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JCU-MBA-CF Lecture 5 (Ross Chapter 7)

Capital Budgeting 1: Net present value and other investment criteria

SOLUTIONS TO TUTORIAL QUESTIONS: PRS 3. Payback period A: 2000 1040 = 960; 960/1260 = 0.76 Payback = 1.76 years Payback period B: 2000 820 880 =300; 300/3800 = 0.08 Payback = 2.08 years Two-year payback required: Investment A would be accepted. It is not necessarily the best investment because payback ignores cash flows that occur after the cut-off period, resulting in a bias for short-term projects. 4. Investment A: NPV = 2,000 + 1040/1.06 + 1260/(1.06)2 + 1954/(1.06)3 = $1,743 Investment B: NPV = 2,000 + 820/1.06 + 880/(1.06)2 + 3800/(1.06)3 = $2,748 Investment B is the better investment. A: 100 = 100/(1 + IRR) + 200/(1 + IRR)2 100/(1 + IRR)3 Descartes rule of sign states there could be two solutions. IRR = 80.19% or 55.50% B: 100 = 100/(1 + IRR)2 + 200/(1 + IRR)3 IRR = 52.14% Project A: 8,000 = 4,820/(1 +IRR) + 5,860/(1 + IRR)2 IRR = 20.86% Project B: 4,000 = 2,620/(1 + IRR) + 3,440/(1 + IRR)2 IRR = 31.10% At 0% interest rate NPVA is $2,680 and NPVB is $2,060. At the IRRs the NPVs are both zero so on an NPV/interest profile the plotted curves must cross. If the required rate of return is less than the crossover rate the IRR will incorrectly accept B. Consider the project AB 4,000 = 2,200/(1 + IRR) + 2,420/(1 + IRR)2

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JCU-MBA-CF: Solutions to Lecture/Tutorial 05

IRR = 10% = crossover rate. Ping would be indifferent between the two projects at this discount rate.

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To calculate the IRR we have to use trial and error. The table summarises some possible results:
Discount rate 0% 10% 20% 30% 40% Limp $55.00 28.83 9.95 (4.09) (14.80) Stumble $50.00 32.14 18.40 7.57 (1.17)

The IRR for Limp must be between 20% and 30% because this is where the NPV is zero. With more trial and error we find it is 26.79%. The IRR for Stumble must be between 30% and 40% because this is where the NPV is zero. With more trial and error we find it is 38.54%. Between 0% and 10% the NPVs are close so the crossover is in this range. To find the crossover we find the IRR on the difference in the cash flows. If we take the cash flows of Limp less the cash flows of Stumble we have:
Year 0 1 2 3 Limp Stumble $0 (40) (10) 55

The cash flows look odd but the sign changes once, so there is only one IRR. The zero NPV occurs at 5.42% so this is the crossover rate. Stumble has the higher IRR. Limp has higher NPVs in the range from 0% to 5.42%, so the rankings will conflict over this range. Who would bother with IRRs when ranking projects?

JCU-MBA-CF: Solutions to Lecture/Tutorial 05