR is BELOW the

? Does the IRR rule work in this case?

Year
1 2 3 4

$8,000,000 $8,000,000 $8,000,000

$5,000,000
($8,000,000) ($8,000,000) ($8,000,000)
declining perpetuity

PV at at year 3 $12,500,000.00
 IRR's.

ore than one IRR.

Crossing point? NPV for 8-16

Discount rate ($503,380.92)
0.0% 2666666.67
2.0% 1652720.30
4.0% 872747.60
6.0% 277283.34
8.0% (171614.83) crossing point
10.0% (503380.92)
12.0% (741075.77)
14.0% (902925.35)
16.0% (1003445.96)
18.0% (1054278.51)
20.0% (1064814.81)
22.0% (1042672.84)
24.0% (994061.09)
26.0% (924060.56)
28.0% (836844.61)
30.0% (735851.92)
32.0% (623923.41)
34.0% (503411.32)
36.0% (376266.74)
38.0% (244110.06)
40.0% (108288.21)
42.0% 30078.86 crossing point
44.0% 170060.11
46.0% 310882.10
48.0% 451903.27
50.0% 592592.59
52.0% 732511.85
54.0% 871300.91
56.0% 1008665.41
58.0% 1144366.41
60.0% 1278211.81
crossing point 62.0% 1410048.95
 64.0% 1539758.60
66.0% 1667249.63
68.0% 1792454.75
70.0% 1915326.68
72.0% 2035835.05
74.0% 2153963.67
76.0% 2269708.28
78.0% 2383074.58
80.0% 2494076.57
82.0% 2602735.13
84.0% 2709076.82
86.0% 2813132.85
88.0% 2914938.18
90.0% 3014530.79
92.0% 3111951.00
94.0% 3207240.99
96.0% 3300444.27
98.0% 3391605.32
1.000 2.000
Problem 8-18

Professor Wendy Smith has been offered the following deal: A law firm would like to retain her for an upfront payment of
$50,000. In return, for the next year the firm would have access to 8 hours of her time every month. Smith's rate is $550 per
hour and her opportunity cost of capital is 15% per year. What does the IRR rule advise regarding this opportunity? What
about the NPV rule?

Timeline: 0 1 2 3 … 12
50000 -4400 -4400 -4400 … -4400

IRR: 0.8484% per month

10.6696% per year
Cost of capital: 15.00%

According to the IRR rule, this is not a good deal.

The monthly discount rate for an NPV analysis is: 1.1715%

The NPV of the investment is: $1,010.06
The NPV of the investment is positive therefore the NPV rule says to take the deal.
Problem 8-19

Innovation Company is thinking about marketing a new software product. Upfront costs to market and develop the product are $5 million. The
product is expected to generate profits of $1 million per year for ten years. The company will have to provide support expected to cost $100,000 per
year in perpetuity. Assume all profits and expenses occur at the end of the year.

a. What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project? Repeat the analysis for discount
rates of 2% and 11%.
b. What is the IRR of this investment opportunity?
c. What does the IRR rule indicate about this investment?

a. Initial cost of development: $5,000,000

Perpetual cost of support: $100,000
Annual Profits from software: $1,000,000
Number of years of profits: 10

NPV of investment at 6%: $693,420

NPV of investment at 2%: -$1,017,415
NPV of investment at 11%: -$19,859

b. There are two IRRs of this investment opportunity. Goal seek was used to find the two IRRs below.
NPV: ($0.00) 10.88% = IRR
NPV: ($0.00) 2.75% = IRR

c. The IRR rule does not indicate anything about this investment, since there are multiple IRRs.
Problem 8-20

You have 3 projects with the following cash flows:

Year 0 1 2 3 4
Project 1 -150 20 40 60 80
Project 2 -825 0 0 7000 -6500
Project 3 20 40 60 80 -245

a. For which of these projects is the IRR rule reliable?

b. Estimate ther IRR for each project (to the nearest 1%).
c. What is the NPV of each project if the cost of capital is 5%? 20%? 50%?

a. Project 1 is the only project where the IRR rule (Take any investment where the IRR exceeds
the opportunity cost of capital). Project 2 has multiple sign switches and thus multiple IRRs.
Project 3 has a positive NPV when the cost of capital is greater than the IRR.

b. Project IRR
Project 1 10%
Project 2 10%
Project 3 10%

c. Project 5% 20% 50%

Project 1 $22.98 -$32.25 -$85.31
Project 2 -$125.70 $91.28 -$34.88
Project 3 -$19.94 $23.14 $48.64
Problem 8-21

You own a coal mining company and are considering a new mine. The mine itself will cost $120 million to open. If this money is spent
immediately, the mine will generate $20 million for the next ten years. After that, the coal will run out and the site must be cleaned and maintained
at environmental standards. The cleaning and maintenance are expected to cost $2 million per year in perpetuity. What does the IRR rule say about
whether you should accept this opportunity? If the cost of capital is 8%, what does the NPV rule say?

Year
0 1 2 3 4 5 6 7 8 9 10
Cash Flows:
Initial Cost: (120,000,000.00) (120,000,000.00)
Revenue 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00
Minus annual cost 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Profit 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00
Number of years until mine is
depleted 10
Perpetual annual revenue
after mine is depleted (2,000,000.00) NPV Profile
There are 2 IRRs, 0.02924 and 0.08723, therefore the IRR rule cannot tell us $20,000,000.00
anything.
According to the list below, NPV at 8% is $2.61 million, so the mine should $0.00
be undertaken. 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0%
($20,000,000.00)
If cost of capital is: Then NPV is:
0.0% #DIV/0! ($40,000,000.00)
1.0% ($111,631,300.32) 0 NPV
2.0% ($22,383,129.86) 0 ($60,000,000.00)
3.0% $997,795.74 1
4.0% $8,439,707.15 1 ($80,000,000.00)
5.0% $9,878,168.44 1
6.0% $8,588,581.80 1 ($100,000,000.00)
7.0% $5,947,365.33 1
8.0% $2,621,790.78 1
9.0% ($1,033,752.80) 0
($120,000,000.00)
10.0% ($4,819,523.67) 0
11.0% ($8,618,713.94) 0
12.0% ($12,361,760.04) 0
13.0% ($16,007,258.91) 0
14.0% ($19,531,170.07) 0
15.0% ($22,920,423.56) 0
16.0% ($26,168,995.47) 0
17.0% ($29,275,426.07) 0
18.0% ($32,241,212.62) 0
19.0% ($35,069,748.72) 0
20.0% ($37,765,614.12) 0
21.0% ($40,334,094.36) 0
22.0% ($42,780,853.77) 0
23.0% ($45,111,712.48) 0
24.0% ($47,332,494.95) 0
25.0% ($49,448,928.05) 0
26.0% ($51,466,573.82) 0
27.0% ($53,390,786.61) 0
28.0% ($55,226,687.44) 0
29.0% ($56,979,150.42) 0
30.0% ($58,652,797.69) 0
31.0% ($60,252,000.34) 0
32.0% ($61,780,883.32) 0
33.0% ($63,243,333.09) 0
34.0% ($64,643,007.11) 0
35.0% ($65,983,344.24) 0
36.0% ($67,267,575.87) 0
37.0% ($68,498,737.09) 0
38.0% ($69,679,677.95) 0
39.0% ($70,813,074.36) 0
40.0% ($71,901,438.72) 0
41.0% ($72,947,130.10) 0
42.0% ($73,952,363.95) 0
43.0% ($74,919,221.25) 0
44.0% ($75,849,657.21) 0
45.0% ($76,745,509.48) 0
46.0% ($77,608,505.75) 0
47.0% ($78,440,271.00) 0
48.0% ($79,242,334.18) 0
49.0% ($80,016,134.51) 0
50.0% ($80,763,027.32) 0
51.0% ($81,484,289.54) 0
52.0% ($82,181,124.78) 0
53.0% ($82,854,668.08) 0
Problem 8-22

Your firm is considering a project that will cost $4.55 million upfront, generate cash flows of $3,500,000 per year for 3 years, and then have a
cleanup and shutdown cost of $6,000,000 in the fourth year.

a. How many IRRs does this project have?

b. Calculate a modified IRR for this project assuming a discount and compounding rate of 10%.
c. Using the MIRR and a cost of capital of 10%, would you take the project?

Initial cost: (4,550,000)

Number of years of operation: 3
Cash flows in operation: 3,500,000
Cleanup and shutdown cost (6,000,000)
Cost of capital 10.00%

a.

NPV Profile of investment

80,000

60,000

40,000
NPV

20,000

0
% % % % % % % % % % % % % % % % % % % % % % % % % % %
00 75 50 25 00 75 50 25 00 75 50 25 00 75 50 25 00 75 50 25 00 75 50 25 00 75 50
0. 0. 1. 2. 3. 3. 4. 5. 6. 6. 7. 8. 9. 9. 10. 11. 12. 12. 13. 14. 15. 15. 16. 17. 18. 18. 19.
(20,000)

(40,000)

(60,000)

(80,000) Cost of capital

This project has two IRRs at about 2% and 16%.

b. Using the MIRR approach, solve for the PV of the cleanup costs in year 4, and add this value to the initial cost of the project.

PV of cleanup costs:` (4,098,081)

PV of initial startup costs and cleanup costs: (8,648,081)

New timeline of costs:

Today (8,648,081)
1 year 3,500,000
2 years 3,500,000
3 years 3,500,000

MIRR: 10.37%

c. Yes, because the MIRR is greater than the cost of capital.

Discount rate NPV

0.00% (50,000)
0.25% (42,655)
0.50% (35,617)
0.75% (28,878)
1.00% (22,434)
1.25% (16,278)
1.50% (10,404)
1.75% (4,807)
2.00% 519
2.25% 5,579
2.50% 10,379
2.75% 14,923
3.00% 19,217
3.25% 23,267
3.50% 27,076
3.75% 30,650
4.00% 33,993
4.25% 37,111
4.50% 40,007
4.75% 42,686
5.00% 45,153
5.25% 47,412
5.50% 49,466
5.75% 51,321
6.00% 52,980
6.25% 54,447
6.50% 55,726
6.75% 56,821
7.00% 57,735
7.25% 58,472
7.50% 59,037
7.75% 59,432
8.00% 59,660
8.25% 59,726
8.50% 59,633
8.75% 59,383
9.00% 58,980
9.25% 58,427
9.50% 57,728
9.75% 56,885
10.00% 55,901
10.25% 54,780
10.50% 53,523
10.75% 52,134
11.00% 50,616
11.25% 48,971
11.50% 47,201
11.75% 45,311
12.00% 43,301
12.25% 41,175
12.50% 38,935
12.75% 36,583
13.00% 34,122
13.25% 31,554
13.50% 28,881
13.75% 26,106
14.00% 23,230
14.25% 20,257
14.50% 17,187
14.75% 14,024
15.00% 10,768
15.25% 7,423
15.50% 3,990
15.75% 470
16.00% (3,133)
16.25% (6,819)
16.50% (10,586)
16.75% (14,431)
17.00% (18,353)
17.25% (22,350)
17.50% (26,422)
17.75% (30,565)
18.00% (34,778)
18.25% (39,060)
18.50% (43,410)
18.75% (47,825)
19.00% (52,304)
19.25% (56,846)
19.50% (61,449)
19.75% (66,112)
20.00% (70,833)
Problem 8-24

You are getting ready to start a new project that will incur
some cleanup and shutdown costs when it is completed. The
project costs $5.4 million up front and is expected to
generate $1.1 million per year for 10 years and then have
some shutdown costs in year 11. Use the MIRR approach to
find the maximum shutdown costs you could incur and still
meet your cost of capital of 15% on this project.

Upfront costs ($5,400.00)

Annual cash flows $1,100.00
Coupon rate 15%
Number of years of inflows 10

Present value of cash inflows $5,520.65

Difference (not including shutdown costs $120.65
Future value of difference -$561.29
Maximum shutdown costs (check) -$561.29
(in thousands of $)
Problem 8-25

You are considering investing in a new gold mine in South Africa. Gold in South Africa is buried very deep, so the mine will require an initial investment of $250
million. Once this investment is made, the mine is expected to produce revenues of $30 million per year for the next 20 years. It will cost $10 million per year to
operate the mine. After 20 years, the gold will be depleted. The mine must then be stabilized on an ongoing basis, which will cost $5 million per year in perpetuity.
Calculate the IRR of this investment. (Hint: Plot the NPV as a function of the discount rate.)

Year
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Cash Flows:
Initial Cost: (250,000,000.00) ($250,000,000.00)
Revenue 30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00
Minus annual cost (10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00)
Profit 20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00
Number of years until mine is
depleted 20
Perpetual annual revenue
after mine is depleted (5,000,000.00) NPV Profile
IRR: The IRR is undefined, since the NPV is never positive
$0.00
0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0%
($50,000,000.00)
If cost of capital is: Then NPV is: ($100,000,000.00)
0.0% #DIV/0!
1.0% ($298,861,175.84) 0 ($150,000,000.00)
2.0% ($91,214,166.39) 0 NPV
3.0% ($44,729,795.16) 0 ($200,000,000.00)
4.0% ($35,241,841.38) 0
5.0% ($38,444,741.44) 0 ($250,000,000.00)
6.0% ($46,585,302.87) 0
7.0% ($56,578,215.29) 0 ($300,000,000.00)
8.0% ($67,046,314.81) 0
9.0% ($77,341,913.83)
($350,000,000.00)
0
10.0% ($87,160,907.01) 0
11.0% ($96,371,342.52) 0
12.0% ($104,930,576.06) 0
13.0% ($112,842,749.01) 0
14.0% ($120,136,021.92) 0
15.0% ($126,850,046.49) 0
16.0% ($133,028,977.51) 0
17.0% ($138,717,581.30) 0
18.0% ($143,959,115.35) 0
19.0% ($148,794,236.08) 0
20.0% ($153,260,506.66) 0
21.0% ($157,392,253.35) 0
22.0% ($161,220,620.29) 0
23.0% ($164,773,732.59) 0
24.0% ($168,076,913.27) 0
25.0% ($171,152,921.50) 0
26.0% ($174,022,192.82) 0
27.0% ($176,703,070.51) 0
28.0% ($179,212,022.16) 0
29.0% ($181,563,838.72) 0
30.0% ($183,771,815.27) 0
31.0% ($185,847,913.73) 0
32.0% ($187,802,908.46) 0
33.0% ($189,646,516.07) 0
34.0% ($191,387,510.76) 0
35.0% ($193,033,826.60) 0
36.0% ($194,592,648.24) 0
37.0% ($196,070,491.13) 0
38.0% ($197,473,272.56) 0
39.0% ($198,806,374.60) 0
40.0% ($200,074,699.78) 0
41.0% ($201,282,720.46) 0
42.0% ($202,434,522.65) 0
43.0% ($203,533,844.80) 0
44.0% ($204,584,112.38) 0
45.0% ($205,588,468.55) 0
46.0% ($206,549,801.55) 0
47.0% ($207,470,768.99) 0
48.0% ($208,353,819.68) 0
49.0% ($209,201,213.02) 0
50.0% ($210,015,036.43) 0
51.0% ($210,797,220.89) 0
52.0% ($211,549,554.94) 0
53.0% ($212,273,697.25) 0
 16 17 18 19 20

$30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00 $30,000,000.00

($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00) ($10,000,000.00)
$20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00 $20,000,000.00
Problem 8-28

You are choosing between two projects, but can only take one. The cash flows for the project are given in the following table:

Timeline: 0 1 2 3 4
A ($50) 25 20 20 15
B ($100) 20 40 50 60

a. What are the IRR's of the two projects?

b. If your discount rate is 5%, what are the NPV's of the two projects
c. Why do IRR and NPV rank the two projects differently?

a. IRR of Investment A: 24%

IRR of Investment B: 21%

b. NPV of Investment A at 5%: $21.57

NPV of Investment B at 5%: $47.88

c. NPV and IRR rank the two projects differently because they are measuring different things. NPV is measuring value creation, while
IRR is measuring return on investment. Because returns do not scale with different levels of investment, the two measures may give
different rankings when initial investment is different.
Problem 8-30

You are considering the following two projects and can only take one. Your cost of capital is 11%.

Timeline: 0 1 2 3 4
A ($100) 25 30 40 50
B ($100) 50 40 30 20

a. What is the NPV of each project at your cost of capital?

b. What is the IRR of each project?
c. At what cost of capital are you indifferent between the two projects?
d. What should you do?

a. NPV of Investment A at 11%: $9.06

NPV of Investment B at 11%: $12.62

b. IRR of Investment A: 14.70%

IRR of Investment B: 17.80%

c. This can be solved two ways. One is to calculate the IRR of the difference in cash flows between the two projects. The other is to create
NPV profiles of both investments, and determine the cost of capital at which the NPV's of both projects are the same.

Timeline: 0 1 2 3 4
A ($100) 25 30 40 50
B ($100) 50 40 30 20

A-B $0 -25 -10 10 30

IRR of Investment A - Investment B: 5.567%

Or, as seen in the graph below, the profiles cross at 5.567%

NPV Profiles of Investments A and B

$50.00

$45.00
$40.00

$35.00
NPV

$30.00
$25.00 Investment
B
$20.00
$15.00
$10.00

$5.00

$0.00
% % % % % % % % % % % % % % % % % % % % %
00 50 00 50 00 50 00 50 00 50 00 50 00 50 00 50 00 50 00 50 00
0. 0. 1. 1. 2. 2. 3. 3. 4. 4. 5. 5. 6. 6. 7. 7. 8. 8. 9. 9. 10.

Cost of capital
 $20.00

$15.00
$10.00
$5.00

$0.00
% % % % % % % % % % % % % % % % % % % % %
00 50 00 50 00 50 00 50 00 50 00 50 00 50 00 50 00 50 00 50 00
0. 0. 1. 1. 2. 2. 3. 3. 4. 4. 5. 5. 6. 6. 7. 7. 8. 8. 9. 9. 10.

Cost of capital

d. You should invest in project B, as it has the higher NPV.

NPVA NPVB
0.00% $45.00 $40.00
0.25% $43.99 $39.25
0.50% $43.00 $38.51
0.75% $42.01 $37.78
1.00% $41.03 $37.05
1.25% $40.07 $36.33
1.50% $39.11 $35.62
1.75% $38.17 $34.91
2.00% $37.23 $34.21
2.25% $36.30 $33.52
2.50% $35.39 $32.83
2.75% $34.48 $32.15
3.00% $33.58 $31.47
3.25% $32.69 $30.80
3.50% $31.81 $30.14
3.75% $30.94 $29.48
4.00% $30.08 $28.83
4.25% $29.22 $28.18
4.50% $28.38 $27.54
4.75% $27.54 $26.90
5.00% $26.71 $26.27
5.25% $25.89 $25.64
5.50% $25.08 $25.02
5.75% $24.27 $24.41
6.00% $23.47 $23.80
6.25% $22.69 $23.20
6.50% $21.90 $22.60
6.75% $21.13 $22.00
7.00% $20.36 $21.41
7.25% $19.61 $20.83
7.50% $18.85 $20.25
7.75% $18.11 $19.68
8.00% $17.37 $19.11
8.25% $16.64 $18.54
8.50% $15.92 $17.98
8.75% $15.20 $17.42
9.00% $14.49 $16.87
9.25% $13.79 $16.33
9.50% $13.10 $15.78
9.75% $12.41 $15.25
10.00% $11.72 $14.71
 NPV Profile for 8-16

4000000.00
2000000.00
0.00
NPV

(2000000.00)0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%
0. 8. 16. 24. 32. 40. 48. 56. 64. 72. 80. 88. 96.
(4000000.00)
(6000000.00) NPV
(8000000.00)
(10000000.00)
(12000000.00)
(14000000.00)
(16000000.00)
Discount rate

Back to problem 8-16

 NPV for Problem 8-17

4000000.00

3000000.00
NPV

2000000.00

1000000.00 NPV

0.00
0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%
0. 8. 16. 24. 32. 40. 48. 56. 64. 72. 80. 88. 96.
(1000000.00)

(2000000.00)
Discount rate

Back to problem 8-17