Chapter 9

1. Payback period and net present value (LO1, 2) If a project with conventional cash flows has a payback period less than the life of the
project, can you definitively establish the algebraic sign of the NPV? Because? If it is known that the discounted payback period is less
than the life of the project, what can we say about the NPV? Explain.

A payback period less than the useful life of the project means that the NPV is positive for a discount rate of zero, but nothing more
definitive can be said. For discount rates greater than zero, the payback period will still be less than the life of the project, but the NPV can
be positive, zero, or negative, depending on whether the discount rate is less than, equal to, or greater than the IRR. The discounted refund
includes the effect of the relevant discount rate. If the discounted payback period of a project is less than the useful life of the project, it
must be the case that the NPV is positive.

2. Net present value (LO1) Suppose a project has conventional cash flows and positive NPV. What do you know about the recovery
period? Of the discounted recovery period? From the profitability index? And the IRR? Explain.

If a project has a positive NPV for a certain discount rate, then it will also have a positive NPV for a discount rate of zero; Therefore, the
payback period should be less than the life of the project. Since the discounted payback is calculated at the same discount rate as the NPV,
if the NPV is positive, the discounted payback period must be less than the life of the project. If the NPV is positive, then the present value
of future cash inflows is greater than the initial investment cost; therefore, PI must be greater than 1. If the NPV is positive for some
discount rate R, then it will be zero for some higher discount rate R*; therefore, the IRR must be greater than the required return.

3. Recovery period (OA2) Regarding recovery:

a) Describe how the payback period is calculated and also describe the information this measure provides about a sequence of cash
flows. What is the decision rule for the payback period criterion?

b) What are the problems related to using the payback period as a means of evaluating cash flows?

c ) What are the advantages of using the payback period to evaluate cash flows? Are there circumstances in which it would be
appropriate to use the recovery period? Explain.

to. The payback period is simply the accounting break-even point of a series of cash flows. To actually calculate the payback period, it is
assumed that any cash flows that occur during a given period occur continuously throughout the period, and not at a single point in time.
Payback is the point in time for the cash flow series when the initial cash outlays are fully recovered. Given a predetermined cutoff for the
payback period, the decision rule is to accept projects that pay back before this cutoff, and reject projects that take longer to pay off.

b. The worst problem associated with the payback period is that it ignores the time value of money. Furthermore, selecting a difficulty
point for the recovery period is an arbitrary exercise that lacks any consistent rule or method. The payback period is skewed toward short-
term projects; it completely ignores cash flows that occur after the cutoff point.

c. Despite its shortcomings, reimbursement is often used because (1) the analysis is direct and simple and (2) accounting numbers and
estimates are readily available. Materiality considerations often justify an amortization analysis as sufficient; Maintenance projects are
another example where detailed analysis of other methods is often not necessary. Since recovery is biased towards liquidity, it can be a
useful and appropriate analysis method for short-term projects where cash management is more important.

4. Discounted recovery period (OA3) Regarding the discounted recovery period:

a) Describe how the discounted payback period is calculated and specify the information this measure provides about a sequence of
cash flows. What is the decision rule for the discounted payback period criterion?

b) What are the problems associated with using the discounted payback period as a means of evaluating cash flows?

c) What theoretical advantage does the discounted payback period have over the ordinary payback period method? Can the discounted
period be longer than the normal period? Explain.

to. The discounted payback is calculated in the same way as the normal payback, except that each cash flow in the series is first converted
to its present value. Therefore, discounted reimbursement provides a measure of economic/economic equilibrium because of this
discount, just as regular reimbursement provides a measure of accounting equilibrium because it does not discount cash flows. Given a
predetermined cutoff for the discounted payback period, the decision rule is to accept projects whose discounted cash flows are repaid
before this cutoff period, and reject all other projects.

b. The main disadvantage of using the discounted payback method is that it ignores all cash flows that occur after the cut-off date, which
biases this criterion towards short-term projects. As a result, the method may reject projects that actually have positive NPVs, or may
accept projects with large future cash outlays that result in negative NPVs. Furthermore, the selection of a cut-off point is again an arbitrary
exercise.

c. The discount refund is an improvement on the regular payment because it takes into account the time value of money. For conventional
cash flows and strictly positive discount rates, the discounted payback will always be greater than the regular payback period.

5. Average accounting performance (LO4) Regarding the RCP:

a) Describe how average accounting yield is calculated and explain the information this measure provides about a sequence of cash
flows. What is the decision rule for the CPR criteria?
b) What are the problems related to using the RCP as a means of evaluating the cash flows of a project? What feature of CPR do you find
most confusing from a financial standpoint? Does CPR have redeemable qualities?

to. Average accounting performance is interpreted as an average measure of a project's accounting performance over time, calculated as a
measure of average profit attributable to the project divided by some average balance sheet value for the project. This text calculates AAR
as average net income to average (total) book value. Given a predetermined cutoff for AAR, the decision rule is to accept projects with an
AAR that exceeds the target measure and reject all other projects.

b. AAR is not a measure of cash flows and market value, but rather a measure of financial statement accounts that often bear little
resemblance to the relevant value of a project. Furthermore, the selection of a cutoff is arbitrary, and the time value of money is ignored.
For a financial manager, both the reliance on accounting figures rather than relevant market data and the exclusion of time from money
considerations are worrying. Despite these problems, the AAR continues to be used in practice because (1) accounting information is often
available, (2) analysts often use accounting ratios to analyze company performance, and (3) management compensation It is usually linked
to the achievement of certain accounting relationship objectives.

6. Net present value (LO1) Regarding the NPV:

a) Describe how NPV is calculated and define the information this measure provides about a sequence of cash flows. What is the NPV
criterion decision rule?

b) Why is NPV considered a better method to evaluate the cash flows of a project? Suppose the NPV of a project's cash flows is
estimated to be $2,500. What does this figure represent for the company's shareholders?

to. NPV is simply the present value of a project's cash flows. NPV specifically measures, after considering the time value of money, the net
increase or decrease in the company's wealth due to the project. The decision rule is to accept projects that have a positive NPV and reject
projects with a negative NPV.

b. The NPV is superior to the other analysis methods presented in the text because it does not have serious defects. The method
unambiguously classifies mutually exclusive projects, and can differentiate between projects of different scale and time horizon. The only
drawback of NPV is that it is based on cash flow and discount rate values which are often estimates and not true, but this is a problem
shared by the other performance criteria as well. A project with NPV = $2,500 implies that the company's total equity will increase by
$2,500 if the project is accepted.

7. Internal rate of return (OA5) Regarding the IRR:

a) Tell how the IRR is calculated and specify the information that this measure provides about a sequence of cash flows. What is the
decision rule for the IRR criterion?

b) What is the relationship between the IRR and the NPV? Are there situations where you would prefer one method over another?
Explain.

c) Despite its shortcomings in some situations, why do almost all financial managers use IRR along with NPV when evaluating projects?
Can you think of a situation where IRR might be a more appropriate measure than NPV? Explain.

to. The IRR is the discount rate that makes the NPV of a series of cash flows exactly zero. Therefore, the IRR can be interpreted as a
financial break-even rate of return; In the IRR, the net value of the project is zero. The IRR decision rule is to accept projects with IRR
greater than the discount rate, and reject projects with IRR less than the discount rate.

b. The IRR is the interest rate that causes the NPV for a series of cash flows to be zero. NPV is preferred in all situations to IRR; The IRR can
lead to ambiguous results if there are unconventional cash flows, and also ambiguously classifies some mutually exclusive projects.
However, for independent projects with conventional cash flows, IRR and NPV are interchangeable techniques.

c. The IRR is frequently used because it is easier for many managers and financial analysts to rate performance in relative terms, such as
"12%," than in absolute terms, such as "$46,000." The IRR may be a preferred method for NPV in situations where an appropriate discount
rate is uncertain; In this situation, the IRR would provide more information about the project than the NPV.

8. Profitability index (LO7) Regarding the profitability index:

a) Comment on how the profitability index is calculated and specify the information that this measure provides about a sequence of
cash flows. What is the decision rule of the profitability index criterion?

b) What is the relationship between the profitability index and the NPV? Are there situations where you would prefer one method over
the other? Explain.

to. The profitability ratio is the present value of cash inflows relative to the cost of the project. As such, it is a benefit/cost ratio, which
provides a measure of the relative profitability of a project. The decision rule of the profitability index is to accept projects with a PI greater
than one, and reject projects with a PI less than one.

b. PI = (NPV + cost) / cost = 1 + (NPV / cost). If a company has a basket of NPV-positive projects and is subject to capital rationing, PI can
provide a good measure of ranking the projects, indicating the "bang for the buck" of each particular project.

9. Payback period and internal rate of return (LO2, 5) A project has permanent cash flows of C per period, a cost of I, and a required
profit of R. What is the relationship between the project's payback period and its IRR? What implications does your answer have for
long projects with more or less constant cash flows?
For a project with future cash flows that are an annuity: Payback = I/C

And the IRR is: 0 = - I + C / IRR

Solving the IRR equation for IRR, we obtain: IRR = C / I

Note that this is just the reciprocal of amortization. So: IRR = 1/PB

For long-lived projects with relatively constant cash flows, the sooner the project is amortized, the higher the IRR.

10. International investment projects (LO1) In January 2008, automobile producer Volkswagen announced plans to build an automatic
transmission and engine plant in South Carolina. Volkswagen apparently believed it would be in a better position to compete and create
value with a plant in the United States. Other companies, such as Fuji Film and the Swiss chemical company Lonza, have reached similar
conclusions and taken similar actions. Why have foreign manufacturers of products as diverse as automobiles, photographic film, and
chemicals come to the same conclusion?

There are a number of reasons. Two of the most important have to do with transportation costs and exchange rates. Manufacturing in the
USA USA It places the finished product much closer to the point of sale, resulting in significant savings on transportation costs. It also
reduces inventories because goods spend less time in transit. Higher labor costs tend to offset these savings to some extent, at least
compared to other possible manufacturing locations. Of great importance is the fact that manufacturing in the United States means that a
much larger proportion of costs are paid in dollars. Since sales are in dollars, the net effect is to largely immunize profits against
fluctuations in exchange rates. This topic is discussed in more detail in the chapter on international finance.

11. Capital budgeting problems (LO1) What difficulties would arise with real applications of the criteria studied in the chapter? Which
would be easier to implement in real applications? Which would be the most difficult?
The single biggest difficulty, by far, is finding reliable cash flow estimates. Determining an appropriate discount rate is also not a simple
task. These topics are discussed in greater depth in the following chapters. The return approach is probably the simplest, followed by the
AAR, but even these require revenue and cost projections. Discounted cash flow measures (discounted amortization, NPV, IRR, and
profitability ratio) are actually only a little more difficult in practice.

12. Capital Budgeting of Nonprofit Entities (LO1) Do the capital budgeting criteria just discussed apply to nonprofit corporations? How
do these entities make their capital budgeting decisions? What is the situation of the federal government? Should you evaluate your
spending proposals using these techniques?
Yes they are. These entities generally need to allocate available capital efficiently, just as for-profit organizations do. However, the
“income” of nonprofit businesses is often not tangible. For example, charitable giving has real opportunity costs, but the benefits are
generally difficult to measure. To the extent that benefits are measurable, the question of an appropriate required return remains.
Amortization rules are commonly used in such cases. Finally, the US government USA You should definitely use a realistic cost/benefit
analysis along the lines indicated, and it would go a long way toward balancing the budget!

13. Modified Internal Rate of Return (OA6) One of the less eloquent interpretations of the acronym MIRR is “meaningless internal rate
of return.” Why do you think this term applies to the MIRR?
The MIRR is calculated by finding the present value of all cash outflows, the future value of all cash inflows at the end of the project, and
then calculating the IRR of the two cash flows. As a result, the cash flows have been discounted or compounded by an interest rate (the
required return), and then the interest rate is calculated between the two remaining cash flows. As such, the MIRR is not a true interest
rate. In contrast, consider the IRR. If you take the initial investment and calculate the future value at the IRR, you can exactly replicate the
future cash flows of the project.

14. Net Present Value (LO1) It is sometimes stated that the “net present value approach involves reinvesting intermediate cash flows at
the required return.” Is this statement correct? To answer, suppose that you calculate the net present value of a project in the usual
way. Next, suppose you do the following:
a) Calculate the future value (at the end of the project) of all cash flows other than the initial outlay if they are assumed to be reinvested
at the required return, which would produce a single future value figure for the project.
b) Calculate the net present value of the project using the single future value that was estimated in the previous step and the initial
disbursement. It is easy to verify that you will get the same net present value as in your original calculation just if you use the required
return as the reinvestment rate in the previous step.
The statement is incorrect. It is true that if you calculate the future value of all intermediate cash flows until the end of the project at the
required return, then calculate the NPV of this future value and the initial investment, you will get the same NPV. However, NPV says
nothing about the reinvestment of intermediate cash flows. The NPV is the present value of the project's cash flows. What is actually done
with those cash flows once they are generated is not relevant. Put another way, the value of a project depends on the cash flows
generated by the project, not the future value of those cash flows. The fact that reinvestment "works" only if you use the required return
as the reinvestment rate is also irrelevant simply because reinvestment is not relevant to the value of the project in the first place.
One caveat: Our discussion here assumes that cash flows are truly available once they are generated, meaning it is up to the company's
management to decide what to do with the cash flows. In certain cases, it may be necessary for cash flows to be reinvested. For example,
in international investments, a company may be required to reinvest cash flows in the country in which they are generated and not
"repatriate" the money. Such funds are said to be "locked up" and reinvestment becomes relevant because the cash flows are not actually
available.

15. Internal rate of return (LO5) It is sometimes stated that the “internal rate of return approach involves reinvesting intermediate cash
flows at the internal rate of return.” Is this statement correct? To answer, suppose that you calculate the internal rate of return for a
project in the usual way. Next, suppose you do the following:
a) Calculate the future value (at the end of the project) of all cash flows other than the initial outlay assuming they are reinvested at the
internal rate of return, which would produce a single future value figure for the project.
b) Calculate the internal rate of return of the project using the single future value that was estimated in the previous step and the initial
disbursement. It is easy to verify that you will get the same internal rate of return as in your original calculation just by using the
internal rate of return as the reinvestment rate in the previous step.
The statement is incorrect. It is true that if you calculate the future value of all intermediate cash flows until the end of the project in the
IRR, then calculate the IRR of this future value and the initial investment, you will get the same IRR. However, as in the previous question,
what is done with the cash flows once they are generated does not affect the IRR. Consider the following example:

C0 C1 C2 IRR
Project A - $100 $10 $110 10%

Let's assume this $100 is a deposit in a bank account. The IRR on cash flows is 10 percent. Does the IRR change if the Year 1 cash flow is
reinvested in the account, or if it is withdrawn and spent on pizza? No. Finally, consider calculating the yield to maturity of a bond. If you
think about it, the YTM is the IRR on the bond, but there is no suggested reinvestment assumption for bond coupons. The reason is that
reinvestment is irrelevant to the YTM calculation; Likewise, reinvestment is irrelevant in the IRR calculation. Our warning about locked
funds applies here too.

Solutions to questions and problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability
limitations, when these intermediate steps are included in this solutions manual, it may appear that rounding has occurred. However, the
final answer for each problem is found without rounding during any step in the problem.

1. Calculation of the payback period (LO2) What is the payback period for the following cash flows?
To calculate the payback period, we must find the time when the project has recovered its initial
investment. After three years, the project has created:
$1,600 + 1,900 + 2,300 = $5,800 in cash flows. The project still needs to create another one: $6,400
- 5,800 = $600
in cash flows. During the fourth year, the project's cash flows will be $1,400. So the payback period
will be 3 years, plus what we still need to divide by what we will do during the fourth year. The
payback period is: Payback = 3 + ($600 / $1,400) = 3.43 years

2. Calculation of the payback period (LO2) An investment project provides cash flow inflows of $765 per year for eight years. What
is the payback period for the project if the initial cost is $2,400? Which one, if the initial cost is $3,600? Which one, if the initial cost
is $6,500?

To calculate the payback period, we must find the time when the project has recovered its initial investment. The cash flows in this problem
are an annuity, so the calculation is simpler. If the initial cost is $2,400, the payback period is:
Repayment = 3 + ($105 / $765) = 3.14 years
There is a shortcut to calculating that future cash flows are an annuity. Simply divide the initial cost by the annual cash flow. For the cost of
$2,400, the payback period is:
Repayment = $2,400 / $765 = 3.14 years
For an initial cost of $3,600, the payback period is: Payback = $3,600 / $765 = 4.71 years
The payback period for an initial cost of $6,500 is a little more complicated. Note that the total cash inflows after eight years will be:
Total cash receipts = 8 ($765) = $6,120
If the initial cost is $6,500, the project never pays for itself. Note that if you use the shortcut method for annuity cash flows, you will get:
Repayment = $6,500 / $765 = 8.50 years
This answer does not make sense since the cash flows stop after eight years, so once again we must conclude that the payback period is
never.

3. Calculation of the payback period (LO2) Buy Coastal, Inc., imposes a three-year limit on the payback period for its international
investment projects. If the company has the offer for the following two projects, should it accept either?
Project A has cash flows of $19,000 in Year 1, so the cash flows are short $21,000
payback on the initial investment, so Project A's payback is:
Payback = 1 + ($21,000 / $25,000) = 1.84 years Project B has cash flows of:
Cash flows = $14,000 + 17,000 + 24,000 = $55,000

during these first three years. The cash flows are still short $5,000 payback on the initial investment, so Project B's payback is:
B: Repayment = 3 + ($5,000 / $270,000) = 3,019 years
Using the payback criterion and a cutoff of 3 years, accept project A and reject project B.

4. Calculation of the discounted payback period (LO3) An investment project has annual cash flow inflows of $4,200, $5,300, $6,100,
and $7,400 and a discount rate of 14%. What is the discounted cash flow payback period if the initial cost is $7,000? Which one, if
the initial cost is $10,000? Which one, if the initial cost is $13,000?
When we use discounted payback, we must find the value of all cash flows today. The present value of the project's cash flows for the first
four years is:
Today's value of Year 1 cash flow = $4,200 / 1.14 = $3,684.21 Today's value of Year 2 cash flow = $5,300 / 1,142 = $4,078.18 Today's value
of Year 3 cash flow = $6,100 / 1,143 = $ 4,117.33 Today's value of Year 4 cash flow = $7,400 / 1,144 = $4,381.39
To find the discounted repayment, we use these values to find the repayment period. The first year's discounted cash flow is $3,684.21, so the
discounted payback for an initial cost of $7,000 is:
Discounted Rebate= 1 + ($7,000 - 3,684.21) / $4,078.18 = 1.81 years For an initial cost of $10,000, the discounted rebate is: Discounted
Rebate = 2 + ($10,000 - 3,684.21 - 4,078.18) / $4,117.33 = 2.54 years

Please note the discounted refund calculation. We know that the payback period is between two and three years, so we subtract the
discounted costs from the Year 1 and Year 2 cash flows from the initial cost. This is the numerator, which is the discounted amount we still
have to make to recover our initial investment. We divide this amount by the discounted amount we will earn in Year 3 to get the fractional
portion of the discounted refund.

If the initial cost is $13,000, the discounted rebate is:

Refund discount = 3 + ($13,000 - 3,684.21 - 4,078.18 - 4,117.33) / $4,381.39 = 3.26 years

5. Calculation of the discounted payback period (LO3) An investment project costs $15,000 and has annual cash flows of $4,300 for
six years. What is the discounted payback period if the discount rate is 0%? Which one, if the discount rate is 5%? Which one, if the
discount rate is 19%?
R = 0%: 3 + ($2,100 / $4,300) = 3.49 years
discounted repayment = regular payment = 3.49 years
R = 5%: $4,300/1.05 + $4,300/1.052 + $4,300/1.053 = $11,709.97
$ 4,300 / 1.054 = $ 3,537.62
discounted repayment = 3 + ($15,000 - 11,709.97) / $3,537.62 = 3.93 years
R = 19%: $4,300 (PVIFA19%, 6) = $14,662.04 The project never pays.

6. RCP Calculation (LO4) You are trying to determine whether or not to expand your business to build a manufacturing plant. The
plant has an installation cost of $15 million, which will depreciate to zero over its four-year life. If the plant projects net profits of
$1,938,200, $2,201,600, $1,876,000, and $1,329,500 over these four years, what is the project's average accounting return (APR)?
Our definition of AAR is average net income divided by average book value. The average net income for this project is:
Average net income = ($1,938,200 + 2,201,600 + 1,876,000 + 1,329,500) / 4 = $1,836,325

And the average book value is:

Average book value = ($15,000,000 + 0) / 2 = $7,500,000 Therefore, the AAR for this project is:
AAR = Average Net Income / Average Book Value = $1,836,325 / $7,500,000 = .2448 or 24.48%

7. Calculation of the IRR (LO5) A company evaluates all its projects with the IRR rule. If the required return is 16%, should the
company accept the next project?

The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation
that defines the IRR for this project is:
0 = -$34,000 + $16,000 / (1 + IRR) + $18,000 / (1 + IRR) 2 + $15,000 / (1 + IRR) 3

Using a spreadsheet, financial calculator, or trial and error method to find the root of the
equation, we find that: IRR = 20.97%
Since the IRR is greater than the required return, we would accept the project.

8. NPV Calculation (LO1) Take the cash flows from the previous problem and assume that the company applies the NPV decision
rule. With a required return of 11%, should the company accept this project? Should you accept it if the required return was 30%?
The NPV of a project is the PV of the outputs minus the PV of the inputs. The equation for the NPV of this project with a
required return of 11 percent is:
NPV = - $34,000 + $16,000 / 1.11 + $18,000 / 1,112 + $15,000 / 1,113 = $5,991.49
At 11 percent required performance, the NPV is positive, so we would accept the project. The equation for the NPV of the
project with a required return of 30 percent is:
NPV = - $34,000 + $16,000 / 1.30 + $18,000 / 1,302 + $15,000 / 1,303 = - $4,213.93

At 30 percent required performance, the NPV is negative, so we reject the project.

9. Calculation of NPV and IRR (LO1, 5) A project that delivers annual cash flows of $28,500 for nine years costs $138,000 today. Is
this a good project if the required return is 8%? Is it good if the yield is 20%? At what discount rate would it make the same
difference to accept or reject the project?
The NPV of a project is the PV of the outputs minus the PV of the inputs. Since the cash inflows are an annuity, the equation
for the NPV of this project with a required 8 percent return is:
NPV = - $138,000 + $28,500 (PVIFA8%, 9) = $40,036.31

At 8 percent required performance, the NPV is positive, so we would accept the project.
The equation for the project's NPV at a 20 percent required return is: NPV = -$138,000 + $28,500 (PVIFA20%, 9) = -
$23,117.45
At 20 percent required performance, the NPV is negative, so we reject the project.

We would feel indifferent to the project if the required return was equal to the project's IRR, since at that required return the
NPV is zero. The IRR of the project is:
0 = -$138,000 + $28,500(PVIFAIRR, 9)
IRR = 14.59%

10. Calculation of IRR (LO5) What is the IRR of the following cash flows?

The IRR is the interest rate that makes the NPV of the project equal to zero. So, the
equation that defines the IRR for this project is:

0 = - $19,500 + $9,800 / (1 + IRR) + $10,300 / (1 + IRR) 2 + $8,600 / (1 + IRR) 3

Using a spreadsheet, financial calculator, or trial and error to find the root of the
equation, we find that: IRR = 22.64%

11. Calculation of NPV (LO1) Take the cash flows from the previous problem. What is the NPV at a 0% discount rate? Which one, if
the discount rate is 10%? Which one, if the discount rate is 20%? Which one, if the discount rate is 30%?

The NPV of a project is the PV of the outputs minus the PV of the inputs. At a zero discount rate (and only at a zero discount
rate), the cash flows can add up over time. Therefore, the NPV of the project at zero percent required performance is:
NPV = - $19,500 + 9,800 + 10,300 + 8,600 = $9,200
The NPV at 10 percent required return is:
NPV = -$19,500 + $9,800/1.1 + $10,300/1.12 + $8,600/1.13 = $4,382.79
The NPV at 20 percent required performance is:
NPV = -$19,500 + $9,800/1.2 + $10,300/1.22 + $8,600/1.23 = $796.30
And the NPV at 30 percent required performance is:
NPV = -$19,500 + $9,800/1.3 + $10,300/1.32 + $8,600/1.33 = -$1,952.44
Note that as the required output increases, the NPV of the project decreases. This will always be true for projects with
conventional cash flows. Conventional cash flows are negative at the beginning of the project and positive throughout the rest
of the project.

12. NPV compared to IRR (LO1, 5) Mahjong Inc. has identified the following two mutually exclusive projects:
a ) What is the IRR of each project? If the IRR decision
rule applies, which project should the company accept?
Is this decision necessarily correct?
b ) If the required return is 11%, what is the NPV of the
two projects? Which project will you choose if the NPV
decision rule applies?
c ) In what interval of discount rates would you choose
project A? Project B? At what discount rate would it be
the same to choose between either of the two projects?
Explain.

to. The IRR is the interest rate that makes the NPV of the project equal to zero. The equation for the IRR of Project A is:

0 = -$43,000 + $23,000 / (1 + IRR) + $17,900 / (1 + IRR) 2 + $12,400 / (1 + IRR) 3 + $9,400 / (1 + IRR) 4

Using a spreadsheet, financial calculator, or trial and error process to find the root of the equation, we find that: IRR = 20.44%
The equation for the IRR of Project B is:
0 = -$43,000 + $7,000 / (1 + IRR) + $13,800 / (1 + IRR) 2 + $24,000 / (1 + IRR) 3 + $26,000 / (1 + IRR) 4
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 18.84%
When examining the IRRs of the projects, we see that the IRRA is greater than the IRRB, so the IRR decision rule involves
accepting project A. This may not be a correct decision; However, because the IRR criterion has a classification problem for
mutually exclusive projects. To see whether the IRR decision rule is correct or not, we need to evaluate the NPV of the project.

b. The NPV of Project A is:

NPVA = - $43,000 + $23,000 / 1.11 + $17,900 / 1,112 + $12,400 / 1,113 + $9,400 / 1,114 NPVA = $7,507.61
And the NPV of Project B is:
NPVB = - $43,000 + $7,000 / 1.11 + $13,800 / 1,112 + $24,000 / 1,113 + $26,000 / 1,114 NPVB = $9,182.29
The NPVB is greater than the NPVA, so we should accept Project B.

c. To find the transition rate, we subtract the cash flows of one project from the cash flows of the other project. Here, we will
subtract the cash flows of Project B from the cash flows of Project A. Once we find these differential cash flows, we find the
IRR. The equation for the crossing rate is:
Crossover fee: 0 = $16,000 / (1 + R) + $4,100 / (1 + R) 2 - $11,600 / (1 + R) 3 - $16,600 / (1 + R) 4

Using a spreadsheet, financial calculator, or trial and error method to find the root of the equation, we find that: R = 15.30%
At discount rates greater than 15.30%, choose project A; for discount rates less than 15.30% choose project B; Indifferent
between A and B at a discount rate of 15.30%.

13. NPV compared to IRR (LO1, 5) Consider these two mutually exclusive projects:
 Plot the NPV profiles of X and Y for different discount rates from 0
to 25%. Which
is the intersection rate of the two projects?

The IRR is the interest rate that makes the NPV of the project
equal to zero. The equation to calculate the IRR of Project X is:

0 = -$15,000 + $8,150 / (1 + IRR) + $5,050 / (1 + IRR) 2 + $6,800 / (1 + IRR) 3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 16.57%
For Project Y, the equation to find the IRR is:
0 = -$15,000 + $7,700 / (1 + IRR) + $5,150 / (1 + IRR) 2 + $7,250 / (1 + IRR) 3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 16.45%
To find the crossover rate, we subtract the cash flows of one project from the cash flows of the other project and find the IRR
of the differential cash flows. Let's subtract the cash flows of Project Y from the cash flows of Project X. It is irrelevant which
cash flows we subtract from the others. By subtracting the cash flows, the equation to calculate the IRR for these differential
cash flows is:
Crossing fee: 0 = $450 / (1 + R) - $100 / (1 + R) 2 - $450 / (1 + R) 3

Using a spreadsheet, financial calculator, or trial and error method to find the root of the equation, we find that: R = 11.73%
The following table shows the NPV of each project for different required returns. Note that Project Y always has a higher NPV
for discount rates below 11.73 percent, and always has a lower NPV for discount rates above 11.73 percent.

14. Problems with IRR (LO5 ) Light Sweet Petroleum, Inc., tries to evaluate an extraction project with the following cash flows:

a ) If the company requires a 12% return on its investments, should it accept the project?
Because?
b ) Calculate the IRR of the project. How many IRRs are there? If the IRR decision rule
applies, would you accept this project or not? what happens in this case?

to. The equation for the NPV of the project is:

NPV = - $45,000,000 + $78,000,000 / 1.1 - $14,000,000 / 1.12 = $13,482,142.86

The NPV is greater than 0, so we would accept the project.

b. The equation for the IRR of the project is:

0 = - $45,000,000 + $78,000,000 / (1 + IRR) - $14,000,000 / (1 + IRR) 2

From Descartes' sign rule, we know that there are potentially two IRRs since the cash flows change signs twice. From trial and
error, the two IRRs are:
IRR = 53.00%, –79.67%
When there are multiple IRRs, the IRR decision rule is ambiguous. Both IRRs are correct, that is, both interest rates make the
NPV of the project equal to zero. If we are evaluating whether or not to accept this project, we would not want to use the IRR
to make our decision.

15. Calculation of the profitability index (LO7) What is the profitability index of the following cash flows if the relevant discount rate
is 10%? Which one, if the discount rate is 15%? Which one, if the discount rate is 22%?

The profitability ratio is defined as the PV of cash inflows divided by the PV of cash
outflows. The equation for the profitability index at a required return of 10 percent
is:

PI = [$7,300/1.1 + $6,900/1.12 + $5,700/1.13]/$14,000 = 1.187

The equation for the profitability index at a required return of 15 percent is: PI = [$7,300 / 1.15 + $6,900 / 1,152 + $5,700 /
1,153] / $14,000 = 1.094
The equation for the profitability index at a required return of 22 percent is: PI = [$7,300 / 1.22 + $6,900 / 1,222 + $5,700 /
1,223] / $14,000 = 0.983
We would accept the project if the required return was 10 percent or 15 percent, since the PI is greater than one. We would
reject the project if the required return was 22 percent, since the PI is less than one.

16. Profitability Index Problems (LO1, 7) The Wriland Computer Corporation wants to choose between the following mutually
exclusive design projects:

a ) If the required return is 10% and the company applies the profitability
index decision rule, which project should it accept?
b ) If the company applies the NPV decision rule, which project should it
accept?
c ) Explain why your answers in a and b are different.

to. The profitability ratio is the PV of future cash flows divided by the initial investment. The cash flows for both projects are
an annuity, so:
PII = $27,000 (PVIFA10%, 3) / $53,000 = 1,267 PIII = $9,100 (PVIFA10%, 3) / $16,000 = 1,414
The profitability index decision rule implies that we accept project II, since PIII is greater than PII.

b. The NPV of each project is:

NPVI = -$53,000 + $27,000 (PVIFA10%, 3) = $14,145.00 NPVII = -$16,000 + $9,100 (PVIFA10%, 3) = $6,630.35
The NPV decision rule involves accepting Project I, since NPVI is greater than NPVII.

c. Using the profitability index to compare mutually exclusive projects can be ambiguous when the magnitude of the cash
flows for the two projects is of different scale. In this problem, project I is approximately 3 times larger than project II and
produces a larger NPV, although the profitability ratio criterion implies that project II is more acceptable.

17. Comparison of investment criteria ( LO1, 2, 3, 5, 7) Consider the following two mutually exclusive projects:

Whichever project you choose, if any, you require a 15% return on your investment.
a ) If you apply the payback period criterion, what investment do you choose? Because?
b ) If you apply the discounted payback period criterion, which
investment do you choose? Because?
c ) If you apply the NPV criterion, what investment do you choose?
Because?
d ) If you apply the IRR criterion, what investment do you choose?
Because?
e ) If you apply the profitability index criterion, what investment do you
choose? Because?
f ) According to the answers from a to e , which project do you ultimately
choose? By
that?
to. The payback period for each project is:
A: 3 + ($180,000 / $390,000) = 3.46 years B: 2 + ($9,000 / $18,000) = 2.50 years
The return criterion involves accepting project B, because it is returned before project A.

b. The discount refund for each project is:

A: $20,000/1.15 + $50,000/1.152 + $50,000/1.153 = $88,074.30
$ 390,000 / 1.154 = $ 222,983.77
Discounted Repayment = 3 + ($390,000 - 88,074.30) / $222,983.77 = 3.95 years B: $19,000 / 1.15 + $12,000 / 1.152 +
$18,000 / 1.153 = $37,430.76
$ 10,500 / 1.154 = $ 6,003.41
Discounted Repayment = 3 + ($40,000 - 37,430.76) / $6,003.41 = 3.43 years
The discounted refund criterion involves accepting project B because it is returned before A.

c. The NPV for each project is:

A: NPV = -$300,000 + $20,000/1.15 + $50,000/1,152 + $50,000/1,153 + $390,000/1,154 NPV = $11,058.07
B: NPV = -$40,000 + $19,000/1.15 + $12,000/1,152 + $18,000/1,153 + $10,500/1,154 NPV = $3,434.16
The NPV criterion implies that we accept project A because project A has a higher NPV than project B.

d. The IRR for each project is:

A: $300,000 = $20,000 / (1 + IRR) + $50,000 / (1 + IRR) 2 + $50,000 / (1 + IRR) 3 + $390,000 / (1 + IRR) 4
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 16.20%
B: $40,000 = $19,000 / (1 + IRR) + $12,000 / (1 + IRR) 2 + $18,000 / (1 + IRR) 3 + $10,500 / (1 + IRR) 4
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 19.50%
The IRR decision rule implies that we accept project B because IRR for B is greater than IRR for A.
and. The profitability index of each project is:
A: PI = ($20,000/1.15 + $50,000/1.152 + $50,000/1.153 + $390,000/1.154) / $300,000 = 1.037
B: PI = ($19,000/1.15 + $12,000/1.152 + $18,000/1.153 + $10,500/1.154) / $40,000 = 1.086
The profitability index criterion implies accepting project B because its PI is greater than project A.
F. In this case, the NPV criteria mean that you should accept project A, while the profitability ratio, payback period, discounted
payback, and IRR mean that you should accept project B. The final decision should be based on NPV, since it has no
classification problem associated with the other capital budgeting techniques. Therefore, you must accept project A.

18. NPV and discount rates (LO1) An investment has a setup cost of $684,680. The four-year cash flows of the investment are
projected to be $263,279, $294,060, $227,604, and $174,356. If the discount rate is zero, what is the NPV? If the discount rate is
infinite, what is the NPV? At what discount rate is the NPV equal to zero? Draw the NPV profile of this investment based on these
three points.
At a zero discount rate (and only at a zero discount rate), cash flows can add up over time. Therefore, the NPV of the project at
zero percent required performance is:
NPV = - $684,680 + 263,279 + 294,060 + 227,604 + 174,356 = $274,619
If the required return is infinite, future cash flows are worthless. Even if the cash flow in one year is $1 trillion, at an infinite
interest rate, the value of this cash flow today is zero. So if the future cash flows have no value today, the NPV of the project is
simply the cash flow today, so at an infinite interest rate:
NPV = - $684,680
The interest rate that makes the NPV of a project equal to zero is the IRR. The equation for the IRR of this project is:
0 = -$684,680 + $263,279 / (1 + IRR) + $294,060 / (1 + IRR) 2 + $227,604 / (1 + IRR) 3 + 174,356 / (1 + IRR) 4
Using a spreadsheet, financial calculator, or trial and error process to find the root of the equation, we find that: IRR = 16.23%

19. MIRR (LO6) Slow Ride Corp. is evaluating a project with the following cash flows:
cash:
The company uses a 10% interest rate on all its projects. Calculate the MIRR of the projects
using the three methods.
The MIRR for the project with the three approaches is:
Discount focus:
In the discounting approach, we find the value of all cash outflows at time 0, while cash inflows remain at the time they occur.
So, by discounting the cash outflows at time 0, we find:

Time 0 cash flow = -$16,000 - $5,100 / 1.105 Time 0 cash flow = -$19,166.70
So the MIRR using the discounting approach is:
0 = -$19,166.70 + $6,100 / (1 + MIRR) + $7,800 / (1 + MIRR) 2 + $8,400 / (1 + MIRR) 3 + 6,500 / (1 + MIRR) 4
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: MIRR = 18.18%
Reinvestment approach:
In the reinvestment approach, we find the future value of all cash except the initial cash flow at the end of the project. So, by
reinvesting the cash flows at time 5, we find:
Time 5 cash flow = $6,100 (1,104) + $7,800 (1,103) + $8,400 (1,102) + $6,500 (1.10) - $5,100
Time 5 cash flow = $31,526.81
So the MIRR using the discounting approach is: 0 = -$16,000 + $31,526.81 / (1 + MIRR) 5
$31,526.81 / $16,000 = (1 + MIRR) 5
MIRR = ($31,526.81 / $16,000) 1/5 - 1 MIRR = .1453 or 14.53%

Combination approach:
In the combination approach, we find the value of all cash outflows at time 0 and the value of all cash inflows at the end of the
project. Then, the value of the cash flows is:

Time 0 cash flow = -$16,000 - $5,100 / 1.105 Time 0 cash flow = -$19,166.70

Time 5 cash flow = $6,100 (1,104) + $7,800 (1,103) + $8,400 (1,102) + $6,500 (1.10)
Time 5 cash flow = $36,626.81
So the MIRR using the discounting approach is: 0 = -$19,166.70 + $36,626.81 / (1 + MIRR) 5
$36,626.81 / $19,166.70 = (1 + MIRR) 5 MIRR = ($36,626.81 / $19,166.70) 1/5 - 1 MIRR = .1383 or 13.83%

20. MIRR (LO6) Suppose that the company in the previous problem uses a discount rate of 11% and a reinvestment rate of 8% on
all its projects. Calculate the project's MIRR using the three methods and these interest rates.
With different discount and reinvestment rates, we must make sure we use the appropriate interest rate. The MIRR for the
project with the three approaches is:

Discount focus:
In the discounting approach, we find the value of all cash outflows at time 0 at the discount rate, while cash inflows remain at
the time they occur. So, by discounting the cash outflows at time 0, we find:
Time 0 cash flow = -$16,000 - $5,100 / 1.115 Time 0 cash flow = -$19,026.60
So the MIRR using the discounting approach is:
0 = -$19,026.60 + $6,100 / (1 + MIRR) + $7,800 / (1 + MIRR) 2 + $8,400 / (1 + MIRR) 3 + 6,500 / (1 + MIRR) 4
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: MIRR = 18.55%

Reinvestment approach:
In the reinvestment approach, we find the future value of all cash except the initial cash flow at the end of the project using the
reinvestment rate. So, by reinvesting the cash flows at time 5, we find:
Time 5 cash flow = $6,100 (1,084) + $7,800 (1,083) + $8,400 (1,082) + $6,500 (1.08) - $5,100
Time 5 cash flow = $29,842.50
So the MIRR using the discounting approach is: 0 = -$16,000 + $29,842.50 / (1 + MIRR) 5
$29,842.50 / $16,000 = (1 + MIRR) 5
MIRR = ($29,842.50 / $16,000) 1/5 - 1 MIRR = .1328 or 13.28%

Combination approach:
In the combination approach, we find the value of all cash outflows at time 0 using the discount rate and the value of all cash
inflows at the end of the project using the reinvestment rate. Then, the value of the cash flows is:
Time 0 cash flow = -$16,000 - $5,100 / 1.115 Time 0 cash flow = -$19,026.60
Time 5 cash flow = $6,100 (1,084) + $7,800 (1,083) + $8,400 (1,082) + $6,500 (1.08)
Time 5 cash flow = $34,942.50
So the MIRR using the discounting approach is: 0 = -$19,026.60 + $34,942.50 / (1 + MIRR) 5
$34,942.50 / $19,026.60 = (1 + MIRR) 5
MIRR = ($34,942.50 / $19,026.60) 1/5 - 1 MIRR = .1293 or 12.93%

21. NPV and profitability index (LO1, 7) If the NPV index is defined as the ratio between the NPV and the cost, what is the
relationship between this index and the profitability index?
Since the NPV index has the cost subtracted in the numerator, NPV index = PI - 1.

22. Cash Flow Intuition (LO1, 2) A project has an initial cost of I, requires a return of R, and pays C per year for N years.
a ) Find C in terms of I and N , so that the project has a payback period exactly equal to its duration.
b ) Find C in terms of I , N and R so that the project is profitable according to the NPV decision rule.
c ) Find C in terms of I , N, and R so that the project has a profit-to-cost ratio of 2.

to. To have a payback equal to the life of the project, given that C is a constant cash flow for N years:
C = I/N

b. To have a positive NPV, I < C (PVIFAR%, N). Thus, C > I / (PVIFAR%, N).

c. Profits = C(PVIFAR%, N) = 2 × costs = 2I

C = 2I / (PVIFAR%, N)

23. Payback period and NPV (LO1, 2 ) An investment is considered to have a payback period of seven years and costs $724,000. If
the required throughput is 12%, what is the worst-case NPV? What is VPN in the best case? Explain. Assume that the cash flows are
conventional.

Given the seven-year payout, the worst case scenario is that the payout occurs at the end of the seventh year. So, the worst
case:
NPV = - $724,000 + $724,000 / 1.127 = - $396,499.17
The best case has infinite cash flows beyond the breakeven point. Therefore, the best case NPV is infinite.

24. Multiple IRRs (LO5) This problem is useful for testing the capabilities of financial calculators and computer software. Consider
the following cash flows. How many IRRs are there? ( Hint: Look for between 20 and 70%.) When should this project be accepted?
Using Descartes' rule of signs, by looking at the cash flows, we know that there are
four IRRs for this project. Even with most computer spreadsheets, we have to do some
trial and error. From trial and error, IRRs of 25%, 33.33%, 42.86% and 66.67% are
found.
We accept the project when the NPV is greater than zero. See for yourself if that NPV
is greater than zero for required returns between 25% and 33.33% or between 42.86%
and 66.67%

The equation for the IRR of the project is:

0 = - $1,512 + $8,586 / (1 + IRR) - $18,210 / (1 + IRR) 2 + $17,100 / (1 + IRR) 3 - $6,000 / (1 + IRR) 4

25. Assessment with the NPV (LO1) The Yurdone Corporation wants to build a private cemetery. According to its chief financial
officer, Barry M. Deep, business is “going up.” Consequently, the cemetery project will give the company a net cash flow of $85,000
during the first year and the cash flows are projected to grow at a rate of 6% per year on an ongoing basis. The project requires an
initial investment of $1,400,000.
a ) If Yurdone requires a 13% return on the company, should the cemetery project be started?
b ) The company is not very sure about the assumption of a 6% growth rate in cash flows. At what constant rate of growth is the
company's break-even point if it continued to require a 13% return on investment?
to. Here the cash inflows from the project continue forever, which is a perpetuity. Unlike ordinary perpetuity cash flows, cash
flows here grow at a constant rate forever, which is a growing perpetuity. If you remember from the chapter on valuing stocks,
we presented a formula for valuing a stock with consistent dividend growth. This formula is actually the formula for increasing
perpetuity, so we can use it here. The PV of the project's future cash flows is:
PV of cash inflows = C1 / (R - g)
PV of cash inflows = $85,000/(. 13 - .06) = $ 1,214,285.71
The NPV is the PV of the outputs minus the PV of the inputs, so the NPV is: Project NPV = -$1,400,000 + 1,214,285.71 = -
$185,714.29
The NPV is negative, so we reject the project.

b. Here we want to know the minimum growth rate in cash flows necessary to accept the project. The minimum growth rate is
the growth rate at which we would have zero NPV. The equation for zero NPV, which uses the equation for the PV of a
growing perpetuity, is:
0 = - $ 1,400,000 + $ 85,000 / (. 13 - g)
Solving for g, we obtain: g = .0693 or 6.93%

26. Problems with the internal rate of return (LO5) A project has the following cash flows:

What is the internal rate of return for this project? If the required return is 12%, should the
company accept the project? What is the net present value of this project? What is the net
present value of the project if the required return is 0%? 24%? What is hapening here?
Sketch the net present value profile to help you answer.
The IRR of the project is: $58,000 = $34,000 / (1 + IRR) + $45,000 / (1 + IRR) 2

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 22.14%
At a 12 percent interest rate, the NPV is: NPV = $58,000 - $34,000 / 1.12 - $45,000 / 1.122 NPV = - $8,230.87
At a zero percent interest rate, we can add cash flows, so the NPV is: NPV = $58,000 - $34,000 - $45,000
NPV = - $21,000.00
And at a 24 percent interest rate, the NPV is: NPV = $58,000 - $34,000 / 1.24 - $45,000 / 1.242 NPV = + $1,314.26
The cash flows for the project are unconventional. Since the initial cash flow is positive and the remaining cash flows are
negative, the decision rule for IRR is not valid in this case. The NPV profile has an upward slope, indicating that the project is
more valuable when the interest rate increases.

27. Problems with the internal rate of return (LO5) McKeekin Corp. has a project with the following cash flows:
What is the internal rate of return for the project? What is hapening here?

The IRR is the interest rate that makes the NPV of the project equal to zero. So, the IRR
of the project is:

0 = $20,000 - $26,000 / (1 + IRR) + $13,000 / (1 + IRR) 2

Although there appear to be two IRRs, a spreadsheet, financial calculator, or trial and error will not provide an answer. The
reason is that there is no real IRR for this set of cash flows. If you look at the IRR equation, what we're really doing is solving
for the roots of the equation. Going back to high school algebra, in this problem we are solving a quadratic equation. In case
you don't remember, the quadratic equation is:

In this case, the equation is:

The square root term is: 676,000,000 - 1,040,000,000 = –364,000,000

The square root of a negative number is a complex number, so there is no real number solution, which means the project has no
real IRR.

28. Net present value and internal rate of return (LO1, 5) Anderson International Limited is evaluating a project in Erewhon. The
project will create the following cash flows:

All cash flows will occur in Erewhon and have been expressed in dollars. In a bid to improve
its economy, the Erewhon government has declared that all cash flows created by a foreign
company are “locked” and must be reinvested with the government for one year. The
reinvestment rate for these funds is 4%. If Anderson uses a required return of 11% on this
project, what are the project's net present value and internal rate of return? Is the internal
rate of return you calculated the project's MIRR? Why yes or why not?

First, we must find the future value of the cash flows for the year they are blocked by the government. So, by reinvesting each
cash flow for one year, we find:

Year 2 cash flow = $205,000 (1.04) = $213,200

Year 3 cash flow = $265,000 (1.04) = $275,600
Year 4 cash flow = $346,000 (1.04) = $359,840
Year 5 cash flow = $220,000 (1.04) = $228,800
Then, the NPV of the project is:
NPV = -$450,000 + $213,200/1,112 + $275,600/1,113 + $359,840/1,114 + $228,800/1,115 NPV = -$2,626.33
And the IRR of the project is:
0 = - $450,000 + $213,200 / (1 + IRR) 2 + $275,600 / (1 + IRR) 3 + $359,840 / (1 + IRR) 4
+$228,800 / (1 + IRR) 5

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that: IRR = 10.89%
While this may seem like a MIRR calculation, it is not a MIRR, but rather a standard IRR calculation. Since cash inflows are
blocked by the government, they are not available to the company for a period of one year. Therefore, all we are doing is
calculating the IRR based on when the cash flows for the company actually occur.