Chapter 05 - Net Present Value and Other Investment Criteria

CHAPTER 5
Net Present Value and Other Investment Criteria

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. a. A = 3 years; B = 2 years; C = 3 years

b. B

c. A, B, and C

d. B and C (At 10%, NPVA = –$1,011; NPVB = $3,378; NPVC = $2,405)

e. True. The payback rule ignores all cash flows after the cutoff date, meaning that future
years’ cash inflows are not considered. Thus, payback is biased towards short-term
projects.

f. It will accept no negative-NPV projects, but will turn down some with
positive NPVs. A project can have a positive NPV if all future cash flows
are considered but still not meet the stated cutoff period.

Est. time: 6 – 10

2. Given the cash flows C0, C1, . . . , CT, IRR is defined by:

NPV = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + … + CT / (1 + IRR)T = 0

IRR is calculated by trial and error, by financial calculators, or by spreadsheet

programs.

Est. time: 1 – 5

3. a. NPV = –$6,750 + $4,500 / (1 + 0) + $4,500 / (1 + 0)2 = $15,750

NPV = –$6,750 + $4,500 / (1 + .50) + $4,500 / (1 + .50) 2 = $4,250
NPV = –$6,750 + $4,500 / (1 + 1) + $4,500 / (1 + 1)2 = $0

b. 100%; NPV = 0 when the discount rate is 100 percent.

Est. time: 1 – 5

4. No; you would not accept this offer as you are effectively “borrowing” at a rate of interest higher
than the opportunity cost of capital. You can verify this decision by proving that the NPV is
negative as follows:

NPV = $5,000 + $4,000 / (1 + .10) + (–$11,000) / (1 + .10)2

NPV = –$454.55

Est. time: 1 – 5

5 a. Two; because the cash flows change direction twice.

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Chapter 05 - Net Present Value and Other Investment Criteria

b. −50% and +50%. The NPV for the project using both of these IRRs is 0.

c. Yes, the NPV is positive at 20 percent

NPV = –$100 + $200 / (1 + .20) + (–$75) / (1 + .20)2

NPV = $14.58

Est. time: 1 – 5

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

($293,000 – 172,000) / (1 + IRR)2

Incremental IRR = 10%

The IRR on Project Beta exceeds the cost of capital. So, since the IRR on the incremental
investment in Project Alpha also exceeds the cost of capital, choose Alpha.

Est. time: 1 – 5

7. 1, 2, 4, and 6

The profitability index for each project is shown below:

Project NPV Investment Profitability Index (NPV/Investment)

1 5,000 10,000 5,000 / 10,000 = .5

2 5,000 5,000 5,000 / 5,000 = 1

3 10,000 90,000 10,000 / 90,000 = .11

4 15,000 60,000 15,000 / 60,000 = .25

5 15,000 75,000 15,000 / 75,000 = .2

6 3,000 15,000 3,000 / 15,000 = .2

Start with the project with the highest profitability index and go from there. Project 2 has the
highest profitability index and has an initial investment of $5,000. The next highest profitability
index is for Project 1, which has an initial investment of $10,000. The next highest is Project 4,
which will cost $60,000 up front. So far we have spent $75,000. Projects 5 and 6 both have
profitability indexes of .2, but we only have $15,000 left to spend, so we will add Project 6 to our
list. This gives us Projects 1, 2, 4, and 6.

Est. time: 1 – 5

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

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

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

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Chapter 05 - Net Present Value and Other Investment Criteria

NPVB = $4,044.73

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

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

Projects B and C have positive NPVs.

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

c. Accept projects A and B

d. Project A:
PV = CFt / (1 + r)t
PVA = $1,000 / (1 + .10)
PVA = $909.09
The present value of the cash inflows for Project A is less than the initial outlay for the
project, which means the project never pays back on a discounted basis. This is true for
any negative NPV project.

Project B:
The present values of the cash inflows for Project B are shown in the second row of the
table below, and the cumulative net present values are shown in the last row.
C0 C1 C2 C3 C4 C5
–$2,000 $1,000.00 $1,000.00 $4,000.00 $1,000.00 $1,000.00
–2,000 909.09 826.45 3,005.26 683.01 620.92
–1,090.91 –264.46 2,740.80 3,423.81 4,044.73

Since the cumulative NPV turns positive between year 2 and year 3, the discounted
payback period is calculated as:
Discounted payback period = 2 + $264.46 / $3,005.26 = 2.09 years

Project C:
The present values of the cash inflows for Project C are shown in the second row of the
table below, and the cumulative net present values are shown in the last row.

C0 C1 C2 C3 C4 C5
–$3,000 $1,000.00 $1,000.00 $ 0.00 $1,000.00 $1,000.00
–3,000 909.09 826.45 0.00 683.01 620.92
–2,090.91 –1,264.46 –1,264.46 –581.45 39.47

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Chapter 05 - Net Present Value and Other Investment Criteria

Since the cumulative NPV turns positive between year 4 and year 5, the discounted
payback period is:

Discounted payback period = 4 + $581.45 / $620.92 = 4.94 years

e. Using the discounted payback period rule with a cutoff of three years, the firm would
accept only Project B.

Est. time: 11– 15

9. a. When using the IRR rule, the firm must still compare the IRR with the opportunity cost of
capital. Thus, even with the IRR method, one must specify the appropriate discount rate.

b. Risky cash flows should be discounted at a higher rate than the rate used to discount
less risky cash flows. Using the payback rule is equivalent to using the NPV rule with a
zero discount rate for cash flows before the payback period and an infinite discount rate
for cash flows thereafter.
Est. time: 1 – 5

10.
r = -17.44% 0.00% 10.00% 15.00% 20.00% 25.00% 45.27%
Year 0 –3,000.00 –3,000.00 –3,000.00 –3,000.00 –3,000.00 –3,000.00 –3,000.00 –3,000.00
Year 1 3,500.00 4,239.34 3,500.00 3,181.82 3,043.48 2,916.67 2,800.00 2,409.31
Year 2 4,000.00 5,868.41 4,000.00 3,305.79 3,024.57 2,777.78 2,560.00 1,895.43
Year 3 –4,000.00 -7,108.06 -4,000.00 -3,005.26 -2,630.06 -2,314.81 -2,048.00 -1,304.76
PV = -.31 500.00 482.35 437.99 379.64 312.00 -.02
The two IRRs for this project are (approximately): –17.44% and 45.27%.
Between these two discount rates, the NPV is positive.

Est. time: 06 - 10

11. a. The figure shown below was drawn from the following points:
Discount Rate
0% 10% 20%
NPVA +20.00 +4.13 -8.33
NPVB +40.00 +5.18 -18.98

b. From the graph, we can estimate the IRR of each project from the point where its line
crosses the horizontal axis:
IRRA = 13.1% and IRRB = 11.9%

This can be checked by calculating the NPV for each project at their respective IRRs,
which give an approximate NPV of 0.

c. The company should accept Project A if its NPV is positive and higher than that of Project
B; that is, the company should accept Project A if the discount rate is greater than 10.7%
(the intersection of NPVA and NPVB on the graph below) and less than 13.1% (the
internal rate of return).

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Chapter 05 - Net Present Value and Other Investment Criteria

d. The cash flows for (B – A) are:

C0 = $ 0
C1 = –$60
C2 = –$60
C3 = +$140
Therefore:
Discount Rate
0% 10% 20%
NPVB − A +20.00 +1.05 -10.65

IRRB − A = 10.7%
The company should accept Project A if the discount rate is greater than 10.7% and less
than 13.1%. As shown in the graph, for these discount rates, the IRR for the incremental
investment is less than the opportunity cost of capital.

50.00
40.00
30.00
20.00 Project A
NPV

10.00 Project B

0.00 Increment

-10.00
-20.00
-30.00
0% 10% 20%
Rate of Interest

Est. time: 06 - 10

12. a. Because Project A requires a larger capital outlay, it is possible that Project A has both a
lower IRR and a higher NPV than Project B. (In fact, NPVA is greater than NPVB for all
discount rates less than 10%.) Because the goal is to maximize shareholder wealth,
NPV is the correct criterion.

b. To use the IRR criterion for mutually exclusive projects, calculate the IRR for the
incremental cash flows:
C0 C1 C2 IRR
A-B −200 +110 +121 10%

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Chapter 05 - Net Present Value and Other Investment Criteria

Because the IRR for the incremental cash flows exceeds the cost of capital, the
additional investment in A is worthwhile.

c. NPVA = –$400 + $250 / 1.09 + $300 / 1.092

NPVA = $81.86

NPVB = –$200 + $140 / 1.09 + $179 / 1.092

NPVB = $79.10

Est. time: 06 - 10

13. NPV = 0 = [–$550,000 – (–$250,000)] / (1 + IRR)1 + [$650,000 – (–$250,000)] / (1 + IRR)2 + ($0 –

NPV = 0 = –$300,000 / (1 + IRR) + $900,000 / (1 + IRR)2 + (–$650,000) / (1 + IRR)3

Because the cash flows change direction twice, there are two IRRs. The IRRs for the incremental
flows are approximately 21.13 percent and 78.87 percent. If the cost of capital is between these
two rates, Titanic should work the extra shift.

Est. time: 06 - 10

14. a. NPVD = –$10,000 + $20,000 / (1 +.10)

NPVD = $8,181.82

NPVE = –$20,000 + $35,000 / (1 + .10)

NPVE = $11,818.18

PI = NPV / investment
PID = $8,181.82 / $10,000
PID = .82

PIE = $11,818.18 / $20,000

PIE = .59

Each project has a positive PI, thus, both projects are acceptable.

b. In order to choose between these projects, we must use incremental analysis. For the
incremental cash flows:

NPVE – D = [–$20,000 – (–$10,000)] + ($35,000 – 20,000) / (1 + .10)

NPVE – D= $3,636.36

PIE – D = $3,636.36 / ABS[–$20,000 – (–$10,000)]

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Chapter 05 - Net Present Value and Other Investment Criteria

PIE – D = .36

The incremental PI is positive so the larger project should be accepted, i.e., accept
Project E. Note that, in this case, the project that was accepted has the lower PI.

Est. time: 11 - 15

15. Using the fact that profitability index = (net present value / investment), we find:
Project Profitability Index
1 .22
2 −.02
3 .17
4 .14
5 .07
6 .18
7 .12
Thus, given the budget of $1 million, the best the company can do is to accept Projects 1, 3, 4,
and 6.
If the company accepted all positive NPV projects, the market value (compared to the market
value under the budget limitation) would increase by the NPV of Project 5 plus the NPV of Project
7: $7,000 + $48,000 = $55,000. Thus, the budget limit costs the company $55,000 in terms of its
market value.

Est. time: 06 - 10

16. The IRR is the discount rate which, when applied to a project’s cash flows, yields NPV = 0. Thus,
it does not represent an opportunity cost. However, if each project’s cash flows could be invested
at that project’s IRR, then the NPV of each project would be zero because the IRR would then be
the opportunity cost of capital for each project. The discount rate used in an NPV calculation is
the opportunity cost of capital. Therefore, it is true that the NPV rule does assume that cash
flows are reinvested at the opportunity cost of capital.

Est. time: 06 - 10

17.
a.
C0 = –3,000 C0 = –3,000
C1 = 3,500 C1 = 3,500
C2 = 4,000 C2 + PV(C3) = 4,000 – 3,571.43 = 428.57
C3 = –4,000 MIRR = 27.84%

xC 2 C3
b. xC1  
1.12 1.12 2
(1.122)(xC1) + (1.12)(xC2) = –C3
(x)[(1.122)(C1) + (1.12C2)] = –C3
X = –C3 / [(1.122)(C1) + (1.12)(C2)
X = 4,000 / [(1.122)(3,500) + (1.12)(4,000)]

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Chapter 05 - Net Present Value and Other Investment Criteria

X = .45

C0 + (1 – x)C1 / (1 + IRR) + (1 – x)C2 / (1 + IRR)2 = 0

–3,000 + (1 – .45)(3,500) / (1 + IRR) + (1 – .45)(4,000) / (1 + IRR)2 = 0

Now, find MIRR using either trial and error or the IRR function (on a financial calculator or
Excel). We find that MIRR = 23.53%.
It is not clear that either of these modified IRRs is at all meaningful. Rather, these
calculations seem to highlight the fact that MIRR really has no economic meaning.

Est. time: 11 - 15

18. Maximize: NPV = 6,700xW + 9,000xX + 0XY – 1,500xZ

subject to: 10,000xW + 0xX + 10,000xY + 15,000xZ  20,000
10,000xW + 20,000xX – 5,000xY – 5,000xZ  20,000
0xW - 5,000xX – 5,000xY – 4,000xZ  20,000
0  xW  1
0  xX  1
0  xY  1
0  xZ  1
Using Excel Spreadsheet Add-in Linear Programming Module:
Optimized NPV = $13,500
with xW = 0; xX = 1.5; xY = 2 and xZ = 0
If financing available at t = 0 is $21,000:
Optimized NPV = $13,725
with xW = 0; xX = 1.53; xY = 2.1 and xZ = 0
Here, the shadow price of an additional $1,000 invested at t =0 is $225.
In both cases, the program viewed xY as a viable choice, even though the NPV of Project Y is
zero. The reason for this result is that Project Y provides a positive cash flow in periods 1 and 2.
If the financing available at t = 1 is $21,000:
Optimized NPV = $13,950
with xW = 0; xX = 1.55; xY = 2 and xZ = 0
Hence, the shadow price of an additional $1,000 in t =1 financing is $450.

Est. time: 11 - 15

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