Week 4 Tutorial Worksheet Solution - For Student

BFF2140 Business Finance
Tutorial Week 04 – Solution
WEEK 4 CAPITAL BUDGETING I: TECHNIQUES FOR EVALUATION
Concept Check Solution:
B, A, C, C, B
Question 1:
Investment A
Year 0 1 2 3 4 5
Cash flow -$15,000 $7,000 $7,000 $7,000 $7,000 $7,000
Investment B
Year 0 1 2 3 4 5
Cash flow -$18,000 $12,000 $2,000 $2,000 $2,000 $2,000
The cash flows for two projects are shown above. The cost of capital is 9.5%. If an investor
decided to take projects with a payback period two years or less, which of these projects
would he take?
SOLUTION
For Payback Period, we use the formula:
For investment A, Payback period = (2 + $1000/ $7000) years = 2.14 years, or apply this
shortcut if equal CFs are given: 15000/7000 = 2.14 years.
Note: This shortcut formula can only be used if the cash inflows are equal.
Decision: As the payback period of 2.14 years is more than 2 years, so this investment is not
acceptable.
For investment B, Payback period = 4 years.

Decision: As the payback period of 4 years is more than 2 years, so not acceptable.
Question 2:
Burke Inc. is considering the purchase of Small Ltd. The acquisition would cost $190,000
but would increase Burke’s cash flows by $30,000 per year for the foreseeable future. If
Burke’s cost of capital is 15%, should it go ahead with the acquisition of Small?
SOLUTION
$ 30 , 000
NPV = - $190,000 + 0 . 15 = $10,000
(Note the use of the perpetuity formula to calculate the PV of $30,000 cash inflow that go on
indefinitely from year 1 onwards – recall the PV of a perpetuity accounts for all future cash
flows from the end of the first period; in other words: this formula values cashflows ONE
period BEFORE the first cashflow)
Question 3:
A development project involves purchasing a home and land for $15 million. In addition the
local council insists on a $4 million fee for defacing the views from the city. It also costs $1
million to lease the relevant equipment to conduct the project.
This project provides a series of cash flows in the following table. You believe the project is
very risky and therefore decided to use a discount rate of 23%. Calculate the Net Present
Value (NPV) and the Internal Rate of Return (IRR). Would your decision change if you used
a discount rate of 10%?
Projected Cash flow Projected Cash flow
Year 1 $1,500,000 Year 11 $2,500,000
Year 2 $3,278,000 Year 12 $2,500,000
Year 3 $5,000,000 Year 13 $2,500,000
Year 4 $6,450,000 Year 14 $2,500,000
Year 5 $2,500,000 Year 15 $2,500,000

Year 6 $2,500,000 Year 16 $2,500,000
Year 7 $2,500,000 Year 17 $2,500,000
Year 8 $2,500,000 Year 18 $2,500,000
Year 9 $2,500,000 Year 19 $2,500,000
Year 10 $2,500,000 Year 20 $2,500,000
SOLUTION
Discount Rate 23% 10%

Net Present Value - $6,533,019.28 $5,593,983.75
Internal Rate of Return 14.29% Same as before
Decision Reject as NPV<0 Accept as NPV>0
Note how the decision changes when the discount rate changes. Discount rates are just
estimations and are subject to change.
Using HP10bII+: For discount rate = 23%,

Keys Display Description
CFLO CLR Clears the cash flow
Note: The message memory
flashes and then
disappears
1.00 Sets the number of
1 payments per year.
23.00 Enters the interest per
23
year.
-20,000,000.00 Enters cash flow at t=0
-20000000
(CF0 flashes and then
disappears)
1,500,000.00 Enters cash flow at t=1
1500000
disappears)
3278000
disappears)
5000000
disappears)
6450000
disappears)
2500000
disappears)
16.00 Enters the number of
16
repetitions of previous
entered number
$462,187.32 Calculate the NPV at t=0
Excel syntax: =NPV(0.23, <range of cash flows from year 1 to year 20>)+<cell for initial cash
outflow) - Follow the steps demonstrated by your instructor in class.
Using HP10bII+: For discount rate = 10%,

flashes and then
disappears
10.00 Enters the interest per
10
year.
-20,000,000.00 Enters cash flow at t=0
-20000000
disappears)
1500000
disappears)
3278000
disappears)
5000000
disappears)
6450000
disappears)
2500000
disappears)
16.00 Enters the number of
16
repetitions of previous
entered number
Excel syntax: =NPV(0.10, <range of cash flows from year 1 to year 20>)+<cell for initial cash
outflow) - Follow the steps demonstrated by your instructor in class.
Question 4:
Initial investment Annual Cash flow
Project A $35 million $14 million
Project B $19 million $7 million
Project C $15 million $7 million
Project D $20 million $10.5 million
An investor has a budget of $35 million. He can invest in the 4-year projects shown above. If
the cost of capital is 8%, what investment(s) should he make?
SOLUTION
This question demonstrates a typical real-life problem of capital rationing. Capital rationing is
the process used to select capital projects when there is a limited amount of funding
available, which in this case, a budget restriction of $35 million. It will result in the
independent projects becoming competitive and mutually exclusive. Under capital rationing,
the projects are competing for the scarce resource of capital. In this situation, ranking of
projects becomes important.
Value created NPV

Profitablity Index PI = =
Resource consumed Initial investment
Project CF0 Annual CF NPV PI Rank Decision

A -35,000,000.00 14,000,000.00 11,369,775.76 0.324850736 3
B -19,000,000.00 7,000,000.00 4,184,887.88 0.2202572569 4
C -15,000,000.00 7,000,000.00 8,184,887.88 0.545659192 2 select
D -20,000,000.00 10,500,000.00 14,777,331.82 0.738866591 1 select
According to PI rule, we start picking the projects based on PIs ranking from highest to
lowest. Projects C and D are selected.
Question 5:
Billy was asked to choose between the following mutually exclusive projects:
Expected Net Cash Flows

Year Project S Project L
0 ($100,000) ($100,000)
1 60,000 33,500
2 60,000 33,500
3 33,500
4 33,500
The projects provide a necessary service, so whichever one is selected is expected to be

repeated into the foreseeable future. Both projects have a 10 percent cost of capital.
Required:
A) What is each project’s initial NPV without replication (naïve NPV rule)?
B) Repeat the analysis assuming now replication takes place. Hint: Use the equivalent
annual annuity approach and lowest common multiple methods introduced in class.
SOLUTION
A) Initial NPV without replication (naïve NPV rule).
NPV(Project S) =
Using hp10bII+ calculator

flashes and then
disappears
10 10.00 Enters the interest per
year.
-100,000.00 Enters cash flow at t=0
-100000 (CF0 flashes and then
disappears)
60,000.00 Enters cash flow at t=1
60000 (CF1 flashes and then
disappears)
disappears)
4,132.23 Calculate the NPV at t=0
Excel Syntax: =NPV(0.1, 60000, 60000) – 100000 - Follow the steps demonstrated by your
instructor in class.
NPV(Project L) =

flashes and then
disappears
year.
disappears)
33,500.00 Enters cash flow annuity
33500 (CF1 flashes and then group amount: Note the
disappears) CFLO annunciator.
4.00 Enters number of
4 (CFn flashes and then repetitions. Note the CFLO
disappears) and N annunciators.
Excel Syntax: =NPV(0.1, 33500, 33500, 33500, 33500) – 100000 - Follow the steps
demonstrated by your instructor in class.
Decision: Prefer Project L on basis of higher NPV.
B) Remember: We cannot simply use NPV to choose between mutually exclusive

projects with different lives. We have to use either one of the following methods:
i. Equivalent Annual Annuity Method (also called the Equivalent Annual Cash
Flow Method or EAC)
ii. Matching Cycle or Lowest common multiple method
Equivalent Annual Annuity Method
Project S
Project L
Decision: Prefer Project S on the basis of higher EAA.
Matching Cycle or Lowest common multiple method
Matching cycle is 4 years
Project S:
S will be undertaken twice throughout the 4 year cycle.
NPV for Project S to undertake twice in 4 years =

flashes and then
disappears
year.
disappears)
60,000 (CF1 flashes and then
disappears)
-40000 (this is the difference
between the initial
investment for cycle 2 and
the CF=2 for cycle 1.
disappears)
disappears)
disappears)
Excel Syntax: =NPV(0.1, 60000, -40000, 60000, 60000) – 100000 - Follow the steps
Project L:
L will be undertaken once in 4 years.
NPV for Project L to undertake once in 4 years = $6,190.49
Decision:
$7,547.37 > $6,190.49 Hence we prefer Project S
Question 6:
Taylor Made Inc. is considering two mutually exclusive projects. The projects’ expected net
cash flows are provided in the table below.
YEAR PROJECT 1 PROJECT 2

0 ($300,000) ($599,000)
1 (387,000) 234,000
2 (193,000) 234,000
3 100,000 234,000
4 600,000 234,000
5 1,270,000 234,000
A. Sketch (with a pen on a paper) the NPV profiles for projects A and B. Be careful to
ensure that you label all axes, lines and points carefully.
B. If you were told that each project’s cost of capital is 10%, which project should be
selected? You are required to calculate the NPV for each project to receive full credit.
C. Calculate the crossover rate exactly? Explain in one or two sentences the importance
of the crossover rate. Specifically in your answer detail the range for cost of capital
that project 1 would be preferable to project 2?
SOLUTION
A) Sketch the NPV profiles for projects A and B. Be careful to ensure that you label all axes,
lines and points carefully.
Ensure that when you construct your graph that you have labelled the y and x axis correctly;
Note: Sketch a “rough” NPV profile of one project requires two points, which can then be
formed a line:
 y-intersect: At 0% discount rate, NPV is simply the SUM OF ALL CASH FLOWS. This
gives a starting point on the y-axis.
Therefore, the sum of cash flow for project 1 is $1,090,000 and for project 2 is
$571,000. These will be plotted on the y-axis, representing the y-intersect for projects
1 and 2 respectively.
 x-intersect: Calculate the IRR of the project. This will give you the point at which the
NPV curve will cut the x-axis.
(NOTE: the x-axis of NPV profile does NOT represent IRR. It plots different costs of
capital as the x variable. The IRR of a project will be the point where the curve cuts
the x-axis).
Therefore, the IRR for project 1 is 24.08%, and the IRR for project 2 is 27.45%.
These will be plotted on the x-axis, representing the x-intersect for projects 1 and 2
respectively.
Note: To make your NPV more precise, you can calculate the NPV at two or three different k
% and roughly plot.
Calculating IRR using HP10BII+ and Excel
IRR for Project A

flashes and then
disappears
disappears)
disappears)
disappears)
disappears)
disappears)
disappears)
24.08 Calculate the Internal Rate
of Return
Excel Syntax: =IRR({-300000,-387000,-193000,100000,600000,1270000}) - Follow the

steps demonstrated by your instructor in class.
IRR for Project B

flashes and then
disappears
disappears)
27.45 Calculate the Internal Rate
of Return
Excel Syntax: =IRR({-599000,234000,234000,234000,234000,234000}) - Follow the steps

Putting them together
project 1: y axis= $1,090,000; x-axis= 24.08%

project 2: y axis = $571,000; x-axis= 27.45%
Cross over
rate
B) If you were told that each project’s cost of capital is 10%, which project should be
selected? You are required to calculate the NPV for each project to receive full credit.
Assuming 10% cost of capital

NPV (Project 1) = $462,187.32
NPV (Project 2) = $288,044.10
Select project 1 as it creates the greatest wealth for shareholders.
Calculating NPV using HP10BII+ & Excel
Project A with cost of capital = 10%

flashes and then
disappears
year.
disappears)
disappears)
disappears)
disappears)
disappears)
disappears)
Excel Syntax: = NPV(0.1, -387000, -193000, 100000, 600000, 1270000) – 300000 - Follow
the steps demonstrated by your instructor in class.
Project B with cost of capital = 10%

flashes and then
disappears
year.
disappears)
disappears)
disappears)
disappears)
234000
disappears)
disappears)
Excel Syntax: = NPV(0.1, 234000, 234000, 234000, 234000, 234000) – 599000 - Follow the
steps demonstrated by your instructor in class.
Note: when entering the annuity cash flow stream between year 1 and year 5 the
process can be sped as follows:

flashes and then
disappears
year.
disappears)
Side note: Calculating for both NPV and IRR in one go using hp10bii+
Note: If asked to calculate the NPV and IRR of a project, you can do this in one go as long
as you do the following: clear cash flow memory; input the rate; input your cash flows;
compute NPV first then compute IRR. It has to be done in this order (it won’t work if you
compute IRR before NPV).
C) Calculate the crossover rate exactly? Explain in one or two sentences the importance of
the crossover rate. Specifically, in your answer detail the range for cost of capital that project
1 would be preferable to project 2?
YEAR PROJECT 1 PROJECT 2 Pr1 - Pr2

0 -$300,000 -$599,000 $299,000
1 -387,000 234,000 -$621,000
2 -193,000 234,000 -$427,000
3 100,000 234,000 -$134,000
4 600,000 234,000 $366,000
5 1270000 234,000 $1,036,000
Crossover rate = 20.02%
The crossover rate represents the rate of indifference (i.e., the rate at which NPV of Project 1
= NPV of Project 2). To calculate the crossover rate, simply calculate the IRR of the cash
flow differences between the two projects. Project 1 is preferred over project 2 for cost of
capital less than 20.02%.
Question 7:
Chloe reportedly was paid a $11 million advance to write a book. The book took one year to
write. In the time she spent writing, she could have been paid to give speeches and appear
on TV news as a political commentator. Given her popularity, assume that she could have
earned $8 million over the year (paid at the end of the year) she spent writing the book.
Assume that once her book is finished, it is expected to immediately generate royalties of $5
million in the first year (paid at the end of the year) and these royalties are expected to
decrease by 40% per year in perpetuity. Assuming that Chloe's cost of capital is 10% and
given these royalties payments, what is the NPV of Chloe's book deal?
SOLUTION
Draw a timeline:
Note: The royalties resemble a perpetuity (with negative growth rate).
$ 8 million $ 5 million
NPV =$ 11million− + =$ 13.72727 million
( 1+0.1 ) ( 0.10−(−0.40 ) )

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BFF2140 Business Finance

Tutorial Week 04 – Solution

WEEK 4 CAPITAL BUDGETING I: TECHNIQUES FOR EVALUATION

Concept Check Solution:

Cash flow -$15,000 $7,000 $7,000 $7,000 $7,000 $7,000

Cash flow -$18,000 $12,000 $2,000 $2,000 $2,000 $2,000

For Payback Period, we use the formula:

For investment B, Payback period = 4 years.

Projected Cash flow Projected Cash flow

Year 1 $1,500,000 Year 11 $2,500,000

Year 2 $3,278,000 Year 12 $2,500,000

Year 3 $5,000,000 Year 13 $2,500,000

Year 4 $6,450,000 Year 14 $2,500,000

Year 5 $2,500,000 Year 15 $2,500,000

Year 7 $2,500,000 Year 17 $2,500,000

Year 8 $2,500,000 Year 18 $2,500,000

Year 9 $2,500,000 Year 19 $2,500,000

Year 10 $2,500,000 Year 20 $2,500,000

Discount Rate 23% 10%

Using HP10bII+: For discount rate = 23%,

Using HP10bII+: For discount rate = 10%,

Initial investment Annual Cash flow

Project A $35 million $14 million

Project B $19 million $7 million

Project C $15 million $7 million

Project D $20 million $10.5 million

Value created NPV

Project CF0 Annual CF NPV PI Rank Decision

Expected Net Cash Flows

The projects provide a necessary service, so whichever one is selected is expected to be

A) Initial NPV without replication (naïve NPV rule).

Using hp10bII+ calculator

Keys Display Description

Using hp10bII+ calculator

Keys Display Description

Decision: Prefer Project L on basis of higher NPV.

B) Remember: We cannot simply use NPV to choose between mutually exclusive

Decision: Prefer Project S on the basis of higher EAA.

Matching Cycle or Lowest common multiple method

Matching cycle is 4 years

S will be undertaken twice throughout the 4 year cycle.

NPV for Project S to undertake twice in 4 years =

Using hp10bII+ calculator

Keys Display Description

L will be undertaken once in 4 years.

NPV for Project L to undertake once in 4 years = $6,190.49

YEAR PROJECT 1 PROJECT 2

Calculating IRR using HP10BII+ and Excel

Using hp10bII+ calculator

IRR for Project A

Keys Display Description

Excel Syntax: =IRR({-300000,-387000,-193000,100000,600000,1270000}) - Follow the

IRR for Project B

Keys Display Description

Excel Syntax: =IRR({-599000,234000,234000,234000,234000,234000}) - Follow the steps

Putting them together

project 1: y axis= $1,090,000; x-axis= 24.08%

Assuming 10% cost of capital

Calculating NPV using HP10BII+ & Excel

Using hp10bII+ calculator

Project A with cost of capital = 10%

Keys Display Description

Project B with cost of capital = 10%