Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

CHAPTER4
INVESTMENT CRITERIAS
1. Calculating Payback Period and NPV Maxwell Software, Inc., has the following mutually
exclusive projects.

a. Suppose the company’s payback period cutoff is two years. Which of these two projects should
be chosen?
 Project A:
 Cummulative cash flow:
Year 1 = $13,200
Year 2 = $13,200 + $8,300 = $21,500
20,000−13,200
 Payback period of A = 1 +
8,300
= 1.82 years

 Project B:
 Cummulative cash flow:
Year 1 = $14,100
Year 2 = $14,100 + 9,800 = $23,900
Year 3 = $14,100 + 9,800 + 7,600 = $31,500
24,000−14,100−9,800
 Payback period of B = 2 +
7,600
= 2.01 years
 Because the company’s payback period cutoff is two years and project A has payback
period less than 2 years, so the Company should choose project A
b. Suppose the company uses the NPV rule to rank these two projects. Which project should be
chosen if the appropriate discount rate is 15 percent?
 Project A:
13,200 8,300 3,200
NPV = -20,000 + 1 + 2 + = - $141.69
( 1+15 % ) ( 1+15 % ) ( 1+15 % )3
 Project B:
14,100 9,800 7,600
NPV = -20,000 + 1 + 2 + = $4,668.2
( 1+15 % ) ( 1+15 % ) ( 1+15 % )3
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

 The Company should choose project B because project B has a POSITIVE NPV.
2. Calculating Discounted Payback An investment project has annual cash inflows of $5,000,
$5,500, $6,000, and $7,000, and a discount rate of 12 percent. What is the discounted payback
period for these cash flows if the initial cost is $8,000? What if the initial cost is $12,000? What if it
is $16,000?
 Initial cost = $8,000
Year 0 1 2 3 4
Cash flow -8,000 5,000 5,500 6,000 7,000
Discounted -8,000 4,464.29 4,384.57 4,270.68 4,448.63
Cash Flow
Cumulative -8,000 -3,535.71 848.86 5,119.54 9,568.17
Cash Flow
3,535.71
 Discounted payback period = 1 + 4,384.57 = 1.81 years

 Initial cost = $12,000

Year 0 1 2 3 4
Cash flow -12,000 5,000 5,500 6,000 7,000
Discounted -12,000 4,464.29 4,384.57 4,270.68 4,448.63
Cash Flow
Cumulative -12,000 -7,535.71 -3,151.14 1,119.54 5,568.17
Cash Flow
3,151.14
 Discounted payback period = 2 + 4,270.68 = 2.74 years

 Initial cost = $16,000

Year 0 1 2 3 4
Cash flow -16,000 5,000 5,500 6,000 7,000
Discounted -16,000 4,464.29 4,384.57 4,270.68 4,448.63
Cash Flow
Cumulative -16,000 -11,535.71 -7,151.14 -2,880.46 1,568.17
Cash Flow
2,880.46
 Discounted payback period = 3 + 4,448.63 = 3.65 years
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

3. Calculating IRR Compute the internal rate of return for the cash flows of the following two
projects:

 Project A:
2,750 2,800 1,600
NPV = -5,700 + 1 + 2 + =0
( 1+ IRR ) ( 1+ IRR ) ( 1+ IRR )3
 IRR = 13.39%
 Project B:
1,380 1,800 1,200
NPV = -3,450 + 1 + 2 + =0
( 1+ IRR ) ( 1+ IRR ) ( 1+ IRR )3
 IRR = 13.22%

4. Calculating Profitability Index Bill plans to open a self-serve grooming center in storefront.
The grooming equipment will cost $265,000, to be paid immediately. Bill expects after tax cash
inflows of $59,000 annually for seven years, after which he plans to scrap the equipment and retire
to the beaches of Nevis. The first cash inflow occurs at the end of the first year. Assume the
required return is 13 percent. What is the project’s PI? Should it be accepted?

PI =
PV of Future Cash Flow
Initial Investment
=
CF
r (
× 1−
1
)=
( 1+r )t
59,000
13 % (
× 1−
1
)
(1+13 % )7 = 0.98
Initial Investment 265,000

Because PI < 1 => reject project

5. NPV versus IRR Consider the following cash flows on two mutually exclusive projects for the
Bahamas Recreation Corporation (BRC). Both projects require an annual return of 14 percent.

b
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

As a financial analyst for BRC, you are asked the following questions:
a. If your decision rule is to accept the project with the greater IRR, which project should you
choose?
 Deepwater Fishing:
320,000 470,000 410,000
NPV = -850,000 + 1 + 2 + =0
( 1+ IRR ) ( 1+ IRR ) ( 1+ IRR )3
 IRR = 18.58%
 Submarine Ride:
810,000 750,000 690,000
NPV = -1,650,000 + 1 + 2 + =0
( 1+ IRR ) ( 1+ IRR ) ( 1+ IRR )3
 IRR = 17.81%

 If the decision rule is to accept the project with the greater IRR, Deepwater Fishing should
be chosen. Because Deepwater Fishing has the higher IRR.

b. Because you are fully aware of the IRR rule’s scale problem, you calculate the incremental IRR
for the cash flows. Based on your computation, which project should you choose?
 The incremental cash flows of the submarine ride are:
Project C0 C1 C2 C3 IRR NPV at
14%
SR - DF -800,000 490,000 280,000 280,000 …….. ………

490,000 280,000 280,000

NPV = -800,000 +
( 1+14 % )1 +
( 1+14 % )2 +
( 1+14 % )3
= $34,267.49

 Because NPV of SR – DF is positive, so it should be accepted.

We have:
490,000 280,000 280,000
NPV = -800,000 + 1 + 2 + =0
( 1+ IRR ) ( 1+ IRR ) ( 1+ IRR )3
 IRR = 16.84%
 Because IRR is higher than discount rate, so SR – DF should be accepted.
 We should choose Submarine Ride

c. To be prudent, you compute the NPV for both projects. Which project should you choose? Is it
consistent with the incremental IRR rule?
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

 Deepwater Fishing:
320,000 470,000 410,000
NPV = -850,000 + 1 + 2 + = $69,089.81
( 1+14 % ) ( 1+14 % ) ( 1+14 % )3

 Submarine Ride:
810,000 750,000 690,000
NPV = -1,650,000 + 1 + 2 + = $103,357.31
( 1+14 % ) ( 1+14 % ) ( 1+14 % )3

 We should choose Submarine Ride. The NPV rule is consistent with the incremental
IRR rule

6. Comparing Investment Criteria Wii Brothers, a game manufacturer, has a new idea for an
adventure game. It can market the game either as a traditional board game or as an interactive DVD,
but not both. Consider the following cash flows of the two mutually
exclusive projects for the company. Assume the discount rate for both projects is 10 percent.

a. Based on the payback period rule, which project should be chosen?

 Board Game:
 Cummulative cash flow:
Year 1 = $700
Year 2 = $700 + $550 = $1,250
950−700
 Payback period = 1 +
550
= 1.45 years

 DVD:
 Cummulative cash flow:
Year 1 = $1,500
Year 2 = $1,500 + $1,050 = $2,550
2,100−1,500
 Payback period = 1 +
1,050
= 1.57 years
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

 Because payback period of Board Game is shorter than payback period of DVD, so Wii
Brothers should choose Board Game
b. Based on the NPV, which project should be chosen?
 Board Game:
700 550 130
NPV = -950 + 1 + 2 + = $238.58
( 1+10 % ) ( 1+10 % ) ( 1+10 % )3
 DVD:
1,500 1,050 450
NPV = -2,100 + 1 + 2 + = $469.5
( 1+10 % ) ( 1+10 % ) ( 1+10 % )3
=> Because NPV of DVD is higher than Board Game, so Wii Brothers should choose DVD
c. Based on the IRR, which project should be chosen?
 Board Game:
700 550 130
NPV = -950 + 1 + 2 + =0
( 1+ IRR ) ( 1+ IRR ) ( 1+ IRR )3
 IRR = 27,51%
 DVD:
1,500 1,050 450
NPV = -2,100 + 1 + 2 + =0
( 1+ IRR ) ( 1+ IRR ) ( 1+ IRR )3
 IRR = 25,09%
=> Because IRR of Board Game is higher than IRR of DVD, so Wii Brothers should choose
Board Game
d. Based on the incremental IRR, which project should be chosen?
 The incremental cash flows of the submarine ride are:
Project C0 C1 C2 C3 IRR NPV at
10%
DVD - BG -1,150 800 500 320 …….. ………

800 500 320

NPV = -1,150 +
( 1+10 % ) 1 +
( 1+10 % ) 2 +
( 1+10 % )3
= $230.92

 Because NPV of DVD - BG is negative, so it should not be accepted.

We have:
800 500 320
NPV = -1,150 + 1 + 2 + =0
( 1+ IRR ) ( 1+ IRR ) ( 1+ IRR )3

 IRR = 23.19%
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

 Because IRR is higher than discount rate, so DVD - BG should be accepted.

 We should choose DVD
7. Profitability Index versus NPV Hanmi Group, a consumer electronics conglomerate, is
reviewing its annual budget in wireless technology. It is considering investments in three different
technologies to develop wireless1 communication devices. Consider the following cash flows of the
three independent projects available to the company. Assume the discount rate for all projects is 10
percent. Further, the company has only $40 million to invest in new projects this year.

a. Based on the profitability index decision rule, rank these investments.

22 15 5
PV of Future Cash Flow + +
PI of CDMA =
Initial Investment
= (1+ 10 %) (1+10 %) (1+10 %)3
1 2
= 2.26
16
20 50 40
PV of Future Cash Flow + +
PI of G4 =
Initial Investment
= 1 2
(1+ 10 %) (1+10 %) (1+10 %)
3
= 3.73
24
36 64 40
PV of Future Cash Flow + +
PI of Wi-FI =
Initial Investment
= 1 2
(1+ 10 %) (1+10 %) (1+10 %)
3
= 2.89
40

 G4 > Wi-Fi > CDMA

b. Based on the NPV, rank these investments.
22 15 5
NPV of CDMA = -16 + 1 + 2 + = $20.15
( 1+10 % ) ( 1+10 % ) ( 1+10 % )3
20 50 40
NPV of G4 = -24 + 1 + 2 + = $65.56
( 1+10 % ) ( 1+10 % ) ( 1+10 % )3
36 64 40
NPV of Wi-Fi = -40 + 1
+ 2
+ 3 = $75.67
(1+10 %) (1+ 10 %) (1+10 %)
 WI-Fi > G4 > CDMA
c. Based on your findings in (a) and (b), what would you recommend to the CEO of the company
and why?
Three projects have positive NPV, so we can choose all to invest. Because the budget is limited
to $40 million, we can only accept the CDMA project and the G4 project, or the Wi-Fi project.
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

NPV of CDMA + G4 = $20.15 + $65.56 = $85.71

However, NPV of CDMA + G4 is higher than NPV of Wi-Fi, so we should choose CDMA and
G4
8. NPV and Multiple IRRs You are evaluating a project that costs $75,000 today. The project has
an inflow of $155,000 in one year and an outflow of $65,000 in two years. What are the IRRs for
the project? What discount rate results in the maximum NPV for this project? How can you
determine that this is the maximum NPV?
155,000 65,000
NPV = -75,000 + 1 - =0
( 1+ IRR ) ( 1+ IRR )2
1
Supposed that:
1+ IRR
=X
=> We have:
NPV = -75,000 + 155,000X - 65,000X2 = 0
 X = 1.7098 or X = 0.6749
1
 With X = 1.7098 = 1+ IRR => IRR = - 41.51%

1
 With X = 0.6749 = 1+ IRR => IRR = 48.17%

 The maximum NPV for this project:

NPV’ = 155,000 – 130,000X = 0 => X = 1.19 => IRR = -16.97%
NPV’’ = -130,000 < 0
=> At IRR = -16.97% the NPV of project is maximum.
9. Payback and NPV An investment under consideration has a payback of six years and a cost of
$573,000. If the required return is 12 percent, what is the worst-case NPV? The best-case NPV?
Explain. Assume the cash flows are conventional.
The worst case is that the payback occurs at the end of the sixth year.
573,000
NPV = -573,000 + = $282,700.37
( 1+12 % )6
The best case has infinite cash flows beyond the payback point. Thus, the best-case NPV is
infinite.
10. Calculating IRR Consider two streams of cash flows, A and B. Stream A’s first cash flow is
$11,600 and is received three years from today. Future cash flows in Stream A grow by 4 percent in
perpetuity. Stream B’s first cash flow is -$13,000, is received two years from today, and will
continue in perpetuity. Assume that the appropriate discount rate is 12 percent.
Concept Questions and Exercises CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

a. What is the present value of each stream?

 Stream A: Since the first cash flow is received in Year 3, the growing perpetuity
actually begins in Year 2. Then, discount the PV as of the end of year 2 back two years
to find the PV as of today, year 0.

PV = r−g ×( CF )
( 1+r )2
1
= ( 1211,600 ) ×
1
%−4 % ( 1+ 12% ) 2 = $ 154,124.15

 Stream B: Since the first cash flow is received in Year 2, the perpetuity actually begins
in Year 1. Then, discount the PV as of the end of year 1 back one year to find the PV as
of today, year 0.

PV = ( CFr ) × ( 1+r1 ) = ( −13,000

1
12 % ) ×
1
( 1+ 12% ) 1 = - $96,726.19

b. Suppose that the two streams are combined into one project, called C. What is the IRR
of Project C?
If the two streams are combined into one project, called C, we will have:

PV = ( CF )A
×
1
r−g ( 1+r )
+ ( CF
r
2 ) ×
1 B

( 1+r ) 1 =0

= ( 11,600
× ) 1
IRR−4 % ( 1+ IRR )2 + ( −13,000
IRR
×) 1
( 1+ IRR )1
=0

=> IRR = 16,9%

c. What is the correct IRR rule for Project C?
Because IRR > discount rate => accept
The correct decision rule for an investing-type project is to accept the project if the discount rate is below the
IRR. Since there is one IRR, a decision can be made.