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CHAPTER 10
The Fundamentals of Capital Budgeting
Learning Objectives
1. Discuss why capital budgeting decisions are the most important decisions made by a
firms management.
2. Explain the benefits of using the net present value (NPV) method to analyze capital
expenditure decisions, and be able to calculate the NPV for a capital project.
3. Describe the strengths and weaknesses of the payback period as a capital
expenditure decision-making tool, and be able to compute the payback period for a
capital project.
4. Explain why the accounting rate of return (ARR) is not recommended for use as a
capital expenditure decision-making tool.
5. Be able to compute the internal rate of return (IRR) for a capital project, and
discuss the conditions under which the IRR technique and the NPV technique
produce different results.
6. Explain the benefits of a postaudit review of a capital project.

I.

Chapter Outline

10.1

An Introduction to Capital Budgeting


A.

The Importance of Capital Budgeting

Capital budgeting decisions are the most important investment decisions made
by management.

The goal of these decisions is to select capital projects that will increase the
value of the firm.

Capital investments are important because they involve substantial cash


outlays and, once made, are not easily reversed.

Capital budgeting techniques help management to systematically analyze


potential business opportunities in order to decide which are worth
undertaking.

B.

Sources of Information

Most of the information needed to make capital budgeting decisions is


generated internally, beginning likely with the sales force.

Then the production team is involved, followed by the accountants.

All this information is then reviewed by the financial managers, who evaluate
the feasibility of the project.

C.

Classification of Investment Projects

Capital budgeting projects can be broadly classified into three types: (1)
independent projects; (2) mutually exclusive projects; and (3) contingent
projects.
1. Independent Projects

Projects are independent when their cash flows are unrelated.

If two projects are independent, accepting or rejecting one project has


no bearing on the decision on the other.

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2. Mutually Exclusive Projects

When two projects are mutually exclusive, accepting one


automatically precludes the other.

Mutually exclusive projects typically perform the same function.

3. Contingent Projects

Contingent projects are those in which the acceptance of one project is


dependent on another project.

There are two types of contingency situations:

Projects that are mandatory

Projects that are optional

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D.

Basic Capital Budgeting Terms

The cost of capital is the minimum return that a capital budgeting project
must earn for it to be accepted.

It is an opportunity cost since it reflects the rate of return investors can earn on
financial assets of similar risk.

Capital rationing implies that a firm does not have the resources necessary to
fund all of the available projects.

It implies that funding needs exceed funding resources.

Thus, the available capital will be allocated to the set of projects that will
benefit the firm and its shareholders the most.

10.2

Net Present Value

It is a capital budgeting technique that is consistent with the goal of maximizing


shareholder wealth.

The method estimates the amount by which the benefits or cash flows from a project
exceeds the cost of the project in present value terms.

A. Valuation of Real Assets

Valuing real assets calls for the same steps as valuing financial assets.

Estimate future cash flows.

Determine the investors cost of capital or required rate of return.

Calculate the present value of the future cash flows.

However, there are some practical difficulties in following the process for real
assets.

First, cash flow estimates have to be prepared in-house and are not readily
available as they are for financial assets in legal contracts.

Second, estimates of required rates of return are more difficult than it is for
financial assets because no market data is available for real assets.

B. NPVThe Basic Concept

The present value of a project is the difference between the present value of the
expected future cash flows and the initial cost of the project.

Accepting a positive NPV project leads to an increase in shareholder wealth,


while accepting a negative NPV project leads to a decline in shareholder wealth.

Projects that have an NPV equal to zero imply that management will be
indifferent between accepting and rejecting the project.

C. Framework for Calculating NPV

The NPV technique uses the discounted cash flow technique.

Our goal is to compute the net cash flow (NCF) for each time period t, where NCFt =
(Cash inflows Cash outflows) for the period t.

A five-step approach can be utilized to compute the NPV.


1. Determine the cost of the project.

Identify and add up all expenses related to the cost of the project.

While we are mostly looking at projects whose entire cost occurs at the start
of the project, we need to recognize that some projects may have costs
occurring beyond the first year also.

The cash flow in year 0 (NCF0) is negative, indicating a cost.

2. Estimate the projects future cash flows over its expected life.

Both cash inflows (CIF) and cash outflows are likely in each year of the
project. Estimate the net cash flow (NCFt) = CIFt COFt for each year of the
project.

Remember to recognize any salvage value from the project in its terminal
year.

3. Determine the riskiness of the project and the appropriate cost of capital.

The cost of capital is the discount rate used in determining the present value of
the future expected cash flows.

The riskier the project, the higher the cost of capital for the project.

4. Compute the projects NPV.

Determine the difference between the present value of the expected cash flows
from the project and the cost of the project.

5. Make a decision.

Accept the project if it produces a positive NPV or reject the project if NPV is
negative.

D. Concluding Comments on NPV

Beware of optimistic estimates of future cash flows.

Recognize that the estimates going into calculating NPV are estimates and not
market data. Estimates based on informed judgments are considered acceptable.

The NPV method of determining project viability is the recommended approach


for making capital investment decisions.

The NPV decision criteria can be summed up as follows:

Summary of Net Present Value (NPV) Method


Decision Rule: NPV > 0: Accept the project.
NPV < 0: Reject the project.
Key Advantages
Key Disadvantages
1. Uses the discounted cash flow
1. Difficult to understand without an
valuation technique.

accounting and finance background.

2. Provides a direct measure of how much


a capital project will increase the value
of the firm.
3. Consistent with the goal of maximizing
shareholder wealth.
10.3

The Payback Period

It is one of the most widely used tools for evaluating capital projects.

The payback period represents the number of years it takes for the cash flows from a
project to recover the projects initial investment.

A project is accepted if its payback period is below some prespecified threshold.

This technique can serve as a risk indicatorthe more quickly you recover the cash,
the less risky is the project.

A. Computing the Payback Period

To compute the payback period, we need to know the projects cost and to
estimate its future net cash flows.

Equation 10.2 shows how to compute the payback period.

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PB Years before cost recovery

Remaining cost to recover


Cash flow during the year

There is no economic rationale that links the payback method to shareholder


wealth maximization.

If a firm has a number of projects that are mutually exclusive, the projects are
selected in order of their payback rank: projects with the lowest payback period
are selected first.

B. How the Payback Period Performs

The payback period analysis can lead to erroneous decisions because the rule does
not consider cash flows after the payback period.

A rapid payback does not necessarily mean a good investment. See Exhibit 10.6
Projects D and E.

C. The Discounted Payback Period

One weakness of the ordinary payback period is that it does not take into account
the time value of money.

The discounted payback period calculation calls for the future cash flows to be
discounted by the firms cost of capital.

The major advantage of the discounted payback is that it tells management how
long it takes a project to reach a positive NPV.

However, this method still ignores all cash flows after the arbitrary cutoff period,
which is a major flaw.

A. Evaluating the Payback Rule

The standard payback period is widely used in business.

It provides a simple measure of an investments liquidity risk.

The greatest advantage of the payback period is its simplicity.

It ignores the time value of money.

It does not adjust or account for differences in the overall, or total, risk for a
project, which could include operating, financing, and foreign exchange risk.

The biggest weakness of either the standard or discounted payback methods is


their failure to consider cash flows after the payback.

The following table summarizes this capital budgeting technique.

Summary of Payback Method


Decision Rule: Payback period Payback cutoff point ] Accept the project.

Payback period > Payback cutoff point ] Reject the project.


Key Advantages
Key Disadvantages
Easy to calculate and understand for
1 Most common version does not account
people without strong finance
backgrounds.

for time value of money.


2

A simple measure of a projects


liquidity.

Does not consider cash flows past the


payback period

Bias against long-term projects such as


research and development and new
product launches.

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10.4

Arbitrary cutoff point.

The Accounting Rate of Return

It is sometimes called the book rate of return.

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This method computes the return on a capital project using accounting numbersthe
projects net income (NI) and book value (BV) rather than cash flow data.

The most common definition is the one given in Equation 10.3:


ARR

Average NI
Average BV

It has a number of major flaws as a tool for evaluating capital expenditure decisions.

First, the ARR is not a true rate of return. ARR simply gives us a number based on
average figures from the income statement and balance sheet.

It ignores the time value of money.

There is no economic rationale that links a particular acceptance criterion to the


goal of maximizing shareholders wealth.

10.5

Internal Rate of Return

The IRR is an important and legitimate alternative to the NPV method.

The NPV and IRR techniques are similar in that both depend on discounting the cash
flows from a project.

When we use the IRR, we are looking for the rate of return associated with a project
so we can determine whether this rate is higher or lower than the firms cost of
capital.

The IRR is the discount rate that makes the NPV to equal zero.

A. Calculating the IRR

The IRR is an expected rate of return, much like the yield to maturity calculation
that was made on bonds.

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We will need to apply the same trial-and-error method to compute the IRR.

B. When the IRR and NPV Methods Agree

The two methods will always agree when the projects are independent and the
projects cash flows are conventional.

After the initial investment is made (cash outflow), all the cash flows in each
future year are positive (inflows).

C. When the IRR and NPV Methods Disagree

The IRR and NPV methods can produce different accept/reject decisions if a
project either has unconventional cash flows or the projects are mutually
exclusive.

1. Unconventional Cash Flows

Unconventional cash flows could follow several different patterns.


A positive initial cash flow followed by negative future cash flows.
Future cash flows from a project could include both positive and negative
cash flows.
A cash flow stream that looks similar to a conventional cash flow stream
except for a final negative cash flow.

In these circumstances, the IRR technique can provide more than one solution.
This makes the result unreliable and should not be used in deciding about
accepting or rejecting a project.

2. Mutually Exclusive Projects

When you are comparing two mutually exclusive projects, the NPVs of the
two projects will equal each other at a certain discount rate. This point at

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which the NPVs intersect is called the crossover point. Depending on whether
the required rate of return is above or below this crossover point, the ranking
of the projects will be different. While it is easy to identify the superior project
based on the NPV, one cannot do so based on the IRR. Thus, ranking conflicts
can arise.

A second situation arises when you compare projects with different costs.
While IRR gives you a return based on the dollar invested, it does not
recognize the difference in the size of the investments. NPV does!

D. Modified Internal Rate of Return (MIRR)

A major weakness of the IRR compared to the NPV method is the reinvestment
rate assumption.

IRR assumes that the cash flows from the project are reinvested at the IRR,
while the NPV assumes that they are invested at the firms cost of capital.

This optimistic assumption in the IRR method leads to some projects being
accepted when they should not be.

An alternative technique is the modified internal rate of return (MIRR). Here,


each operating cash flow is reinvested at the firms cost of capital.

The compounded values are summed up to get the projects terminal value.

The MIRR is the interest rate that equates the projects cost to the terminal value
at the end of the project.

Equation 10.5 shows how to calculate the MIRR.

E. IRR versus NPV: A Final Comment

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While the IRR has an intuitive appeal to managers because the output is in the
form of a return, the technique has some critical problems.

On the other hand, decisions made based on the projects NPV are consistent with
the goal of shareholder wealth maximization. In addition, the result shows
management the dollar amount by which each project is expected to increase the
value of the firm.

For these reasons, the NPV method should be used to make capital budgeting
decisions.

The following table summarizes the IRR decision-making criteria.

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Review of Internal Rate of Return (IRR)
Decision Rule: IRR > Cost of capital ] Accept the project.
IRR < Cost of capital ] Reject the project.
Key Advantages
Key Disadvantages
1. Intuitively easy to understand.
1. With nonconventional cash flows, IRR
2. Based on the discounted cash flow
technique.

approach can yield no or multiple answers.


2. A lower IRR can be better if a cash inflow is
followed by cash outflows.
3. With mutually exclusive projects, IRR can
lead to incorrect investment decisions.

10.6

Capital Budgeting in Practice


A. Practitioners Methods of Choice

Exhibit 10.12 summarizes surveys of practitioners on the capital budgeting


methods of choice.

In the late 1950s, less than 20 percent of managers used the NPV or IRR methods.

By 1981, over 65 percent of financial managers surveyed used the IRR, but only
16.5 percent of managers used the NPV.

In a recent study of Fortune 1000 managers, 85 percent of managers used the


NPV while 77 percent used the IRR. Surprisingly, over 50 percent of managers
used the payback method.

B. Ongoing and Postaudit Reviews

Management should systematically review the status of all ongoing capital


projects and perform postaudits on all completed capital projects.

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In a postaudit review, management compares the actual results of a project with


what was projected in the capital budgeting proposal.

A postaudit examination would determine why the project failed to achieve its
expected financial goals.

Managers should also conduct ongoing reviews of capital projects in progress.

The review should challenge the business plan, including the cash flow
projections and the operating cost assumptions.

Management must also evaluate people responsible for implementing a capital


project.

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II.

Suggested and Alternative Approaches to the Material

This chapter is about capital budgeting, a topic we first visited in Chapter 1. We open the chapter
with a discussion of the types of capital projects that firms undertake and how the capital
budgeting process is managed within the firm. Next we examine some of the techniques financial
managers use to evaluate capital budgeting decisions. We first discuss the net present value
(NPV) method, which is the capital budgeting approach recommended in this book. We then
examine two other capital budgeting techniques that have some serious deficiencies with regard
to selecting capital projectsthe payback period and the accounting rate of return. These
techniques do not consider the time value of money and can lead to decisions that decrease
stockholders wealth.
The fourth and last capital budgeting technique discussed in this chapter is the internal
rate of return (IRR), which is the expected rate of return for a capital project. We close the
chapter by looking at survey data that provide information on what capital budgeting techniques
financial managers actually use when making capital decisions.
The instructor can decide to take up the capital budgeting techniques in any order,
although the authors intent is to emphasize the net present value as the best possible approach to
capital budgeting decision making.

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III. Summary of Learning Objectives


1.

Discuss why capital budgeting decisions are the most important decisions made by a
firms management.
Capital budgeting is the process by which management decides which productive assets
the firm should invest in. Because capital expenditures involve large amounts of money,
are critical to achieving the firms strategic plan, define the firms line of business over
the long term, and determine the firms profitability for years to come, they are
considered the most important investment decisions made by management.

2.

Explain the benefits of using the net present value (NPV) method to analyze capital
expenditure decisions.
The net present value (NPV) method leads to better investment decisions than other
techniques because the NPV method does the following: (1) uses the discounted cash
flow valuation approach, which accounts for the time value of money, and (2) provides a
direct measure of how much a capital project is expected to increase the dollar value of
the firm. Thus, NPV is consistent with the top management goal of maximizing
stockholders wealth. NPV calculations are described in Section 10.2 and Learning by
Doing Application 10.1.

3.

Describe the strengths and weaknesses of the payback period as a capital


expenditure decision-making tool, and be able to compute the payback period for a
capital project.

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The payback period is the length of time it will take for the cash flows from a project to
recover the cost of the project. The payback period is widely used, mainly because it is
simple to apply and easy to understand. It also provides a simple measure of liquidity risk
because it tells management how quickly the firm will get its money back. The payback
period has a number of shortcomings, however. For one thing, the payback period, as
most commonly computed, ignores the time value of money. We can overcome this
objection by using discounted cash flows to calculate the payback period. Regardless of
how the payback period is calculated, it fails to take account of cash flows recovered after
the payback period. Thus, the payback period is biased in favor of short-lived projects.
Also, the hurdle rate used to identify what payback period is acceptable is arbitrarily
determined. Payback period calculations are described in Section 10.3 and Learning by
Doing Application 10.2.

4.

Explain why the accounting rate of return (ARR) is not recommended as a capital
expenditure decision-making tool.
The ARR is based on accounting numbers, such as book value and net income, rather
than cash flow data. As such, it is not a true rate of return. Instead of discounting a
projects cash flows over time, it simply gives us a number based on average figures from
the income statement and balance sheet. Furthermore, as with the payback method, there
is no economic rationale for establishing the hurdle rate. Finally, the ARR does not
account for the size of the projects when a choice between two projects of different sizes
must be made.

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5.

Be able to compute the internal rate of return (IRR) for a capital project, and
discuss the conditions under which the internal rate of return (IRR) technique and
the NPV technique produce different results.
The IRR is the expected rate of return for an investment project; it is calculated as the
discount rate that equates the present value of a projects expected cash inflows to the
present value of the projects outflowsin other words, as the discount rate at which the
NPV is equal to zero. Calculations are shown in Section 10.5 and Learning by Doing
Application 10.3. If a projects IRR is greater than the required rate of return, the cost of
capital, the project is accepted. The IRR rule often gives the same investment decision for
a project as the NPV rule. However, the IRR method does have operational pitfalls that
can lead to incorrect decisions. Specifically, when a projects cash flows are
unconventional, the IRR calculation may yield no solution or more than one IRR. In
addition, the IRR technique cannot be used to rank projects that are mutually exclusive
because the project with the highest IRR may not be the project that would add the
greatest value to the firm if acceptedthat is, the project with the highest NPV.

6.

Explain the benefits of a postaudit review of a capital project.


Postaudit reviews of capital projects allow management to determine whether the
projects goals were met and to quantify the benefits or costs of the project. By
conducting these reviews, managers can avoid similar mistakes and possibly better
recognize opportunities.

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IV. Summary of Key Equations


Equation

Description

Formula
NPV NCF0

10.1

Net present value

NCF1
NCF2
NCFn


1
2
(1 k )
(1 k )
(1 k ) n

NCFt
t
t 0 (1 k )
n

10.2

Payback period

PB Years before cost recovery

10.3

Average rate of return

ARR

10.4

Internal rate of return

Average Net Income


Average Book Value
n

NPV

=
t 0

CFt
=0
(1+IRR) t

Modified internal rate of


PVCost = TV/ (1 + MIRR)n

10.5
return

Remaining cost to recover


Cash flow during year

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V.

Before You Go On Questions and Answers

Section 10.1
1.

Why are capital investments considered the most important decisions made by a firms
management?

Capital investments are the most important decisions made by a firms management,
because they usually involve large cash outflows and once made are not easily reversed.
These are usually long-term projects that will define the firms line of business and
significantly contribute to the total revenue figure for years to come.

2.

What are the differences between capital projects that are independent, mutually exclusive,
and contingent?

A project is independent if the decision to accept or reject it does not affect the decision
to accept or reject another project. On the other hand, projects are mutually exclusive if
the acceptance of one implies rejection of the other. Contingent projects are those in
which the acceptance of one project is dependent on another project.

Section 10.2
1. What is the NPV of a project?

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NPV is simply the difference between the present value of a projects expected future
cash flows and its cost. It is the recommended technique used to value capital
investments, as it takes into account both the timing of the cash flows and their risk.

2. If a firm accepts a project with a $10,000 NPV, what is the effect on the value of the
firm?

If a firm accepts a project with a $10,000 NPV, it will increase its value by $10,000.

3.

What are the five steps used in NPV analysis?


The five-step process used in the NPV analysis can be listed as follows:
(1) Determine the cost of the project.
(2) Estimate the projects future cash flows over its expected life.
(3) Determine the riskiness of a project and the appropriate cost of capital.
(4) Compute the projects NPV.
(5) Make a decision.

Section 10.3
1. What is the payback period?

The payback period is defined as the number of years it takes to recover the projects
initial investment. All other things being equal, the project with the shortest payback
period is usually the optimal investment.

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2. Why does the payback period provide a measure of a projects liquidity risk?

The payback period determines how quickly you recover your investment in a project.
Thus, it serves as a good measure of the projects liquidity.

3.

What are the main shortcomings of the payback method?

The payback method does not account for time value of money, nor does it distinguish
between high- and low-risk projects. In addition, there is no rationale behind choosing the
cutoff criteria. For all these reasons, the payback method is not the ideal capital decision
rule.

Section 10.4
1.

What are the major shortcomings of using the ARR method as a capital budgeting
method?

The biggest shortcoming of using ARR as a capital budgeting tool is that it uses
historical, or book value data rather than cash flows and thus disregards the time value of
money principle. In addition, as in the payback method, it fails to establish a rationale
behind picking the appropriate hurdle rate.

Section 10.5

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1.

What is the IRR method?

The IRR, or the internal rate of return, is the discount rate that makes the net present
value of the projects future cash flows zero. The IRR determines whether the projects
return rate is higher or lower than the required rate of return, which is the firms cost of
capital. As a rule, a project should be accepted if the IRR exceeds the firms cost of
capital; otherwise the project should be rejected.

2.

In capital budgeting, what is a conventional cash flow?

A conventional project cash flow in capital budgeting is one in which an initial cash
outflow is followed by one or more future cash inflows.

3.

Why should the NPV method be the primary decision tool used in making capital
investment decisions?

Given all the different methods to evaluate capital investment decisions, the NPV method
is the preferred valuation tool as it accounts for both time value of money and the
projects risk. Furthermore, NPV is not sensitive to nonconventional projects, and
therefore it is superior to the IRR technique and it gives a measure of the value
increase/decrease to the firm by taking the project.

Section 10.6

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1.

What shifts have taken place in the capital budgeting techniques used by U.S.
companies?

Over the years, there has been a shift from using payback and ARR as the primary capital
budgeting tools to using NPV and IRR instead. Managers nowadays understand the
importance of the time value of money and discounting and thus regard ARR as an
inaccurate and obsolete decision tool.

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VI. Self-Study Problems

10.1

Premium Manufacturing Company is evaluating two forklift systems to use in its plant that
produces the towers for a windmill power farm. The costs and the cash flows from these
systems are shown here. If the company uses a 12 percent discount rate for all projects,
determine which forklift system should be purchased using the net present value (NPV)
approach.

Year 0
Year 1
Year 2
Year 3
Otis Forklifts
$3,123,450
$979,225
$1,358,886
$2,111,497
Craigmore Forklifts
$4,137,410
$875,236
$1,765,225
$2,865,110
Solution:
NPV for Otis Forklifts:

CFt
t
t 0 (1 k )
n

NPV

$979,225 $1,358,886 $2,111,497

(1 0.12)1
(1.12) 2
(1.12) 3
$3,123,450 $874,308 $1,083,296 $1,502,922
$3,123,450

$337,075

NPV for Craigmore Forklifts:

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CFt
t
t 0 (1 k )
n

NPV

$875,236 $1,765,225 $2,865,110

(1 0.12)1
(1.12) 2
(1.12) 3
$4,137,410 $781,461 $1,407,229 $2,039,227
$4,137,410

$90,606

Premium should purchase the Otis forklift since it has a larger NPV.

10.2

Rutledge, Inc., has invested $100,000 in a project that will produce cash flows of
$45,000, $37,500, and $42,950 over the next three years. Find the payback period for the
project.

Solution:
Payback period for Rutledge project:
Cumulative
Year
0
1
2
3

CF
(100,000)
45,000
37,500
42,950

Cash Flow
(100,000)
(55,000)
(17,500)
25,450

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 2 + ($17,500 / $42,950)
= 2.41 years

10.3

Perryman Crafts Corp. is evaluating two independent capital projects that together will
cost the company $250,000. The two projects will provide the following cash flows:

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Which
chosen if

Year
1
2
3
4

Project A
$80,750
$93,450
$40,325
$145,655

Project B
$32,450
$76,125
$153,250
$96,110

project will be
the companys

payback criterion is three years? What if the company accepts all projects as long as the
payback period is less than five years?

Solution:
Payback periods for Perryman projects A and B:
Project A
Cumulative
Year
0
1
2
3
4

Cash Flow
$(250,000)
80,750
93,450
40,235
145,655

Cash Flows
$(250,000)
(169,250)
(75,800)
(35,565)
110,090

Project B
Cumulative
Year
0
1
2
3
4

Cash Flow
$(250,000)
32,450
76,125
153,250
96,110

Cash Flows
$(250,000)
(217,550)
(141,425)
11,825
107,935

Payback period for Project A:


PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 3 + ($35,565 / $145,655)
= 3.24 years

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Payback period for Project B:


PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 2 + ($141,425/ $153,250)
= 2.92 years

If the payback period is three years, project B will be chosen. If the payback criterion is five
years, then both A and B will be chosen.

10.4

Terrell Corp. is looking into purchasing a machine for its business that will cost $117,250
and will be depreciated on a straight-line basis over a five-year period. The sales and
expenses (excluding depreciation) for the next five years are shown in the following table.
The companys tax rate is 34 percent.

Year 1

Year 2
$176,875
$126,488

Year 3

Year 4

Year 5

The company will accept all projects that provide an accounting rate of return (ARR) of at
least 45 percent. Should the company accept this project?

Solution:
Sales
Expenses
Depreciation
EBIT
Taxes (34%)
Net Income

Year 1
$123,450
137,410
23,450
$ (37,410)
12,719
$ (24,691)

Year 2
$176,875
126,488
23,450
$ 26,937
9,159
$ 17,778

Year 3
$242,455
141,289
23,450
$ 77,716
26,423
$ 51,293

Year 4
$255,440
143,112
23,450
$ 88,878
30,219
$ 58,659

Year 5
$267,125
133,556
23,450
$110,119
37,440
$ 72,679

30
Beginning Book Value
Less: Depreciation
Ending Book Value
Average net income

117,250
(23,450)
$ 93,800

93,800
(23,450)
$ 70,350

70,350
(23,450)
$ 46,900

46,900
(23,450)
$ 23,450

23,450
(23,450)
$
0

= ($24,691 + $17,778 + $51,293 + $58,659 + $72,679) / 5


= $35,143.60

Average book value

= ($93,800 + $70,350 + $46,900 + $23,450 + $0) / 5


= $46,900.00

Accounting rate of return = $35,143.6 / $46,900


= 74.93%
The company should accept the project.

10.5

Refer to Problem 10.1. Compute the IRR for each of the two systems. Is the choice different

from the one determined by NPV?

Solution:
IRR for two forklift systems:
Otis Forklifts:
First compute the IRR by the trial-and-error approach:
NPV (Otis) = $337,075 > 0
Use a higher discount rate to get NPV = 0!
At k = 15%,

31
$979,225 $1,358,886 $2,111,497

(1 0.15)1
(1.15) 2
(1.15) 3
$3,123,450 $851,500 $1,027,513 $1,388,344
$143,907.

NPV $3,123,450

Try a higher rate. At k = 17%,

NPV $3,123,450 $836,944 $992,685 $1,318,357


$24,536.
Try a higher rate. At k = 17.5%,

NPV $3,123,450 $833,383 $984,254 $1,301,598


$4,215
Thus the IRR for Otis is less than 17.5 percent. Using a financial calculator, you can find
that the exact rate to be 17.43 percent.

Craigmore Forklifts:
First compute the IRR by the trial-and-error approach:
NPV (Craigmore) = $90,606 > 0
Use a higher discount rate to get NPV = 0! At k = 15%,
$875,236 $1,765,225 $2,865,110

(1.15)1
(1.12) 2
(1.12) 3
$4,137,410 $761,075 $1,334,764 $1,883,856

NPV $4,137,410
$157,715

Try a lower rate. At k = 13%,

NPV $4,137,410 $774,545 $1,382,430 $1,985,665


$5,230
Try a higher rate. At k = 13.1%,

NPV $4,137,410 $773,860 $1,379,987 $1,980,403


$3,161

32
Thus the IRR for Craigmore is less than 13.1 percent. The exact rate is 13.06 percent.
Based on the IRR, we would still pick Otis over Craigmore forklift systems.

33

VII. Critical Thinking Questions


10.1

Explain why the cost of capital is referred to as the hurdle rate in capital budgeting.

The cost of capital is the minimum required return on any new investment that allows a
firm to break even. Since we are using the cost of capital as a benchmark or hurdle to
compare the return earned by any project, it is sometimes referred to as the hurdle rate.

10.2

a. A company is building a new plant on the outskirts of Smallesville. The town has
offered to donate the land, and as part of the agreement, the company will have to
build an access road from the main highway to the plant. How will the project of
building the road be classified in capital budgeting analysis?
b. Sykes, Inc., is considering two projectsa plant expansion and a new computer
system for the firms production department. Classify each of these projects as
independent, mutually exclusive, or contingent projects and explain your reasoning.
c. Your firm is currently considering the upgrading of the operating systems of all the
firms computers. The firm can choose the Linux operating system that a local
computer services firm has offered to install and maintain. Microsoft has also put in a
bid to install the new Windows Vista operating system for businesses. What type of
project is this?

a. This is a contingent project. Acceptance of the road-building project is contingent


on the new plant being a financially viable project. If the new plant will not have
a positive value, then the firm will not even consider this project. However, this

34
projects cost will have to be considered along with the cost of building the new
plant in the capital budgeting analysis.
b. These two projects are independent projects. Accepting or rejecting one will not
influence the decision on the other project. The cash flows of the two projects are
unrelated.
c. These are two mutually exclusive projects. The companys computers need only
one operating system. Either the Linux or the Windows operating system needs to
be installed, not both. Hence, the selection of one will eliminate the other from
consideration.

10.3

In the context of capital budgeting, what is capital rationing?

Capital rationing implies that a firm does not have the resources necessary to fund all of
the available projects. In other words, funding needs exceed funding resources. Thus, the
available capital will be allocated to the projects that will benefit the firm and its
shareholders the most. Projects that create the largest increase in shareholder wealth will
be accepted until all the available resources have been allocated.

10.4

Explain why we use discounted cash flows instead of actual market price data.

While market price data would be preferable to estimating future cash flows in
determining an assets value, it is often not available. Thus, the discounted cash flow
approach is used as a proxy for actual market price of an assets value.

35

10.5

a. A firm takes on a project that would earn a return of 12 percent. If the appropriate
cost of capital is also 12 percent, did the firm make the right decision. Explain.
b. What is the impact on the firm if it accepts a project with a negative NPV?

a. We would normally argue that a firm should only accept projects in which the
projects return exceeds the cost of capital. In other words, only if the net present
value exceeds zero should a project be accepted. But in reality, projects with a
zero NPV should also be accepted because the project earns a return that equals
the cost of capital. For some firms like the one above, this could be the situation
because they may not have projects that provide a return greater than the cost of
capital for the firm.
b. When a firm takes on positive NPV projects, the value of the firm increases. By
the same token, when a project undertaken has a negative NPV, the value of the
firm will decrease by the amount of the net present value.

10.6

Identify the weaknesses of the payback period method.

There are several critical weaknesses in the payback period approach of evaluating
capital projects.

The payback period ignores the time value of money by not discounting future
cash flows.

When comparing projects, it ignores risk differences between the projects.

36

A firm may establish payback criteria with no economic basis for that decision
and thereby run the risk of losing out on good projects.

The method ignores cash flows beyond the payback period, thus leading to
nonselection of projects that may produce cash flows well beyond the payback
period or more cash flows than accepted projects. This leads to a bias against
longer-term projects.

10.7

What are the strengths and weaknesses of the accounting rate of return (ARR) approach?

The biggest advantage of ARR is that it is easy to compute since accounting data is
readily available, whereas estimating cash flows is more difficult. However, the
disadvantages outweigh this specific advantage. Similar to the payback, it does not
discount cash flows, but merely averages net income over time. No economic rationale is
used in establishing an ARR cutoff rate. Finally, the ARR uses net income to evaluate the
project and not cash flows or market data. This is a serious flaw in this approach.

10.8

Under what circumstances might the IRR and NPV approaches have conflicting results?

IRR and the NPV methods of evaluating capital investment projects might produce
dissimilar results under two circumstances. First, if the projects cash flows are not
conventionalthat is, if the sign of the cash flow changes more than once during the life
of a projectthen multiple IRRs can be obtained as solutions. We would be unable to
identify the correct IRR for decision making. (See Learning by Doing Application 10.3.)

37
The second situation occurs when two or more projects are mutually exclusive. The
project with the highest IRR may not necessarily be the one with the highest NPV and
thereby be the right choice. There is an important reason for this. IRR assumes that all
cash flows received during the life of a project are reinvested at the IRR, whereas the
NPV method assumes that they are reinvested at the cost of capital. Since the cost of
capital is the better proxy for opportunity cost, NPV uses the better proxy, while the IRR
uses an unrealistically higher rate as proxy.

10.9

A company estimates that an average-risk project has a cost of capital of 8 percent, a belowaverage risk project has a cost of capital of 6 percent, and an above-average risk project has a
cost of capital of 10 percent. Which of the following independent projects should the
company accept? Project A has below-average risk and a return of 6.5 percent. Project B has
above-average risk and a return of 9 percent. Project C has average risk and a return of 7
percent.

Since Project A has below-average risk, it should be accepted if it earns a return of 6


percent, which is the cost of capital for projects of this risk type. Project A earns a return
of 6.5 percent and hence should be accepted. Project B is an above-average risk type and
only earns 9 percent, while the required rate of return is 10 percent. Thus, this project is a
negative NPV project and should be rejected. This is the case with Project C whose return
of 7 percent is below the cost of capital of 8 percent and should be rejected. Thus, only
Project A is accepted.

38
10.10 Elkridge Construction Company has an overall (composite) cost of capital of 12 percent. This
cost of capital reflects the cost of capital for an Elkridge Construction project with average
risk. However, the firm takes on projects of various risk levels. The company experience
suggests that low-risk projects have a cost of capital of 10 percent and high-risk projects have
a cost of capital of 15 percent. Which of the following projects should the company select to
maximize shareholder wealth?

Project
1. Single-family homes
2. Multifamily residential
3. Commercial
4. Single-family homes
5. Commercial

Project
1. Single-family homes
2. Multifamily residential
3. Commercial
4. Single-family homes
5. Commercial

Expected Return
13%
12
18
9
13

Risk
Low
Average
High
Low
High

Required

Expected

Return
10%
12
15
10
15

Return
13%
12
18
9
13

Risk
Low
Average
High
Low
High

Decision
Accept
Accept / Indifferent
Accept
Reject
Reject

39

VIII.

Questions and Problems

BASIC
10.1

Net present value: Riggs Corp. is planning to spend $650,000 on a new marketing
campaign. It believes that this action will result in additional cash flows of $325,000 over
the next three years. If the firm uses a discount rate of 17.5 percent, what is the NPV on
this project?

Solution:
Initial investment = $650,000
Annual cash flows = $325,000
Length of project = n = 3 years
Required rate of return = k = 17.5%
Net present value = NPV

NCFt
$325,000 $325,000 $325,000
$650,000

t
(1.175)1
(1.175) 2
(1.175) 3
t 0 (1 k )
$650,000 276,596 $235,401 $200,341
$62,337
n

NPV

10.2

Net present value: Kingston, Inc., is looking to add a new machine at a cost of
$4,133,250. The company expects this equipment will lead to cash flows of $814,322,
$863,275, $937,250, $1,017,112, $1,212,960, and $1,225,000 over the next six years. If
the appropriate discount rate is 15 percent, what is the NPV of this investment?

Solution:

40
Cost of new machine = $4,133,250
Length of project = n = 6 years
Required rate of return = k = 15%
NCFt
t
t 0 (1 k )
n

NPV

$814,322 $863,275 $937,250 $1,017,112 $1,212,960 $1,225,000

(1.15)1
(1.15) 2
(1.15)3
(1.15) 4
(1.15)5
(1.15) 6
$4,133,250 708,106 $$652,760 $616257 $581,537 $603,055 $529,601
$4,133,250
$441,933

10.3

Net present value: Crescent Industries is planning to replace some existing machinery in
its plant. The cost of the new equipment and the resulting cash flows are shown in the
accompanying table. If the firm uses an 18 percent discount rate, should the firm go
ahead with the project?
Year
0
1
2
3
4
5

Solution:
Initial investment = $3,300,000
Length of project = n = 5 years
Required rate of return = k = 18%

Cash Flow
$3,300,000
$875,123
$966,222
$1,145,000
$1,250,399
$1,504,445

41
NCFt
t
t 0 (1 k )
n

NPV

$875,123 $966,222 $1,145,000 $1,250,399 $1,504,455

(1.18)1
(1.18) 2
(1.18)3
(1.18) 4
(1.18)5
$3,300,000 $741,630 $693,926 $696,882 $644,942 $657,607
$134,986
$3,300,000

Since the NPV is positive, the firm should accept the project.

10.4

Net present value: Franklin Mints, a confectioner, is looking to purchase a new


jellybean-making machine at a cost of $312,500. The company projects that the cash
flows from this investment will be $121,450 for the next seven years. If the appropriate
discount rate is 14 percent, what is the NPV for the project?

Solution:
Initial investment = $312,500
Annual cash flows = $121,450
Length of project = n = 7 years
Required rate of return = k = 14%
NCFt
t
t 0 (1 k )
n

NPV

$121,450 $121,450 $121,450 $121,450 $121,450

(1.14)1
(1.14) 2
(1.14) 3
(1.14) 4
(1.14)5
$121,450 $121,450

(1.14)6
(1.14) 7
$312,500 $106,535 $93,452 $81,975 $71,908 $63,077 $55,331 $48,536
$208,315
$312,500

42
10.5

Payback: Quebec, Inc., is purchasing machinery at a cost of $3,768,966. The company


expects, as a result, cash flows of $979,225, $1,158,886, and $1,881,497 over the next
three years. What is the payback period?

Solution:
Cumulative
Year
CF
Cash Flow
0
$(3,768,966) $(3,768,966)
1
979,225
(2,789,741)
2
1,158,886
(1,630,855)
3
1,881,497
250,642
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 2 + ($1,630,855 / $1,881,497) = 2.87 years

10.6

Payback: Northern Specialties just purchased inventory-management computer software


at a cost of $1,645,276. Cost savings from the investment over the next six years will be
reflected in the following cash flow stream: $212,455, $292,333, $387,479, $516,345,
$645,766, and $618,325. What is the payback period on this investment?

Solution:
Cumulative
Year
0
1
2
3
4
5
6

CF
$(1,645,276)
212,455
292,333
387,479
516,345
645,766
618,325

Cash Flow
$(1,645,276)
(1,432,821)
(1,140,488)
(753,009)
(236,664)
409,102
1,027,427

43
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($236,664 / $645,766)
= 4.37 years

10.7

Payback: Nakamichi Bancorp has made an investment in banking software at a cost of


$1,875,000. The institution expects productivity gains and cost savings over the next
several years. If the firm is expected to generate cash flows of $586,212, $713,277,
$431,199, and $318,697 over the next four years, what is the investments payback
period?

Solution:
Cumulative
Year
0
1
2
3
4

CF
$(1,875,000)
586,212
713,277
431,199
318,697

Cash Flow
$(1,875,000
(1,288,788)
(575,511)
(144,312)
174,385

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 3 + ($144,312 / $318,697)
= 3.45 years

10.8

Accounting rate of return (ARR): Capitol Corp. is expecting to generate after-tax


income of $63,435 over each of the next three years. The average book value of its
equipment over that period will be $212,500. If the firms acceptance decision on any
project is based on an ARR of 37.5 percent, should this project be accepted?

44

Solution:
Annual after-tax income = $63,435
Average after-tax income = ($63,435 +$63,435 + $63,435) / 3 = $63,435
Average book value of equipment = $212,500

Average after - tax income


Average book value
$63,435

29.9%
$212,500

Accounting rate of return

Since the projects ARR is below the acceptance rate of 37.5 percent, the project should be
rejected.

10.9

Internal rate of return: Refer to Problem 10.4. What is the IRR that Franklin Mints can
expect on this project?

Solution:
Initial investment = $312,500
Annual cash flows = $121,450
Length of project = n = 7 years
Required rate of return = k = 14%
To determine the IRR, a trial-and-error approach can be used. Set NPV = 0.
Since the project had a positive NPV of $134,986, try IRR > k.
Try IRR = 25%.

45
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1 (1.25)7
0 $312,500 $121,450

0.25

$312,500 $383,920 $71,420

Try a higher rate, IRR = 34%.


FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1 (1.34) 7
0 $312,500 $121,450

0.34

$312,500 $311,161 $1,339


Try a lower rate, IRR = 33.8%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1 (1.338) 7
0 $312,500 $121,450

0.338

$312,500 $312,515 $15 0


The IRR of the project is 33.8 percent. Using a financial calculator, we find that the IRR
is 33.83 percent.

10.10 Internal rate of return: Hathaway, Inc., a resort company, is refurbishing one of its
hotels at a cost of $7.8 million. The firm expects that this improvement will lead to
additional cash flows of $1.8 million for the next six years. What is the IRR of this

46
project? If the appropriate cost of capital is 12 percent, should it go ahead with this
project?

Solution:
Initial investment = $7,800,000
Annual cash flows = $1,800,000
Length of project = n = 6 years
Required rate of return = k = 12%
To determine the IRR, a trial-and-error approach can be used. Set NPV = 0.
Try IRR = 12%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1 (1.12) 6
0 $7,800,000 $1,800,000

0.12

$7,800,000 $7,400,533 $399,467

Since NPV < 0, try a lower rate, IRR = 10%.


FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1 (1.10)6
0 $7,800,000 $1,800,000

0.10

$7,800,000 $7,839,469 $39,469


Try IRR = 10.2%.

47
FCFt
t
t 0 (1 IRR )
n

NPV 0

1 (1.102) 6
0 $7,800,000 $1,800,000

0.102

$7,800,000 $7,793,735 $6,265


Try IRR = 10.15%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1 (1.1015)6
0 $7,800,000 $1,800,000

0.1015

$7,800,000 $7,805,129 $5,129


The IRR of the project is between 10.15 and 10.2 percent. Using a financial calculator,
we find that the IRR is 10.1725 percent. Since IRR < k, reject the project.

INTERMEDIATE

10.11 Net present value: Champlain Corp. is investigating two computer systems. The Alpha
8300 costs $3,122,300 and will generate annual cost savings of $1,345,500 over the next
five years. The Beta 2100 system costs $3,750,000 and will produce cost savings of
$1,125,000 in the first three years and then $2 million for the next two years. If the
companys discount rate for similar projects is 14 percent, what is the NPV for the two
systems? Which one should be chosen based on the NPV?

48
Solution:
Cost of Alpha 8300 = $3,122,300
Annual cost savings = $1,345,500
Length of project = n = 5 years
Required rate of return = k = 14%

1
1

FCFt
(1.14)5
NPV

$
3
,
122
,
300

$
1
,
345
,
500

t
0.14
t 0 (1 k )

$3,122,300 $4,619,210
$1,496,910
n

Cost of Beta 2100 = $3,750,000


Length of project = n = 5 years
Required rate of return = k = 14%

1
1

FCFt
(1.14)3 $2,000,000 $2,000,000
NPV

$
3
,
750
,
000

$
1
,
125
,
500


t
4
0
.
14
(
1
.
14
)
(1.14)5
t 0 (1 k )

$3,750,000 $2,611,836 $1,184,161 1,038,737


$1,084,734
Based on the NPV, the Alpha 8300 system should be chosen.

10.12 Net present value: Briarcrest Condiments is a spice-making firm. Recently, it developed
a new process for producing spices. This calls for acquiring machinery that would cost
$1,968,450. The machine will have a life of five years and will produce cash flows as
shown in the table. What is the NPV if the firm uses a discount rate of 15.9 percent?

49
Year
1
2
3
4
5

Cash Flow
$512,496
$(242,637)
$814,558
$887,225
$712,642

Solution:
Cost of equipment = $1,968,450
Length of project = n = 5 years
Required rate of return = k = 15.9%

FCFt
t
t 0 (1 k )
n

NPV

$512,496 $242,637 $814,558 $887,225 $712,642

(1.159)1
(1.159) 2
(1.159) 3
(1.159) 4
(1.159) 5
$1,968,450 $442,188 $180,630 $523,205 491,700 340,764
$1,968,450
$351,223

10.13 Net present value: Cranjet Industries is expanding its product line and its production
capacity. The costs and expected cash flows of the two independent projects are given in
the following table. The firm typically uses a discount rate of 16.4 percent.
a.

Are these projects independent or mutually exclusive?

b.

What are the NPVs of the two projects?

c.

Should both projects be accepted? Or either? Or neither? Explain your reasoning.

Year
0

Product Line

Production Capacity

Expansion
$(2,575,000)

Expansion
$(8,137,250)

50
1
2
3
4
5

$600,000
$875,000
$875,000
$875,000
$875,000

$2,500,000
$2,500,000
$2,500,000
$3,250,000
$3,250,000

Solution:
a.

Both are independent projects.

b.

Required rate of return = 16.4%


Product Line Expansion:
Cost of product line expansion = $2,575,000
FCFt
t
t 0 (1 k )
n

NPV

$600,000 $875,000 $875,000 $875,000 $875,000

(1.164)1
(1.164) 2
(1.164 )3
(1.164) 4
(1.164)5
$2,575,000 $515,464 $645,806 $554,816 476,646 409,490
$27,222
$2,575,000

Production CapacityExpansion:
Cost of production capacity expansion = $8,137,250
FCFt
t
t 0 (1 k )
n

NPV

1 (1.164) 3 $3,250,000 $3,250,000


$8,137,250 $2,500,000


0.164
(1.164) 4
(1.164) 5

$8,137,250 $5,578,116 $1,770,400 $1,520,962


$732,228
c.

Since they are independent, and both have NPV > 0, both projects should be
accepted.

51
10.14 Net present value: Emporia Mills is evaluating two heating systems. Costs and projected
energy savings are given in the following table. The firm uses 11.5 percent to discount
such project cash flows. Which system should be chosen?

Year
0
1
2
3
4

System 100
$(1,750,000)
$275,223
$512,445
$648,997
$875,000

System 200
$(1,735,000)
$750,000
$612,500
$550,112
$384,226

Solution:
Required rate of return = 11.5%
System 100:
Cost of product line expansion = $1,750,000
FCFt
$275,223 $512,445 $648,997 $875,000
$1,750,000

t
(1.115)1
(1.115) 2
(1.115)3
(1.115) 4
t 0 (1 k )
$1,750,000 $246,837 $412,190 $468,186 566,120
$56,667
n

NPV

System 200:
Cost of product line expansion = $1,735,000
FCFt
$750,000 $612,500 $550,112 $384,226
$1,735,000

t
(1.115)1
(1.115) 2
(1.115) 3
(1.115) 4
t 0 (1 k )
$1,735,000 $672,446 $492,670 $396,850 248,592
$75,758
n

NPV

Since System 200 has a positive NPV, select that system. Reject System 100 as it has
negative NPV.

52
10.15 Payback: Creative Solutions, Inc., has invested $4,615,300 in equipment. The firm uses
payback period criteria of not accepting any project that takes more than four years to
recover costs. The company anticipates cash flows of $644,386, $812,178, $943,279,
$1,364,997, $2,616,300, and $2,225,375 over the next six years. Does this investment
meet the firms payback criteria?

Solution:
Cumulative
Year
0
1
2
3
4
5
6

CF
$(4,615,300)
644,386
812,178
943,279
1,364,997
2,616,300
2,225,375

Cash Flow
$(4,615,300)
(3,970,914)
(3,158,736)
(2,215,457)
(850,460)
1,765,840
3,991,215

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($850,460 / $2,616,300)
= 4.33 years
Since the project payback period exceeds the firms target of four years, it should not be
accepted.

10.16 Discounted payback: Timeline Manufacturing Co. is evaluating two projects. It uses
payback criteria of three years or less. Project A has a cost of $912,855, and project Bs
cost will be $1,175,000. Cash flows from both projects are given in the following table.
What are the discounted payback periods, and which will be accepted if the firm uses a

53
discount rate of 8 percent?
Year
1
2
3
4

Project A
$ 86,212
$313,562
$427,594
$285,552

Project B
$586,212
$413,277
$231,199

Solution:
Project A
Cumulativ
Year
0
1
2
3
4

CF
$(912,855)
86,212
313,562
427,594
285,552

e CF
$(912,855)
(826,643)
(513,081)
(85,487)
200,065

Cumulative
PVCF
$(912,855)
79,826
268,829
339,438
209,889

PVCF
$(912,855)
(833,029)
(564,200)
(224,762)
(14,873)

The payback period exceeds four years.


Project B
Cumulative
Year
0
1
2
3

Cumulative

CF
$(1,175,000)

CF
$(1,175,000

PVCF
$(1,175,000)

PVCF
$(1,175,000)

586,212
413,277
231,199

)
(588,788)
(175,511)
55,688

542,789
354,318
183,533

(632,211)
(277,893)
(94,359)

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 3 + years
Since the firms acceptance criteria is three years, neither project will be accepted.

10.17 Payback: Regent Corp. is evaluating three competing pieces of equipment. Costs and

54
cash flow projections for all three are given in the following table. Which would be the
best choice based on payback period?
Year
0
1
2
3
4
5
6

Type 1
$(1,311,450)
$212,566
$269,825
$455,112
$285,552
$121,396

Type 2
$(1,415,888)
$586,212
$413,277
$331,199
$141,442

Type 3
$(1,612,856)
$786,212
$175,000
$175,000
$175,000
$175,000
$175,000

Solution:
Type 1
Cumulativ

Type 2
Cumulativ

Type 3
Cumulative

Year

CF

e CF

CF

e CF

CF

CF

0
1
2
3
4
5
6

$(1,311,450)
212,566
269,825
455,112
285,552
121,396

$(1,311,450)
(1,098,884)
(829,059)
(373,947)
(88,395)
33,001

$(1,415,888)
586,212
413,277
331,199
141,442

$(1,415,888)
(829,676)
(416,399)
(85,200)
56,242

$(1,612,856)
786,212
175,000
175,000
175,000
175,000
175,000

($1,612,856)
(826,644)
(651,644)
(476,644)
(301,644)
(126,644)
48.356

Type 1:
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($88,395 / $121,396)
= 4.73 years
Type 2:
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 3 + ($85,200 / $141,442)
= 3. 6 years
Type 3:

55
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 5 + ($126,644 / $175,000)
= 5.72 years
Select Type 2 because it has the lowest payback period.

10.18 Discounted payback: Nugent Communication Corp. is investing $9,365,000 in new


technologies. The company expects significant benefits in the first three years after
installation (as can be seen by the cash flows), and a constant amount for four more years.
What is the discounted payback period for the project assuming a discount rate of 10
percent?
Years
Cash flows

1
$2,265,433

2
$4,558,721

3
$3,378,911

47
$1,250,000

Solution:
Discount rate = k = 10%
Cumulative
Year
0
1
2
3
4
5
6
7

Cumulative

CF
$(9,365,000)

CF
$(9,365,000

PVCF
$(9,365,000)

PVCF
$(9,365,000)

2,265,433
4,588,721
3,378,911
1,250,000
1,250,000
1,250,000
1,250,000

)
(7,099,567)
(2,540,846)
838,065
2,088,065
3,338,065
4,588,065
5,838,065

2,059,485
3,767,538
2,538,626
853,767
776,152
705,592
641,448

(7,305,515)
(3,537,977)
(999,352)
(145,585)
630,567
1,336,159
1,977,607

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($145,585 / $1,250,000)

56
= 4.19 years

10.19 Modified internal rate of return (MIRR): Morningside Bakeries has recently purchased
equipment at a cost of $650,000. The firm expects to generate cash flows of $275,000 in each
of the next four years. The companys cost of capital is 14 percent. What is the MIRR for this
project?

Solution:
PV of costs = $650,000
Length of project = n = 4 years
Cost of capital = k = 14%
Annual cash flows = CFt = $275,000
TV CF1 (1 k ) n 1 CF2 (1 k ) n 2 CFn (1 k ) n n
$275,000(1.14)3 $275,000(1.14) 2 $275,000(1.14)1 $275,000(1.14)0
$407,425 $357,390 $313,500 $275,000 $1,353,315

Now we can solve for the MIRR using Equation 10.5.


TV
(1 MIRR ) t
$1,353,315
$650,000
(1 MIRR ) 4
$1,353,315
(1 MIRR ) 4
2.0820
$650,000
PVCosts

(1 MIRR ) (3.5962) 4 1.2012


1

MIRR 0.2012 20.1%

10.20 Modified internal rate of return (MIRR): Sycamore Home Furnishings is looking to
acquire a new machine that can create customized window treatments. The equipment will

57
cost $263,400 and will generate cash flows of $85,000 over each of the next six years. If the
companys cost of capital is 12 percent, what is the MIRR on this project?

Solution:
PV of costs = $263,400
Length of project = n = 6 years
Cost of capital = k = 12%
Annual cash flows = CFt = $85,000

TV CF1 (1 k ) n 1 CF2 (1 k ) n 2 CFn (1 k ) n n


$85,000(1.12)5 $85,000(1.12) 4 $85,000(1.12)3 $85,000(1.12) 2
$85,000(1.12)1 $85,000(1.12)0
$149,799 $133,749 $119,419 $106,624 $95,200 $85,000
$689,791
Now we can solve for the MIRR using Equation 10.5.
TV
(1 MIRR ) t
$689,791
$263,400
(1 MIRR )6
$689,791
(1 MIRR ) 6
2.6188
$263,400
PVCosts

(1 MIRR ) ( 2.6188) 6 1.1740


MIRR 0.1740 17.4%
1

10.21 Internal rate of return: Great Flights, Inc., an aviation firm, is exploring the purchase of
three aircraft at a total cost of $161 million. Cash flows from leasing these aircraft are

58
expected to build slowly as shown in the following table. What is the IRR on this project?
The firms required rate of return is 15 percent.

Solution:
Initial investment =

Years
14
57
810

Cash Flow
$23,500,000
$72,000,000
$80,000,000

$161,000,000

Length of project = n = 10 years


Required rate of return = k = 15%
To determine the IRR, the trial-and-error approach can be used. Set NPV=0.
Try a higher rate than k = 15%; try IRR = 22%.

FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1

1 (1.22) 4
1 (1.22) 3
1
0 $161,000,000 $23,500,000
$72,000,000

0.22
0.22 (1.22) 4

1 (1.22) 3
1
$80,000,000

0.22 (1.22)7

$161,000,000 $58,600,552 $66,374,346 $40,614,233 $4,589,131


Try IRR = 23%.

59
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1

1 (1.23) 4
1 (1.23)3
1
0 $161,000,000 $23,500,000
$72,000,000

0.23
0.23 (1.23) 4

1 (1.23) 3
1
$80,000,000

0.23 (1.23)7

$161,000,000 $57,534,386 $63,271,035 $37,778,708 $2,415,871


Try IRR = 22.7%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1

1 (1.227) 4
1 (1.227) 3
1
0 $161,000,000 $23,500,000
$72,000,000

0.227
0.227 (1.227) 4

1 (1.227) 3
1
$80,000,000

0.227 (1.227) 7

$161,000,000 $57,850,786 $64,183,552 $38,605,355 $360,307


The IRR of the project is between 22 and 23 percent. Using a financial calculator, we find
that the IRR is 22.65 percent.

10.22 Internal rate of return: Compute the IRR on the following cash flow streams:
a.

An initial investment of $25,000 followed by a single cash flow of $37,450 in


year 6

b.

An initial investment of $1 million followed by a single cash flow of $1,650,000


in year 4

60
c.

An initial investment of $2 million followed by cash flows of $1,650,000 and


$1,250,000 in years 2 and 4, respectively

Solution:
a.

Try IRR = 7%.


FCFt
t
t 0 (1 IRR )
$37,450
0 $25,000
(1.07) 6
$25,000 $24,955 $45
n

NPV 0

Try IRR = 6.97%.


FCFt
t
t 0 (1 IRR )
$37,450
0 $25,000
(1.0697)6
$25,000 $24,997 $3
n

NPV 0

The IRR of the project is approximately 6.97 percent. Using a financial calculator,
we find that the IRR is 6.968 percent.
b.

Try IRR = 12%.


FCFt
t
t 0 (1 IRR )
$1,650,000
0 $1,000,000
(1.12) 4
$1,000,000 $1,048,605 $48,605
n

NPV 0

Try IRR = 13%.

61
FCFt
t
t 0 (1 IRR )
$1,650,000
0 $1,000,000
(1.13) 4
$1,000,000 $1,011,976 $11,976
n

NPV 0

Try IRR = 13.3%.


FCFt
t
t 0 (1 IRR )
$1,650,000
0 $1,000,000
(1.133) 4
$1,000,000 $1,1,001,300 $1,300
n

NPV 0

The IRR of the project is approximately 13.3 percent. Using a financial calculator,
we find that the IRR is 13.337 percent.
c.

Try IRR = 15%.


FCFt
t
t 0 (1 IRR )
$1,650,000 $1,250,000
0 $2,000,000

(1.15) 2
(1.15) 4
$2,000,000 $1,247,637 $714,692 $37,671
n

NPV 0

Try IRR = 14%.


FCFt
t
t 0 (1 IRR )
$1,650,000 $1,250,000
0 $2,000,000

(1.14) 2
(1.14) 4
$2,000,000 $1,269,621 $740,100 $9,721
n

NPV 0

The IRR of the project is between 14 and 15 percent. Using a financial calculator,
we find that the IRR is 14.202 percent.

10.23 Internal rate of return: Compute the IRR for the following project cash flows.

62
a.

An initial outlay of $3,125,000 followed by annual cash flows of $565,325 for the
next eight years

b.

An initial investment of $33,750 followed by annual cash flows of $9,430 for the
next five years

c.

An initial outlay of $10,000 followed by annual cash flows of $2,500 for the next
seven years

Solution:
a.

Initial investment = $3,125,000


Annual cash flows = $565,325
Length of investment = n = 8 years

Try IRR = 8%.

1
1

n
FCFt
(1.08)8
NPV

$
3
,
125
,
000

$
565
,
325

t
0.08
t 0 (1 k )

$3,125,000 $3,249,006
$124,006
Try a higher rate, IRR = 9%.

1
1

FCFt
(1.09)8
NPV

$
3
,
125
,
000

$
565
,
325

t
0.09
t 0 (1 k )

$3,125,000 $3,129,248
$4,248
n

63
The IRR of the project is approximately 9 percent. Using a financial calculator,
we find that the IRR is 9.034 percent.
b.

Initial investment = $33,750


Annual cash flows = $9,430
Length of investment = n = 5 years
Try IRR = 12%.

1
1

FCFt
(1.12)5
NPV

$
33
,
750

$
9
,
430

t
0.12
t 0 (1 k )

$33,750 $33,993
n

$243

Try IRR = 12.3%.

n
FCFt
(1.123)
NPV
$33,750 $9,430

t
0.123
t 0 (1 k )

$33,750 $33742
$8 0

The IRR of the project is approximately 12.3 percent. Using a financial calculator,
we find that the IRR is 12.29 percent.
c.

Initial investment = $10,000


Annual cash flows = $2,500
Length of investment = n = 7 years
Try IRR = 16%.

64

1
1

FCFt
(1.16) 7
NPV

$
10
,
000

$
2
,
500

t
0.16
t 0 (1 k )

$10,000 $10,096
$96

Try IRR = 16.3%.

1
7

FCFt
(1.163)
NPV
$10,000 $2,500

t
0.163
t 0 (1 k )

$10,000 $10,008
$8 0

The IRR of the project is approximately 16.3 percent. Using a financial calculator,
we find that the IRR is 16.327 percent.

ADVANCED

10.24 Draconian Measures, Inc., is evaluating two independent projects. The company uses a
13.8 percent discount rate for such projects. Cost and cash flows are shown in the table.
What are the NPVs of the two projects?

Year
0
1
2
3
4
5
6
7

Project 1
$(8,425,375)
$3,225,997
$1,775,882
$1,375,112
$1,176,558
$1,212,645
$1,582,156
$1,365,882

Project 2
$(11,368,000)
$2,112,589
$3,787,552
$3,125,650
$4,115,899
$4,556,424

65

Solution:
Project 1:
Cost of Project 1 = $8,425,375
Length of project = n = 7 years
Required rate of return = k = 13.8%
FCFt
t
t 0 (1 k )
n

NPV

$3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645

(1.138)1
(1.138) 2
(1.138) 3
(1.138) 4
(1.138)5
$1,582,156 $1,365,882

(1.138) 6
(1.138)7
$8,425,375 $2,834,795 $1,371,291 $933,064 701,527 $635,364 $728,443
$552,608
$668,283
$8,425,375

Since Project 1 NPV is negative, we reject this project.

Project 2:
Cost of Project 2 = $11,368,000
Length of project = n = 5 years
Required rate of return = k = 13.8%
FCFt
t
t 0 (1 k )
n

NPV

$2,112,589 $3,787,552 $3,125,650 $4,115,889 $4,556,424

(1.138)1
(1.138) 2
(1.138) 3
(1.138) 4
(1.138)5
$11,368,000 $1,856,405 $2,924,651 $2,120,868 $2,454,119 $2,387,332
$375,375
$11,368,000

Since Project 2 NPV is positive, we accept this project.

66

10.25 Refer to Problem 10.24.


a.

What are the IRRs for both projects?

b.

Does the IRR decision criterion differ from the earlier decisions?

c.

Explain how you would expect the management of Draconian Measures to decide.

Solution:
a.

Project 1:
At the required rate of return of 13.8 percent, Project 1 has a NPV of $(668,283).
To find the IRR, try lower rates.
Try IRR = 11%.
FCFt
t
t 0 (1 k )
n

NPV

$3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645

(1.11)1
(1.11) 2
(1.11)3
(1.11) 4
(1.11)5
$1,582,156 $1,365,882

(1.11)6
(1.11)7
$8,425,375 $2,906,304 $1,441,346 $1,005,470 $775,035 $719,646
$845,885 $657,889
$73,801
$8,425,375

Try a lower rate, IRR=10.7%.

67
FCFt
t
t 0 (1 k )
n

NPV

$3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645

(1.107)1
(1.107) 2
(1.107)3
(1.107) 4
(1.107)5
$1,582,156 $1,365,882

(1.107)6
(1.107)7
$8,425,375 $3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645
$1,582,156 $1,365,882
$5,235
$8,425,375

The IRR of the project is approximately 10.7 percent. Using a financial calculator,
we find that the IRR is 10.677 percent.

Project 2:
At the required rate of return of 13.8 percent, Project 1 has a NPV of 375,375. To
find the IRR, try higher rates.
Try IRR = 15%.
FCFt
t
t 0 (1 IRR )
$2,112,589 $3,787,552 $3,125,650 $4,115,889 $4,556,424
0 $11,368,000

(1.15)1
(1.15) 2
(1.15) 3
(1.15) 4
(1.15)5
$11,368,000 $1,837,034 $2,863,933 $2,055,166 $2,353,279 $2,265,348
$6,760
n

NPV 0

Try IRR = 15.1%.


FCFt
t
t 0 (1 IRR )
$2,112,589 $3,787,552 $3,125,650 $4,115,889 $4,556,424
0 $11,368,000

(1.151)1
(1.151) 2
(1.151) 3
(1.151) 4
(1.151)5
$11,368,000 $1,835,438 $2,858,959 $2,049,814 $2,345,111 $2,255,524
$23,154
n

NPV 0

68
The IRR of the project is between 15 and 15.1 percent. Using a financial
calculator, we find that the IRR is 15.023 percent.
b.

Based on the IRR, Project 1 will be rejected and Project 2 will be accepted. These
decisions are identical to those based on NPV.

c.

Management would use the decision spelled out by NPV, although in this case the
IRR has come up with the same decision.

10.26 Dravid, Inc., is currently evaluating three projects that are independent. The cost of funds
can be either 13.6 percent or 14.8 percent depending on their financing plan. All three
projects cost the same at $500,000. Expected cash flow streams are shown in the
following table. Which projects would be accepted at a discount rate of 14.8 percent?
What if the discount rate was 13.6 percent?

Year
1
2
3
4

Solution:
Cost

Project 1
0
$125,000
$150,000
$375,000

Project 2
0
0
$500,000
$500,000

Project 3
$245,125
$212,336
$112,500
$74,000

of projects =

$500,000
Length of project = n = 4 years
Required rate of return = k = 14.8%

Project 1:

FCFt
$0
$125,000 $150,000 $375,000
$500,000

t
1
(1.148)
(1.148) 2
(1.148) 3
(1.148) 4
t 0 (1 k )
$500,000 $0 $94,848 $99,144 $215,906
$90,103
n

NPV

69

Project 2:

FCFt
$0
$0
$500,000 $500,000
$500,000

t
1
2
(1.148) (1.148)
(1.148) 3
(1.148) 4
t 0 (1 k )
$500,000 $0 $0 $330,479 $287,874
$118,353
n

NPV

Project 3:
FCFt
$245,125 $212,336 $112,500 $74,000
$500,000

t
(1.148)1
(1.148) 2
(1.148)3 (1.148) 4
t 0 (1 k )
$500,000 $213,524 $161,116 $74,358 $42,605
$8,397
n

NPV

At a discount rate of 14.8 percent, only project 2 will be accepted. At a discount rate of
13.6 percent, the NPVs of the three projects are -$75,645, $141,295, and $1,491
respectively. Both projects 2 and 3 have positive NPVs and will be accepted.
Year
0
1
2
3
4
NPV

Project 1
$(500,000)

125,000
150,000
375,000

PVCF
$(500,000)

96,862
102,319
225,175
(75,645)

Project 2
$(500,000)

500,000
500,000

PVCF
$(500,000)

341,063
300,232
141,295

Project 3
$(500,000)
245,125
212,336
112,500
74,000

PVCF
$(500,000)
215,779
164,538
76,739
44,434
1,491

10.27 Intrepid, Inc., is looking to invest in two or three independent projects. The costs and the
cash flows are given in the following table. The appropriate cost of capital is 14.5
percent. Compute the IRRs and identify the projects that will be accepted.

Year

Project 1

Project 2

Project 3

70
0
1
2
3
4

$(275,000)
$63,000
$85,000
$85,000
$100,000

$(312,500)
$153,250
$167,500
$112,000

$(500,000)
$212,000
$212,000
$212,000
$212,000

Solution:
Project 1:
Cost of Project 1 = $275,000
Length of project = n = 4 years
Required rate of return = k = 14.5%
FCFt
t
t 0 (1 k )
n

NPV

$63,000 $85,000 $85,000 $100,000

(1.145)1 (1.145) 2 (1.145)3 (1.145) 4


$275,000 55,022 $64,835 $56,624 $58,181
$40,338
$275,000

At the required rate of return of 14.5 percent, Project 1 has a NPV of $(40,338). To find
the IRR, try lower rates.

Try IRR = 7.6%.


FCFt
t
t 0 (1 IRR )
$63,000 $85,000 $85,000 $100,000
0 $275,000

(1.075)1 (1.075) 2 (1.075) 3 (1.075) 4


$275,000 58,550 $73,417 $68,231 $74,602
$200 0
n

NPV 0

The IRR of the project is approximately 7.6 percent. Using a financial calculator, we find
that the IRR is 7.57 percent.

71
Project 2:
Cost of Project 2 = $312,500
Length of project = n = 3 years
Required rate of return = k = 14.5%

FCFt
$153,250 $167,500 $112,000
$312,500

t
(1.145)1
(1.145) 2
(1.145) 3
t 0 (1 k )
$312,500 $ 133,843 $127,763 $74,611
$23,717
n

NPV

At the required rate of return of 14.5 percent, Project 1 has a NPV of $23,717. To find the
IRR, try higher rates.
Try IRR =19%.
FCFt
t
t 0 (1 IRR )
$153,250 $167,500 $112,000
0 $312,500

(1.19)1
(1.19) 2
(1.19) 3
$312,500 $128,782 $118,283 $66,463
$1,027
n

NPV 0

Try IRR=19.2%.
FCFt
t
t 0 (1 IRR )
$153,250 $167,500 $112,000
0 $312,500

(1.192)1
(1.192) 2
(1.192) 3
$312,500 $128,565 $117,886 $66,129
$80 0
n

NPV 0

The IRR of the project is approximately 19.2 percent. Using a financial calculator, we
find that the IRR is 19.22 percent.

Project 3:

72
Cost of Project 3 = $500,000
Length of project = n = 4 years
Required rate of return = k = 14.5%

n
FCFt
(1.145)
NPV
$500,000 $212,000

t
0.145
t 0 (1 k )

$500,000 $611,429
$111,429
At the required rate of return of 14.5 percent, Project 1 has a NPV of $111,429. To find
the IRR, try higher rates.
Try IRR =25%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1

(1.25) 4
0 $500,000 $212,000

0.25

$500,000 $500,659
$659
Try IRR=25.1%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1 (1.251) 4
0 $500,000 $212,000

0.251

$500,000 $500,659
$231 0
The IRR of the project is approximately 25.1 percent. Using a financial calculator, we
find that the IRR is 25.07 percent.

73
Only Projects 2 and 3 will be accepted as the IRRs exceed the required rate of return of
14.5 percent.

10.28 Jekyll & Hyde Corp. is evaluating two mutually exclusive projects. Their cost of capital
is 15 percent. Costs and cash flows are given in the following table. Which project should
be accepted?

Year
0
1
2
3
4
5

Project 1
$(1,250,000)
$250,000
$350,000
$450,000
$500,000
$750,000

Project 2
$(1,250,000)
$350,000
$350,000
$350,000
$350,000
$350,000

Solution:
Project 1:
Cost of project = $1,250,000
Length of project = n = 5 years
Required rate of return = k = 15%
FCFt
t
t 0 (1 k )
n

NPV

$250,000 $350,000 $450,000 $500,000 $750,000

(1.15)1
(1.15) 2
(1.15) 3
(1.15) 4
(1.15)5
$1,250,000 $217,391 $264,650 $295,882 $285,877 $372,883
$186,683
$1,250,000

At the required rate of return of 15 percent, Project 1 has a NPV of $(186,683). To find
the IRR, try higher rates.

74
Try IRR = 20%.
FCFt
t
t 0 (1 k )
n

NPV 0

$250,000 $350,000 $450,000 $500,000 $750,000

(1.20)1
(1.20) 2
(1.20)3
(1.20) 4
(1.20)5
$1,250,000 $208,333 $243,056 $260,417 $241,127 $301,408
$4,340

0 $1,250,000

Try IRR = 20.1%.


FCFt
t
t 0 (1 IRR )
$250,000 $350,000 $450,000 $500,000 $750,000
0 $1,250,000

(1.201)1
(1.201) 2
(1.201)3
(1.201) 4
(1.201)5
$1,250,000 $208,160 $242,651 $259,767 $240,324 $300,155
$1,057 0
n

NPV 0

The IRR of the project is approximately 20.1 percent. Using a financial calculator, we
find that the IRR is 20.132 percent.

Project 2:
Cost of project = $1,250,000
Length of project = n = 5 years
Required rate of return = k = 15%

1
1

FCFt
(1.15)5
NPV

$
1
,
250
,
000

$
350
,
000

t
0.15
t 0 (1 k )

$1,250,000 $1,173,254
$76,746
At the required rate of return of 15 percent, Project 1 has an NPV of $(76,746). To find
the IRR, try lower rates.

75
Try IRR = 12%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1 (1.12)5
0 $1,250,000 $350,000

0.12

$1,250,000 $1,261,672
$11,672
Try IRR = 12.4%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1 (1.124)5
0 $1,250,000 $350,000

0.124

$1,250,000 $1,249,269
$732 0
The IRR of the project is approximately 12.4 percent. Using a financial calculator, we
find that the IRR is 12.376 percent.
Given a required rate of return of 15 percent, Project 1 will be accepted as the IRR of
20.1 percent exceeds the required rate of return. Project 2 will be rejected.

10.29 Larsen Automotive, a manufacturer of auto parts, is planning to invest in two projects.
The company typically compares project returns to a cost of funds of 17 percent.
Compute the IRRs based on the given cash flows, and state which projects will be
accepted.
Year
0
1

Project 1
$(475,000)
$300,000

Project 2
$(500,000)
$117,500

76
2
3
4

$110,000
$125,000
$140,000

$181,300
$244,112
$278,955

Solution:
Project 1:
Cost of project = $475,000
Length of project = n = 4 years
Required rate of return = k = 17%
FCFt
t
t 0 (1 k )
n

NPV

$300,000 $110,000 $125,000 $140,000

(1.17)1
(1.17) 2
(1.17)3
(1.17) 4
$475,000 $256,410 $80,356 $78,046 $74,711
$14,524
$475,000

At the required rate of return of 17 percent, Project 1 has an NPV of $14,524. To find the
IRR, try higher rates.

Try IRR = 19%.


FCFt
t
t 0 (1 k )
n

NPV

$300,000 $110,000 $125,000 $140,000

(1.19)1
(1.19) 2
(1.19)3
(1.19) 4
$475,000 $252,101 $77,678 $74,177 $69,814
$1,230
$475,000

Try IRR = 18.8%.

77
FCFt
t
t 0 (1 k )
n

NPV

$300,000 $110,000 $125,000 $140,000

(1.188)1
(1.188) 2
(1.188)3
(1.188) 4
$475,000 $252,525 $77,940 $74,552 $70,285
$302 0
$475,000

The IRR of the project is approximately 18.8 percent. Using a financial calculator, we
find that the IRR is 18.839 percent.

Project 2:
Cost of project = $500,000
Length of project = n = 4 years
Required rate of return = k = 17%
FCFt
t
t 0 (1 k )
n

NPV

$117,500 $181,300 $244,312 $278,955

(1.17)1
(1.17) 2
(1.17)3
(1.17) 4
$475,000 $100,427 $132,442 $152,416 $148,864
$34,150
$500,000

At the required rate of return of 17 percent, Project 1 has an NPV of $34,150. To find the
IRR, try higher rates.
Try IRR = 20%.
FCFt
t
t 0 (1 IRR )
$117,500 $181,300 $244,312 $278,955
0 $500,000

(1.20)1
(1.20) 2
(1.20)3
(1.20) 4
$475,000 $97,917 $125,903 $141,269 $134,527
$385 0
n

NPV 0

78
The IRR of the project is approximately 20 percent. Using a financial calculator, we find
that the IRR is 19.965 percent.
Both projects can be accepted since their IRRs exceed the cost of capital of 17 percent.

10.30 Compute the IRR for each of the following cash flow streams:
Year
0
1
2
3
4
5

Project 1
$(10,000)
$4,750
$3,300
$3,600
$2,100

Project 2
$(10,000)
$1,650
$3,890
$5,100
$2,750
$800

Project 3
$(10,000)
$800
$1,200
$2,875
$3,400
$6,600

Solution:
Project 1:
Cost of project = $10,000
Length of project = n = 4 years
FCFt
t
t 0 (1 IRR )
$4,750 $3,300 $3,600 $2,100
0 $10,000

(1.16)1 (1.16) 2 (1.16)3 (1.16) 4


$10,000 $4,095 $2,452 $2,306 $1,160
$13 0
n

NPV 0

The IRR of the project is approximately 16 percent. Using a financial calculator, we find
that the IRR is 16.076 percent.

Project 2:
Cost of project = $10,000

79
Length of project = n = 5 years
FCFt
t
t 0 (1 IRR )
$1,650
$3,890
$5,100
$2,750
$800
0 $10,000

1
2
3
4
(1.137) (1.137)
(1.137)
(1.137)
(1.137)5
$10,000 $1,451 $3,009 $3,470 $1,545 $421
$4 0
n

NPV 0

The IRR of the project is approximately 13.7 percent. Using a financial calculator, we
find that the IRR is 13.685 percent.

Project 3:
Cost of project = $10,000
Length of project = n = 5 years
FCFt
t
t 0 (1 IRR )
$800
$1,200
$2,875
$3,400
$6,600
0 $10,000

1
2
3
4
(1.109) (1.109)
(1.109)
(1.109)
(1.109)5
$10,000 $721 $976 $2,108 $2,248 $3,934
$13 0
n

NPV 0

The IRR of the project is approximately 10.9 percent. Using a financial calculator, we
find that the IRR is 10.862 percent.

10.31 Primus Corp. is planning to convert an existing warehouse into a new plant that will
increase its production capacity by 45 percent. The cost of this project will be
$7,125,000. It will result in additional cash flows of $1,875,000 for the next eight years.
The company uses a discount rate of 12 percent.
a.

What is the payback period?

80
b.

What is the NPV for this project?

c.

What is the IRR?

Solution:
a.
Year
0
1
2
3
4
5
6
7
8

Project 1
Cumulative CF
$(7,125,000)
$(7,125,000)
1,875,000
(5,250,000)
1,875,000
(3,375,000)
1,875,000
(1,500,000)
1,875,000
375,000
1,875,000
2,250,000
1,875,000
4,125,000
1,875,000
6,000,000
1,875,000
7,875,000

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the
year)
= 3 + ($1,500,000 / $1,875,000) = 3.80 years
b.

Cost of this project = $7,125,000


Required rate of return = 12%
Length of project = n = 8 years
FCFt
t
t 0 (1 k )
n

NPV

1
1 (1.12)8
$7,1250,000 $1,875,000

0.12

$7,125,000 $9,314,325
$2,189,325

81
c.

To compute the IRR, try rates higher than 12 percent.


Try IRR = 20%.
FCFt
t
t 0 (1 k )
n

NPV 0

1
1 (1.20)8
0 $7,1250,000 $1,875,000

0.20

$7,125,000 $7,194,675
$69,675
Try IRR = 20.3%.
FCFt
t
t 0 (1 k )
n

NPV 0

1 (1.203)8
0 $7,1250,000 $1,875,000

0.203

$7,125,000 $7,130,832
$5,832
The IRR of the project is approximately 20.3 percent. Using a financial calculator,
we find that the IRR is 20.328 percent.

10.32 Quasar Tech Co. is investing $6 million in new machinery that will produce the nextgeneration routers. Sales to its customers will amount to $1,750,000 for the next three
years and then increase to $2.4 million for three more years. The project is expected to
last six years and cost the firm annually $898,620 (excluding depreciation). The
machinery will be depreciated to zero by year 6 using the straight-line method. The
companys tax rate is 30 percent, and its cost of capital is 16 percent.
a.

What is the payback period?

82
b.

What is the average accounting return (ARR)?

c.

Calculate the project NPV.

d.

What is the IRR for the project?

Solution:

a.
Project 1
Year
0
1
2
3
4
5
6

Net Income

Depreciation

$(104,034)
$(104,034)
$(104,034)
350,966
350,966
350,966

$1,000,000
$1,000,000
$1,000,000
$1,000,000
$1,000,000
$1,000,000

Cash Flows
$(6,000,000)
895,966
895,966
895,966
1,350,966
1,350,966
1,350,966

Cumulative
CF
$(6,000,000)
(5,104,034)
(4,208,068)
(3,312,102)
(1,961,136)
(610,170)
740,796

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the
year)
= 5 + ($610,170 / $1,350,966) = 5.45 years
b.
Sales
Expenses
Depreciation
EBIT
Taxes (30%)
Net income
Beginning BV
Less: Depreciation
Ending BV

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

$ 1,750,000
898,620
1,000,000
$(1,48,620)
44,586
$ (104,034)
6,000,000
1,000,000
$ 5,000,000

$ 1,750,000
898,620
1,000,000
$(1,48,620)
44,586
$ (104,034)
5,000,000
1,000,000
$ 4,000,000

$ 1,750,000
898,620
1,000,000
$(1,48,620)
44,586
$ (104,034)
4,000,000
1,000,000
$ 3,000,000

$ 2,400,000
898,620
1,000,000
$ 501,380
(150,414)
$ 350,966
3,000,000
1,000,000
$ 2,000,000

$ 2,400,000
898,620
1,000,000
$ 501,380
(150,414)
$ 350,966
2,000,000
1,000,000
$ 1,000,000

$ 2,400,000
898,620
1,000,000
$ 501,380
(150,414)
$ 350,966
1,000,000
1,000,000
$
0

Average after-tax income = 123,466

83
Average book value of equipment = $2,500,000

Average after - tax income


Average book value
$123,466

4.9%
$2,500,000

Accounting rate of return

c.

Cost of this project = $6,000,000


Required rate of return = 16%
Length of project = n = 6 years
FCFt
t
t 0 (1 k )
n

NPV

1
1

1
(1.16)
(1.16) 3
$6.000,000 $895,966
$1,350,966

0.16
0.16 (1.16)3

$6,000,000 $2,012,241 $1,943,833


$2,043,927
d.

To compute the IRR, try rates lower than 16 percent.


Try IRR = 3%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1

1 (1.03)3
1 (1.03) 3
1
0 $6.000,000 $895,966
$1,350,966

0.03
0.03 (1.03)3

$6,000,000 $2,534,340 $3,497,084


$31,424
Try IRR = 3.1%.

84
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1

3
3

1
(1.031)
(1.031)
0 $6.000,000 $895,966
$1,350,966

0.031
0.031 (1.031)3

$6,000,000 $2,529,475 $3,480,225


$9,700
The IRR of the project is approximately 3.1 percent. Using a financial calculator,
we find that the IRR is 3.145 percent.

10.33 Skywards, Inc., an airline caterer, is purchasing refrigerated trucks at a total cost of $3.25
million. After-tax net income from this investment is expected to be $750,000 for the next
five years. Annual depreciation expense was $650,000. The companys cost of capital is
17 percent.
a.

What is the discounted payback period?

b.

Compute the ARR.

c.

What is the NPV on this investment?

d.

Calculate the IRR.

Solution:
a.
Cumulative
Year
0
1
2
3
4

Project 1
$(3,250,000)
1,400,000
1,400,000
1,400,000
1,400,000

CF
$(3,250,000)
(1,850,000)
(450,000)
950,000
2,350,000

Cumulative
PVCF
$(3,250,000)
1,196,581
1,022,719
874,119
747,110

PVCF
$(3,250,000)
(2,053,419)
(1,030,700)
(156,581)
590,529

85
5

1,400,000

3,750,000

638,556

1,229,085

Discount payback period = Years before recovery + (Remaining cost / Next years CF)
= 3 + ($156,581 / $747,110) = 3.21 years
b.
Net income
Beginning BV
Less: Depreciation
Ending BV

Year 1

Year 2

Year 3

Year 4

Year 5

$ 750,000
3,250,000
650,000
$2,600,000

$ 750,000
2,600,000
650,000
$1,950,000

$ 750,000
1,950,000
650,000
$1,300,000

$ 750,000
1,300,000
650,000
$ 650,000

$ 750,000
650,000
650,000
$
0

Average after-tax income = $750,000


Average book value of equipment = $1,300,000

Average after - tax income


Average book value
$750,000

5 7 .7 %
$1,300,000

Accounting rate of return

c.

Cost of this project = $3,250,000


Required rate of return = 17%
Length of project = n = 5 years

1
1

FCFt
(1.17) 5
NPV

$
3
,
250
,
000

$
1
,
400
,
000

t
0.17
t 0 (1 k )

$3,250,000 $4,479,085
$1,229,085
n

d.

To compute the IRR, try rates much higher than 17 percent.

86
Try IRR = 30%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1 (1.30) 5
0 $3,250,000 $1,400,000

0.30

$3,250,000 $3,409,798
$159,798
Try IRR = 32.5%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1 (1.325) 5
0 $3,250,000 $1,400,000

0.325

$3,250,000 $3,252,904
$2,904 0
The IRR of the project is approximately 32.5 percent. Using a financial calculator,
we find that the IRR is 32.548 percent.

10.34 Trident Corp. is evaluating two independent projects. The costs and expected cash flows
are given in the following table. The companys cost of capital is 10 percent.
Year
0
1
2
3
4
5
a.

Calculate the projects NPV.

A
$(312,500)
$121,450
$121,450
$121,450
$121,450
$121,450

B
$(395,000)
$153,552
$158,711
$166,220
$132,000
$122,000

87
b.

Calculate the projects IRR.

c.

What is the decision based on NPV? What is the decision based on IRR? Is there
a conflict?

d.

If you are the decision maker for the firm, which project or projects will be
accepted? Explain your reasoning.

Solution:
a.

Project A:
Cost of this project = $312,500
Annual cash flows = $121,450
Required rate of return = 10%
Length of project = n = 5 years

1
1

FCFt
(1.10)5
NPV

312
,
500

$
121
,
450

t
0.10
t 0 (1 k )

$312,5000 460,391
$147,891
n

Project B:
Cost of this project = $395,000
Required rate of return = 10%
Length of project = n = 5 years

88
FCFt
t
t 0 (1 k )
n

NPV

$153,552 $158,711 $166,220 $132,000 $122,000

(1.10)1
(1.10) 2
(1.10)3
(1.10) 4
(1.10)5
395,000 $139,553 $131,166 $124,884 90,158 75,752
$166,553
$395,000

b.

Project A:
Since NPV > 0, to compute the IRR, try rates higher than 10 percent.
Try IRR = 27%.
FCFt
t
t 0 (1 IRR )
n

NPV 0

1
1 (1.27)5
0 312,500 $121,450

0.27

$312,5000 313,666
$1,166
Try IRR = 27.2%,
FCFt
t
t 0 (1 IRR )
n

NPV 0

(1.272)
0 312,500 $121,450

0.272

$312,5000 313,666
$82 0
The IRR of Project A is approximately 27.2 percent. Using a financial calculator,
we find that the IRR is 27.187 percent.
Project B:
Since NPV > 0, to compute the IRR, try rates higher than 10 percent.

89
Try IRR = 26%.
FCFt
t
t 0 (1 IRR )
$153,552 $158,711 $166,220 $132,000 $122,000
0 $395,000

(1.26)1
(1.26) 2
(1.26)3
(1.26) 4
(1.26)5
395,000 $121,867 $99,969 $83,094 52,371 38,416
$717
n

NPV 0

Try IRR = 26.1%.


FCFt
t
t 0 (1 IRR )
$153,552 $158,711 $166,220 $132,000 $122,000
0 $395,000

(1.261)1
(1.261) 2
(1.261)3
(1.261) 4
(1.261)5
395,000 $121,770 $99,811 $82,897 52,205 38,263
$54 0
n

NPV 0

The IRR of Project A is approximately 26.1 percent. Using a financial calculator,


we find that the IRR is 26.093 percent.
c.

Since both projects have positive NPVs and they are independent projects, both
should be accepted under the NPV decision criteria. Under the IRR decision
criteria since both projects have IRRs greater than the cost of capital, both will be
accepted. Thus, there is no conflict between the NPV and IRR decisions.

d.

Based on NPV, both projects will be accepted.

10.35 Tyler, Inc., is looking to move to a new technology for its production. The cost of
equipment will be $4 million. The company normally uses a discount rate of 12 percent.
Cash flows that the firm expects to generate are as follows.

Years
0

CF
$(4,000,000)

90
1-2
35
69

0
$845,000
$1,450,000

a.

Compute the payback and discounted payback period for the project.

b.

What is the NPV for the project? Should the firm go ahead with the project?

c.

What is the IRR, and what would be the decision under the IRR?

Solution:
a.

Year
0
1
2
3
4
5
6
7
8
9

Cash Flows
$(4,000,000)
--845,000
845,000
845,000
1,450,000
1,450,000
1,450,000
1,450,000

PVCF
$(4,000,000)
--601,454
537,013
479,476
734,615
655,906
585,631
522,885

Cumulative

Cumulative

CF
$(4,000,000)
$(4,000,000)
$(4,000,000)
(3,155,000)
(2,310,000)
(1,465,000)
(15,000)
1,435,000
2,885,000
4,335,000

PVCF
$(4,000,000)
$(4,000,000)
$(4,000,000)
(3,398,546)
(2,861,533)
(2,382,057)
(1,647,442)
(991,536)
(405,905)
116,979.48

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the
year)
= 6 + ($15,000 / $1,450,000) = 6.01 years
Discount PB

= Years before Recovery + (Remaining Cost / Next Years CF)


= 8 + ($405,905 / $522,885) = 8.8 years

b.

Cost of this project = $4,000,000


Required rate of return = 12%

91
Length of project = n = 9 years

1
1

FCFt
1
(1.12) 3
NPV

$
4
.
000
,
000

$
845
,
000


t
0.12 (1.12) 2
t 0 (1 k )

1 (1.12) 4
1
$1,450,000

0.12 (1.12)5

$4,000,000 0 0 $1,617,943 $2,499,037


$116,980
n

Since NPV > 0, the project should be accepted.


c.

Given a positive NPV, to compute the IRR, one should try rates higher than 12
percent.

Try IRR = 12.5%.

n
FCFt
1
(1.125)
NPV
$4.000,000 0 0 $845,000

t
0.125 (1.125) 2
t 0 (1 k )

1 (1.125) 4
1
$1,450,000

0.125 (1.125)5

$4,000,000 0 0 $1,589,915 $2,418,479


$8,394
The IRR is approximately 12.5 percent. Using the financial calculator, we find
that the IRR is 12.539 percent. Based on the IRR exceeding the cost of capital of
12 percent, the project should be accepted.

92

CFA Problems
10.36. Given the following cash flows for a capital project, calculate the NPV and IRR. The
required rate of return is 8 percent.
YEAR
0
1
2
3
4
5
CASH FLOW
50,000 15,000 15,000 20,000
10,000
5,000
NPV
IRR
A.
$1,905
10.9%
B.
$1,905
26.0%
C.
$3,379
10.9%
D.
$3,379
26.0%
SOLUTION:

C is correct.
NPV 50, 000

15, 000 15, 000 20, 000 10, 000 5, 000

1.08
1.082
1.083
1.084
1.085

NPV = 50,000 + 13,888.89 + 12,860.08 + 15,876.64 + 7,350.30 +


3,402.92
NPV = 50,000 + 53,378.83 = 3,378.83
The IRR, found with a financial calculator, is 10.88 percent.

10.37. Given the following cash flows for a capital project, calculate its payback period and
discounted payback period. The required rate of return is 8 percent. The discounted
payback period is
YEAR
0
1
2
3
4
5
CASH FLOW
50,000 15,000 15,000 20,000
10,000
5,000
A. 0.16 years longer than the payback period.
B. 0.80 years longer than the payback period.
C. 1.01 years longer than the payback period.
D. 1.85 years longer than the payback period.

SOLUTION:
C is correct.

93
0
50,000

1
15,000

2
15,000

3
20,000

4
10,000

5
5,000

50,000

35,000

20,000

10,000

FLOW

50,000

CUMULATIVE DCF

50,000

13,888.89

36,111.11

12,860.08

23,251.03

0
15,876.6
4

7,374.38

15,000
3,402.9
2
3,378.8
3

YEAR
CASH FLOW
CUMULATIVE CASH
FLOW

DISCOUNTED CASH

7,350.30
24.09

As the table shows, the cumulative cash flow offsets the initial investment in
exactly three years. The payback period is 3.00 years. The discounted payback
period is between four and five years. The discounted payback period is 4 years
plus 24.09/3,402.92 = 0.007 of the fifth year cash flow, or 4.007 = 4.01 years. The
discounted payback period is 4.01 3.00 = 1.01 years longer than the payback
period.

10.38. An investment of $100 generates after-tax cash flows of $40 in Year 1, $80 in Year 2, and
$120 in Year 3. The required rate of return is 20 percent. The net present value is closest
to
A. $42.22
B. $58.33
C. $68.52
D. $98.95
SOLUTION:

B is correct.
3

NPV
t 0

CFt
40
80
120
100

t
2
(1 r )
1.20 1.20 1.203 = $58.33

10.39. An investment of $150,000 is expected to generate an after-tax cash flow of $100,000 in


one year and another $120,000 in two years. The cost of capital is 10 percent. What is the
internal rate of return?
A. 28.19 percent
B. 28.39 percent
C. 28.59 percent
D. 28.79 percent
SOLUTION:

D is correct. The IRR can be found using a financial calculator or with trial and error.
Using trial and error, the total PV is equal to zero if the discount rate is 28.79 percent.
YEA
R

CASH FLOW

PRESENT VALUE
28.19%
28.39%

28.59%

28.79%

94
0
1
2
Total

150,000
100,000
120,000

150,000
78,009
73,025
1,034

150,000
77,888
72,798
686

150,000
77,767
72,572
338

150,000
77,646
72,346
8

A more precise IRR of 28.7854 percent has a total PV closer to zero.

10.40. An investment has an outlay of 100 and after-tax cash flows of 40 annually for four years.
A project enhancement increases the outlay by 15 and the annual after-tax cash flows by
5. As a result, the vertical intercept of the NPV profile of the enhanced project shifts
A. up and the horizontal intercept shifts left.
B. up and the horizontal intercept shifts right.
C. down and the horizontal intercept shifts left.
D. down and the horizontal intercept shifts right.
SOLUTION:
A is correct. The vertical intercept changes from 60 to 65, and the horizontal intercept changes
from 21.86 percent to 20.68 percent.

Sample Test Problems

10.1

Net present value: Techno Corp. is considering developing new computer software. The
cost of development will be $675,000, and the company expects the revenue from the sale of
the software to be $195,000 for each of the next six years. If the company uses a discount rate
of 14 percent, what is the net present value of this project?

Solution:
Cost of this project = $675,000
Annual cash flows = $195,000
Required rate of return = 14%
Length of project = n = 6 years

95

1
1

FCFt
(1.14) 6
NPV

$
675
,
000

$
195
,
000

t
0.14
t 0 (1 k )

$675,000 $758,290
$83,290

10.2

Payback method: Parker Office Supplies is looking to replace its outdated inventorymanagement software. The cost of the new software will be $168,000. Cost savings is
expected to be $43,500 for each of the first three years and then to drop off to $36,875 for the
next two years. What is the payback period for this project?

Solution:
Cumulative
Year
0
1
2
3
4
5

CF
$(168,000)
43,500
43,500
43,500
36,875
36,875

CF
$(168,000)
(124,500)
(81,000)
(37,500)
(625)
36,250

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year)
= 4 + ($625 / $36,875) = 4.02 years

10.3

Accounting rate of return: Fresno, Inc., is expecting to generate after-tax income of


$156,435 over each of the next three years. The average book value of its equipment over
that period will be $322,500. If the firms acceptance decision on any project is based on
an ARR of 40 percent, should this project be accepted?

96

Solution:
Annual after-tax income = $156,435
Average after-tax income = $156,435
Average book value of equipment = $322,500

Average after - tax income


Average book value
$156,435

4 8 .5 %
322,500

Accounting rate of return

Since the projects ARR is above the acceptance rate of 40 percent, the project should be
accepted.

10.4

Internal rate of return: Refer to Problem 10.1. What is the IRR on this project?

Solution:
Cost of this project = $675,000
Annual cash flows = $195,000
Required rate of return = 14%
Length of project = n = 6 years

1
1

FCFt
(1.14) 6
NPV
$675,000 $195,000

t
0.14
t 0 (1 k )

$675,000 $758,290
$83,290

97

Since NPV > 0, try IRR > k. Try IRR = 18%.

1
1

FCFt
(1.18)6
NPV 0
0

$
675
,
000

$
195
,
000

t
0.18
t 0 (1 IRR )

$675,000 $682,033
$7,033
n

Try IRR = 18.4%.

1
6

FCFt
(1.184)
NPV 0
$675,000 $195,000

t
0.184
t 0 (1 IRR )

$675,000 $675,096
n

$96 0

The IRR is approximately 18.4 percent. Using the financial calculator, we find that the
IRR is 18.406 percent.

10.5

Net present value: Raycom, Inc., needs a new overhead crane and two alternatives are
available. Crane T costs $1.35 million and will produce cost savings of $765,000 for the
next three years. Crane R will cost the firm $1.675 million and will lead to cost savings
of $815,000 for the next three years. The firms required rate of return is 15 percent.
Which of the two options should Raycom choose based on NPV calculations and why?

Solution:
Crane T:
Cost of this project = $1,350,000

98
Annual cash flows = $765,000
Required rate of return = 15%
Length of project = n = 3 years

1
1

n
FCFt
(1.15)3
NPV

$
1
,
350
,
000

$
765
,
000

t
0.15
t 0 (1 k )

$1,350,000 $1,746,667
$396,667

Crane R:
Cost of this project = $1,675,000
Annual cash flows = $815,000
Required rate of return = 15%
Length of project = n = 3 years

1
1

FCFt
(1.15)3
NPV

$
1
,
675
,
000

$
815
,
000

t
0.15
t 0 (1 k )

$1,675,000 $1,860,829
$185,829