Chapter 10

Part5
LongTermInvestmentDecisions
ChaptersinthisPart
Chapter10
CapitalBudgetingTechniques
Chapter11
CapitalBudgetingCashFlows
Chapter12
RiskandRefinementsinCapitalBudgeting
Integrative Case 5: Lasting Impressions Company
Chapter10CapitalBudgetingTechniques194
Chapter10
CapitalBudgetingTechniques
Instructors Resources
Overview
Thischapteristhefirstofthreethatdealwithlongterminvestmentdecisions.Thischaptercoverscapital
budgetingtechniques,Chapter11dealswiththebasicprinciplesofdeterminingrelevantcashflows,and
Chapter12considersriskandrefinementsincapitalbudgeting.Boththesophisticated[netpresentvalue
(NPV)andtheinternalrateofreturn(IRR)]andunsophisticated(averagerateofreturnandpayback
period)capitalbudgetingtechniquesarepresentedhere.Discussioncentersonthecalculationand
evaluationoftheNPVandIRRininvestmentdecisions,withandwithoutacapitalrationingconstraint.
Severalillustrationsexistexplainingwhycapitalbudgetingtechniqueswillbeusefultostudentsintheir
professionalandpersonallives.
Suggested Answers to Opener in Review Questions

a.
Based on the facts that the NPV is positive and the IRR is 20%, what can you infer about Gencos
cost of capital? Is it more or less than 20%?
It must be less than 20%, because at 20% the NPV is zero (by definition o f the IRR being 20%). Because
the NPV is positive, Genco Resources must be discounting cash flows at a rate less than 20%.
b.
If the payback period is 3.6 years, what is the annual cash inflow produced by the expansion project?
If the payback period is 3.6 years, then 3.6 times the annual cash flow must equal $149 million.
Therefore, 3.6X $149 million, and X $41.4 million
c.
Calculate the NPV and the IRR of the project given your answer to part b and a 9% cost of capital for
Genco.
If the project costs $149 million up front and brings in $41.4 million in each of the next 7 years, the IRR
is 20% and the NPV (at a discount rate of $9%) is $75 million, just as described in the opener. The key
strokes are:
Solving for the IRR: N 7, PV 149 million, PMT 41.4 million; Solve for I 20%
Solving for the NPV: N 7, I 9, PMT $41,4 million; Solve for PV 208.4 million
$208.4 million $149 million $59.4 million
2012PearsonEducation,Inc.PublishingasPrenticeHall
Answers to Review Questions

1. Once the relevant cash flows have been developed, they must be analyzed to determine whether the
projects are acceptable or to rank the projects in terms of acceptability in meeting the firms goal.
Managers reach their goal of maximizing shareholder wealth when they undertake all investments
wherein the present value of the cash inflows exceeds the present value of cash outflows.
2. The payback period is the exact amount of time required to recover the firms initial investment in
a project. In the case of a mixed stream, the cash inflows are added until their sum equals the initial investment
in the project. In the case of an annuity, the payback is calculated by dividing the initial investment by the
annual cash inflow.
3. The weaknesses of using the payback period are (1) no explicit consideration of shareholders wealth, (2) failure
to take fully into account the time value of money, and (3) failure to consider returns beyond the payback period
and hence overall profitability of projects. (Note: If you discount each cash flow at the time value of money and
subtract that from the original expenditure, you end up with a revised payback period, usually called the
discounted payback period. However, this technique still does not consider all of the cash flows.)
4. NPV computes the present value of all relevant cash flows associated with a project. For conventional cash
flow, NPV takes the present value of all cash inflows over years 1 through n and subtracts from that sum the
initial investment at time zero. The formula for the NPV of a project with conventional cash flows is:
NPV present value of cash inflows initial investment
5. Acceptance criterion for the NPV method is if NPV > 0, accept; if NPV < 0, reject. If the firm undertakes projects
with a positive NPV, the market value of the firm should increase by the amount of the NPV.
6. NPV, PI, and EVA are all based on the same underlying idea, that investments should earn a rate of return high
enough to meet investors expectations. The PI differs from NPV in that it is expressed as a rate of return. That
is, it measures the present value of an investments cash inflows relative to the up-front cash outflow. EVA
calculates a cost of capital charge which is deducted each year from a projects cash flows. To calculate the
overall project EVA, you take the annual EVA figures and discount them at the cost of capital. In general, NPV,
PI, and EVA will always agree on whether a project is worth investing in or not.
7. The IRR on an investment is the discount rate that would cause the investment to have a NPV of zero. It is
found by solving the NPV equation given below for the value of k that equates the present value of cash inflows
with the initial investment.
CFt
I0
t
t 1 (1 r )
n
NPV
8. If a projects IRR is greater than the firms cost of capital, the project should be accepted; otherwise, the project
should be rejected. If the project has an acceptable IRR, the value of the firm should increase. Unlike the NPV,
the amount of the expected value increase is not known.
9. The NPV and IRR always provide consistent accept/reject decisions. These measures, however, may not
agree with respect to ranking the projects. The NPV may conflict with the IRR due to different cash flow
characteristics of the projects. The greater the difference between timing and magnitude
of cash inflows, the more likely it is that rankings will conflict.
10. An NPV is a graphic representation of the NPV of a project at various discount rates. The NPV profile may
be used when conflicting rankings of projects exist by depicting each project as a line on the profile and
determining the point of intersection. If the intersection occurs at a positive discount rate, any discount
rate below the intersection will cause conflicting rankings, whereas any discount rates above the
intersection will provide consistent rankings. Conflicts in project rankings using NPV and IRR result
from differences in the magnitude and timing of cash flows. Projects with similar-sized
investments having low early-year cash inflows tend to be preferred at lower discount rates. At high
discount rates, projects with the higher early-year cash inflows are favored, as later-year cash inflows
tend to be severely penalized in present value terms.
11.
The reinvestment rate assumption refers to the rate at which reinvestment of intermediate cash
flows theoretically may be achieved under the NPV or the IRR methods. The NPV method assumes the
intermediate cash flows are reinvested at the discount rate, whereas the IRR method assumes intermediate
cash flows are reinvested at the IRR. On a purely theoretical basis, the NPVs reinvestment rate
assumption is superior because it provides a more realistic rate, the firms cost
of capital, for reinvestment. The cost of capital is generally a reasonable estimate of the rate at which a
firm could reinvest these cash inflows. The IRR, especially one well exceeding the cost of capital, may
assume a reinvestment rate the firm cannot achieve. In practice, the IRR is preferred due to the general
disposition of business people toward rates of return rather than pure dollar returns.
Suggested Answer to Focus on Practice Box:

Limits on Payback Analysis
Inyourview,ifthepaybackperiodmethodisusedinconjunctionwiththeNPVmethod,should
itbeusedbeforeoraftertheNPVevaluation?
Whilethepaybackmethodissimpletouseandcanbeusedtoinitiallyscreenprojects,themajor
disadvantageisthataveryrewardingprojectmaybeoverlookedifitdoesnotmeetthearbitrarypayback
period.Forexample,ifallprojectsthatdonotmakeaspecifiedpaybackperiodsay,3yearsare
rejected,thecompanymightforgoaveryrewardingprojectwhosepaybackisjustifiedat,say,3.5years.
TheprojectsmostlikelyrejectedbythepaybackanalysisthatcouldbeacceptableusingtheNPVmethod
arethosethatareslowtoprovideareturncashflowinearlyyearsbutthatprovideasignificantcashflow
inoutlyingyears.However,thefartheroutthecashflowsare,themoreuncertaintheybecome.
Therefore,ifthereisanabundanceofprojectstoevaluate,itmaymakesensetouseasimplemethodsuch
asthepaybackperiodanalysistowinnowdowntheprojectsbeforeapplyingamoresophisticatedmethod,
suchastheNPVmethod,tothesurvivors.Ifthereisnotanabundanceofprojectsoriftimeallows,it
makessensetoapplymorethanonemethodofanalysistoalloftheprojectsbeforemakingafinal
decision.
Anothervariationistoextendthepaybackperiodanextrayearontheinitialscreensothatthoseprojects
justbeyondthepreferredpaybackhorizonaregivenasecondchance.
Suggested Answer to Focus on Ethics Box: Nonfinancial

Considerations for Project Selection
Whatarethepotentialriskstoacompanyofunethicalbehaviorsbyemployees?Whatarepotential
riskstothepublicandtostakeholders?
Theconsequencestothecompanymayincludeprosecution,fines,andotherpenaltiesfortheimproper
conductofitsemployees.Legalsanctionsbringunwantedpublicitythatcanresultinlossofbusinessor
damagetothecompanysgoodname,tradeandcustomerrelations,andevenfuturebusinessopportunities.
Consequencesfortheemployeecanincludeprosecution,fines,andimprisonment.Otherpenaltiesfor
improperconductcanincludelossofincentivepayandannualincreasesandotherformsofdisciplinary
actionasdeterminedbythecompany.Seriousunethicalbehaviorwillalmostcertainlyleadtotermination
ofemployment,nottomentiondamagetotheemployeespersonalreputation.
Employeesunethicalbehaviorcouldcostthecompanycustomers,suppliers,andsourcesofcapital.
Consequencesforthepublic,dependinguponthetypesofproductsthefirmproduces,mayinclude
compromisedproductsafety,anincreasedenvironmentalrisk,andalossoffaithinthecompany.Risksto
thepublicincludehealthrisksandriskstotheirlivelihoods(consider,forexample,theoilspillintheGulf
ofMexico).Stakeholders(e.g.,shareholders,creditors,employees)risksincludethepossibilitythatthe
unethicalbehaviordamagesthefirmsbusinesstotheextentthatthefirmdefaultsonitsobligationsand/or
doesnotsurviveasagoingconcern.Thiswouldhaveadevastatingimpactonthefirmsinvestmentvalue.
Answers to Warm-Up Exercises

E101.
Paybackperiod
Answer:
The payback period for Project Hydrogen is 4.29 years. The payback period for Project Helium is 5.75
years. Both projects are acceptable because their payback periods are less than Elysian Fields maximum
payback period criterion of 6 years.
E102.
Answer:
NPV
Year
CashInflow
$400,000
$377,358.49
375,000
333,748.67
300,000
251,885.78
350,000
277,232.78
200,000
149,451.63
Total
PresentValue
$1,389,677.35
NPV$1,389,677.35$1,250,000$139,677.35
HerkyFoodsshouldacquirethenewwrappingmachine.
E103:
Answer:
NPVcomparisonoftwoprojects
ProjectKelvin
Presentvalueofexpenses
$45,000
Presentvalueofcashinflows
forPV)
51,542(PMT$20,000,N3,I8,Solve
NPV
$6,542
ProjectThompson
Presentvalueofexpenses
Presentvalueofcashinflows
forPV)
NPV
$275,000
277,373(PMT$60,000,N6,I8,Solve
$2,373
BasedonNPVanalysis,AxisCorporationshouldchooseanoverhauloftheexisting
system.
E104:
Answer:
IRR
YoumayuseafinancialcalculatortodeterminetheIRRofeachproject.Choosethe
projectwiththehigherIRR.
ProjectTShirt
PV15,000,N4,PMT8,000
SolveforI
IRR39.08%
ProjectBoardShorts
PV25,000,N5,PMT12,000
SolveforI
IRR38.62%
BasedonIRRanalysis,BillabongTechshouldchooseprojectTShirt.
E105:
Answer:
NPV
Note:TheIRRforProjectTerrais10.68%whilethatofProjectFirmais10.21%.
Furthermore,whenthediscountrateiszero,thesumofProjectTerrascashflowsexceed
thatofProjectFirma.Hence,atanydiscountratethatproducesapositiveNPV,Project
Terraprovidesthehighernetpresentvalue.
Solutions to Problems
Notetoinstructor:InmostproblemsinvolvingtheIRRcalculation,afinancialcalculatorhasbeenused.
AnswerstoNPVbasedquestionsinthefirsttenproblemsprovidedetailedanalysisofthepresentvalue
ofindividualcashflows.Thereafter,financialcalculatorworksheetkeystrokesareprovided.Moststudents
willprobablyemploycalculatorfunctionalitytofacilitatetheirproblemsolutioninthischapterand
throughoutthecourse.
P101. Paybackperiod
LG 2; Basic
a.
$42,000$7,0006years
b. Thecompanyshouldaccepttheproject,since68.
P102. Paybackcomparisons
LG 2; Intermediate
a.
Machine1:$14,000$3,0004years,8months
Machine2:$21,000$4,0005years,3months
b. OnlyMachine1hasapaybackfasterthan5yearsandisacceptable.
c.
Thefirmwillacceptthefirstmachinebecausethepaybackperiodof4years,8months
is
lessthanthe5yearmaximumpaybackrequiredbyNovaProducts.
d. Machine2hasreturnsthatlast20yearswhileMachine1hasonly7yearsofreturns.
Paybackcannotconsiderthisdifference;itignoresallcashinflowsbeyondthepayback
period.Inthiscase,thetotalcashflowfromMachine1is$59,000($80,000$21,000)
lessthanMachine2.
P103. Choosingbetweentwoprojectswithacceptablepaybackperiods
LG 2; Intermediate
a.
ProjectA
Year
Cash
Inflows
ProjectB
Investment
Balance
Year
$100,000
Cash
Inflows
Investment
Balance
$100,000
$10,000
90,000
40,000
60,000
20,000
70,000
30,000
30,000
30,000
40,000
20,000
10,000
40,000
10,000
20,000
20,000
BothProjectAandProjectBhavepaybackperiodsofexactly4years.
b. Basedontheminimumpaybackacceptancecriteriaof4yearssetbyJohnShell,both
projectsshouldbeaccepted.However,sincetheyaremutuallyexclusiveprojects,John
shouldacceptProjectB.
c.
ProjectBispreferredoverAbecausethelargercashflowsareintheearlyyearsofthe
project.Thequickercashinflowsoccur,thegreatertheirvalue.
P104. Personalfinance:Longterminvestmentdecisions,paybackperiod
LG4
a.andb.
ProjectA
Year
Annual
CashFlow
ProjectB
Cumulative
CashFlow
Annual
CashFlow
Cumulative
CashFlow
$(9,000)
$(9,000)
$(9,000)
$(9,000)
2,00
(6,800)
1,500
(7,500)
2,500
(4,300)
1,500
(6,000)
2,500
(1,800)
1,500
(4,500)
2,000
3,500
(1,000)
1,800
4,000
TotalCash
Flow
Payback
Period
c.
11,000
31,800/2,0003.9years
12,000
41,000/4,0004.25years
ThepaybackmethodwouldselectProjectAsinceitspaybackof3.9yearsislowerthan
ProjectBspaybackof4.25years.
d. Oneweaknessofthepaybackmethodisthatitdisregardsexpectedfuturecashflowsas
inthecaseofProjectB.
P105. NPV
LG 3; Basic
NPVPVnInitialinvestment
a.
N20,I14%,PMT$2,000
SolveforPV$13,246.26
NPV$13,246.26$10,000
NPV$3,246.26
Acceptproject
b. N20,I14%,PMT$3,000
SolveforPV19,869.39
NPV$19,869.39$25,000
NPV$5,130.61
Reject
c.
N20,I14%,PMT$5,000
NPV$33,115.65$30,000
NPV$33,115.65
NPV$3,115
Accept
P106. NPVforvaryingcostofcapital
LG 3; Basic
a.
10%
N8,I10%,PMT$5000
NPV$26,674.63$24,000
NPV$2,674.63
Accept;positiveNPV
b. 12%
N8,I12%,PMT$5,000
NPV$24,838.20$24,000
NPV$838.20
Accept;positiveNPV
c.
14%
N8,I14%,PMT$5,000
NPV$23,194.32$24,000
NPV$805.68
Reject;negativeNPV
P107. NPVindependentprojects
LG 3; Intermediate
ProjectA
N10,I14%,PMT$4,000
NPV$20,864.46$26,000
NPV$5,135.54
Reject
ProjectBPVofCashInflows
CF0$500,000;CF1$100,000;CF2$120,000;CF3$140,000;CF4$160,000;
CF5$180,000;CF6$200,000
SetI14%
SolveforNPV$53,887.93
Accept
ProjectCPVofCashInflows
CF0$170,000;CF1$20,000;CF2$19,000;CF3$18,000;CF4$17,000;
CF5$16,000;CF6$15,000;CF7$14,000;CF8$13,000;CF9$12,000;CF10
$11,000,
SetI14%
Reject
ProjectD
N8,I14%,PMT$230,000
SolveforPV$1,066,939
NPV$1,066,939$950,000
NPV$116,939
Accept
ProjectEPVofCashInflows
CF0$80,000;CF1$0;CF2$0;CF3$0;CF4$20,000;CF5$30,000;CF6$0;
CF7$50,000;CF8$60,000;CF9$70,000
SetI14%
Accept
P108. NPV
LG 3; Challenge
a.
N5,I9%,PMT$385,000
SolveforPV$1,497,515.74
Theimmediatepaymentof$1,500,000isnotpreferredbecauseithasahigherpresent
valuethandoestheannuity.
b. N5,I9%,PV$1,500,000
SolveforPMT$385,638.69
c.
PresentvalueAnnuityDuePVordinaryannuity(1discountrate)
$1,497,515.74(1.09)$1,632,292
Calculatorsolution:$1,632,292
ChangingtheannuitytoabeginningoftheperiodannuityduewouldcauseSimes
Innovationstoprefertomakea$1,500,000onetimepaymentbecausethepresentvalue
oftheannuitydueisgreaterthanthe$1,500,000lumpsumoption.
d. No,thecashflowsfromtheprojectwillnotinfluencethedecisiononhowtofundthe
project.Theinvestmentandfinancingdecisionsareseparate.
P109. NPVandmaximumreturn
LG 3; Challenge
a.
N4,I10%,PMT$4,000
NPVPVInitialinvestment
NPV$12,679.46$13,000
NPV$320.54
RejectthisprojectduetoitsnegativeNPV.
b. N4,PV$13,000,PMT$4,000
SolveforI8.86%
8.86%isthemaximumrequiredreturnthatthefirmcouldhavefortheprojecttobe
acceptable.Sincethefirmsrequiredreturnis10%thecostofcapitalisgreaterthanthe
expectedreturnandtheprojectisrejected.
P1010. NPVmutuallyexclusiveprojects
LG 3; Intermediate
a.andb.
PressA
CF0$85,000;CF1$18,000;F18
SetI15%
Reject
PressB
CF0$60,000;CF1$12,000;CF2$14,000;CF3$16,000;CF4$18,000;
CF5$20,000;CF6$25,000
SetI15%
Accept
PressC
CF0$130,000;CF1$50,000;CF2$30,000;CF3$20,000;CF4$20,000;
CF5$20,000;CF6$30,000;CF7$40,000;CF8$50,000
SetI15%
Accept
c.
RankingusingNPVascriterion
Rank
Press
NP
V
$15,0
43.89
2,584
.34
4,2
28.21
d. ProfitabilityIndexes
ProfitabilityIndexPresentValueCashInflowsInvestment
PressA:$80,771$85,0000.95
PressB:$62,588$60,0001.04
PressC:$145,070$130,0001.12
e. TheprofitabilityindexmeasureindicatesthatPressCisthebest,thenPressB,thenPress
A(whichisunacceptable).ThisisthesamerankingaswasgeneratedbytheNPVrule.
P1011. Personalfinance:Longterminvestmentdecisions,NPVmethod
LG3
Keyinformation:
CostofMBAprogram
$100,000
Annualincrementalbenefit
$20,000
Timeframe(years)
40
Opportunitycost
6.0%
CalculatorWorksheetKeystrokes:
CF0
100,000
CF1
20,000
F1
40
6%
SetI
SolveforNPV$200,926
ThefinancialbenefitsoutweighthecostoftheMBAprogram.
P1012. PaybackandNPV
LG 2, 3; Intermediate
a.
Project
PaybackPeriod
$40,000$13,0003.08years
3($10,000$16,000)3.63years
2($5,000$13,000)2.38years
ProjectC,withtheshortestpaybackperiod,ispreferred.
b. Worksheetkeystrokes
Year
ProjectA
ProjectB
Project
C
$40,000
$40,000
$40,000
1
2
3
4
5
13,000
13,000
13,000
13,000
13,000
7,000
10,000
13,000
16,000
19,000
19,000
16,000
13,000
10,000
7,000
Solvefor
NPV
$2,565.82
$322.53
$5,454.17
Accept
Reject
Accept
ProjectCispreferredusingtheNPVasadecisioncriterion.
c. Atacostof16%,ProjectChasthehighestNPV.BecauseofProjectCscashflow
characteristics,highearlyyearcashinflows,ithasthelowestpaybackperiodandthe
highestNPV.
P1013. NPVandEVA
LG 3; Intermediate
a. NPV$2,500,000$240,0000.09$166,667
b. AnnualEVA$240,000($2,500,000x0.09)$15,000
c. OverallEVA$15,0000.09$166,667
Inthiscase,NPVandEVAgiveexactlythesameanswer.
P1014. IRRMutuallyexclusiveprojects
LG 4; Intermediate
IRRisfoundbysolving:
CFt
initialinvestment
t
t 1 (1 IRR)
n
$0
MostfinancialcalculatorshaveanIRRkey,allowingeasycomputationoftheinternalrate
ofreturn.Thenumericalinputsaredescribedbelowforeachproject.
ProjectA
CF0$90,000;CF1$20,000;CF2$25,000;CF3$30,000;CF4$35,000;CF5
$40,000
SolveforIRR17.43%
Ifthefirmscostofcapitalisbelow17%,theprojectwouldbeacceptable.
ProjectB
CF0$490,000;CF1$150,000;CF2$150,000;CF3$150,000;CF4$150,000
[or,CF0$490,000;CF1$150,000,F14]
SolveforIRR8.62%
Thefirmsmaximumcostofcapitalforprojectacceptabilitywouldbe8.62%.
ProjectC
CF0$20,000;CF1$7500;CF2$7500;CF3$7500;CF4$7500;CF5$7500
[or,CF0$20,000;CF1$7500;F15]
SolveforIRR25.41%
Thefirmsmaximumcostofcapitalforprojectacceptabilitywouldbe25.41%.
ProjectD
CF0$240,000;CF1$120,000;CF2$100,000;CF3$80,000;CF4$60,000
SolveforIRR21.16%
Thefirmsmaximumcostofcapitalforprojectacceptabilitywouldbe21%(21.16%).
P1015. IRRMutuallyexclusiveprojects
LG 4; Intermediate
a.andb.
ProjectX
$0
$100,000
$120,000 $150,000 $190,000 $250,000
$500,000
1
(1 IRR)
(1 IRR)2 (1 IRR)3 (1 IRR) 4 (1 IRR)5
CF0$500,000;CF1$100,000;CF2$120,000;CF3$150,000;CF4$190,000
CF5$250,000
SolveforIRR15.67;sinceIRRcostofcapital,accept.
ProjectY
$0
$140,000
$120,000
$95,000
$70,000
$50,000
$325,000
1
2
3
4
(1 IRR)
(1 IRR) (1 IRR) (1 IRR)
(1 IRR)5
CF0$325,000;CF1$140,000;CF2$120,000;CF3$95,000;CF4$70,000
CF5$50,000
SolveforIRR17.29%;sinceIRRcostofcapital,accept.
c.
ProjectY,withthehigherIRR,ispreferred,althoughbothareacceptable.
P1016. PersonalFinance:Longterminvestmentdecisions,IRRmethod
LG 4; Intermediate
IRRistherateofreturnatwhichNPVequalszero
Computerinputsandoutput:
N5,PV$25,000,PMT$6,000
SolveforIRR6.40%
Requiredrateofreturn:7.5%
Decision:Rejectinvestmentopportunity
P1017. IRR,investmentlife,andcashinflows
LG 4; Challenge
a.
N10,PV$61,450,PMT$10,000
SolveforI10.0%
TheIRRcostofcapital;rejecttheproject.
b. I15%,PV$61,450,PMT$10,000
SolveforN18.23years
Theprojectwouldhavetorunalittleover8moreyearstomaketheprojectacceptable
withthe15%costofcapital.
c.
N10,I15%,PV$61,450
SolveforPMT$12,244.04
P1018. NPVandIRR
a.
N7,I10%,PMT$4,000
NPVPVInitialinvestment
NPV$19,472$18,250
NPV$1,223.68
b. N7,PV$18,250,PMT$4,000
SolveforI12.01%
c.
TheprojectshouldbeacceptedsincetheNPV0andtheIRRthecostofcapital.
P1019. NPV,withrankings
a.
NPVA$45,665.50(N3,I15,PMT$20,000)$50,000
NPVA$4,335.50
Or,usingNPVkeystrokes
CF0$50,000;CF1$20,000;CF2$20,000;CF3$20,000
SetI15%
NPVA$4,335.50
Reject
NPVBKeystrokes
CF0$100,000;CF1$35,000;CF2$50,000;CF3$50,000
SetI15%
Accept
NPVCKeystrokes
CF0$80,000;CF1$20,000;CF2$40,000;CF3$60,000
SetI15%
Accept
NPVDKeystrokes
CF0$180,000;CF1$100,000;CF2$80,000;CF3$60,000
SetI15%
Accept
b.
Rank
1
2
3
4
c.
Press
C
D
B
A
NP
V
$7,088.02
6,898.99
1,117.78
4335.50
Usingthecalculator,theIRRsoftheprojectsare:
Project
A
IRR
9.70%
15.63%
19.44%
17.51%
SincethelowestIRRis9.7%,alloftheprojectswouldbeacceptableifthecostof
capital
was9.7%.
Note:SinceProjectAwastheonlyrejectedprojectfromthefourprojects,allthatwas
neededtofindtheminimumacceptablecostofcapitalwastofindtheIRRofA.
P1020.Alltechniques,conflictingrankings
LG 2, 3, 4: Intermediate
a.
ProjectA
Year
0
1
2
3
4
5
6
Cash
Inflows
ProjectB
Investment
Balance
Year
$150,000
105,000
60,000
15,000
30,000
0
1
2
3
4
$45,000
45,000
45,000
45,000
45,000
45,000
Payback A
Cash
Inflows
$75,000
60,000
30,000
30,000
30,000
30,000
Investment
Balance
$150,000
75,000
15,000
15,000
0
$150,000
3.33years 3years4months
$45,000
Payback B 2years
$15,000
years 2.5years 2years6months
$30,000
b. Atadiscountrateofzero,dollarshavethesamevaluethroughtimeandallthatis
neededisasummationofthecashflowsacrosstime.
NPVA($45,0006)$150,000$270,000$150,000$120,000
NPVB$75,000$60,000$120,000$150,000$105,000
c.
NPVA:
CF0$150,000;CF1$45,000;F16
SetI9%
SolveforNPVA$51,886.34
NPVB:
CF0$150,000;CF1$75,000;CF2$60,000;CF3$120,000
SetI9%
Accept
d. IRRA:
CF0$150,000;CF1$45,000;F16
SolveforIRR19.91%
IRRB:
CF0$150,000;CF1$75,000;CF2$60,000;CF3$120,000
SolveforIRR22.71%
e.
Rank
Project
Payback
NPV
IRR
2
1
1
2
2
1
A
B
TheprojectthatshouldbeselectedisA.TheconflictbetweenNPVandIRRisdue
partiallytothereinvestmentrateassumption.TheassumedreinvestmentrateofProject
Bis22.71%,theprojectsIRR.ThereinvestmentrateassumptionofAis9%,thefirms
costofcapital.OnapracticallevelProjectBmaybeselectedduetomanagements
preferenceformakingdecisionsbasedonpercentagereturnsandtheirdesiretoreceivea
returnofcashquickly.
P1021. Payback,NPV,andIRR
LG 2, 3, 4; Intermediate
a.
Paybackperiod
Balanceafter3years:$95,000$20,000$25,000$30,000$20,000
3($20,000$35,000)3.57years
b. NPVcomputation
CF0$95,000;CF1$20,000;CF2$25,000;CF3$30,000;CF4$35,000
CF5$40,000
SetI12%
$0
$20,000
$25,000
$30,000
$35,000
$40,000
$95,000
(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR)4 (1 IRR)5
c.
CF0$95,000;CF1$20,000;CF2$25,000;CF3$30,000;CF4$35,000
CF5$40,000
SolveforIRR15.36%
d. NPV$9,080;sinceNPV0;accept
IRR15%;sinceIRR12%costofcapital;accept
TheprojectshouldbeimplementedsinceitmeetsthedecisioncriteriaforbothNPVand
IRR.
P1022. NPV,IRR,andNPVprofiles
LG 3, 4, 5; Challenge
a.andb.
ProjectA
CF0$130,000;CF1$25,000;CF2$35,000;CF3$45,000
CF4$50,000;CF5$55,000
SetI12%
NPVA$15,237.71
BasedontheNPVtheprojectisacceptablesincetheNPVisgreaterthanzero.
SolveforIRRA16.06%
BasedontheIRRtheprojectisacceptablesincetheIRRof16%isgreaterthanthe12%
costofcapital.
ProjectB
CF0$85,000;CF1$40,000;CF2$35,000;CF3$30,000
CF4$10,000;CF5$5,000
SetI12%
NPVB$9,161.79
BasedontheNPVtheprojectisacceptablesincetheNPVisgreaterthanzero.
SolveforIRRB17.75%
BasedontheIRRtheprojectisacceptablesincetheIRRof17.75%isgreaterthanthe
12%costofcapital.
c.
DataforNPVProfiles
NPV
DiscountRate
0%
12%
15%
16%
18%
A
$80,000
$15,238
B
$35,000
$9,161
$4,177
d. Thenetpresentvalueprofileindicatesthatthereareconflictingrankingsatadiscount
ratelessthantheintersectionpointofthetwoprofiles(approximately15%).The
conflictinrankingsiscausedbytherelativecashflowpatternofthetwoprojects.At
discountratesaboveapproximately15%,ProjectBispreferable;belowapproximately
15%,ProjectAisbetter.BasedonThomasCompanys12%costofcapital,ProjectA
shouldbechosen.
e.
ProjectAhasanincreasingcashflowfromYear1throughYear5,whereasProjectB
hasadecreasingcashflowfromYear1throughYear5.Cashflowsmovinginopposite
directionsoftencauseconflictingrankings.TheIRRmethodreinvestsProjectBslarger
earlycashflowsatthehigherIRRrate,notthe12%costofcapital.
P1023. Alltechniquesdecisionamongmutuallyexclusiveinvestments
LG 2, 3, 4, 5, 6; Challenge
Project
Cashinflows(years15)
a. Payback*
b. NPV*
c. IRR*
$20,000
3years
$10,345
19.86%
$31,500
3.2years
$10,793
17.33%
$32,500
3.4years
$4,310
14.59%
Supportingcalculationsshownbelow:
a.
PaybackPeriod: ProjectA:$60,000$20,000 3years

ProjectB:$100,000$31,500 3.2years
ProjectC:$110,000$32,500 3.4years
b. NPV
ProjectA
CF0$60,000;CF1$20,000;F15
SetI13%
ProjectB
CF0$100,000;CF1$31,500;F15
SetI13%
SolveforNPVB$10,792.78
ProjectC
CF0$110,000;CF1$32,500;F15
SetI13%
SolveforNPVC$4,310.02
c.
IRR
ProjectA
CF0$60,000;CF1$20,000;F15
SolveforIRRA19.86%
ProjectB
CF0$100,000;CF1$31,500;F15
SolveforIRRB17.34%
ProjectC
CF0$110,000;CF1$32,500;F15
SolveforIRRC14.59%
d.
DataforNPVProfiles
NPV
DiscountRate
0%
$40,000
$57,500
$52,500
13%
$10,340
10,793
4,310
15%
17%
20%
ThedifferenceinthemagnitudeofthecashflowforeachprojectcausestheNPVto
comparefavorablyorunfavorably,dependingonthediscountrate.
e.
EventhoughArankshigherinPaybackandIRR,financialtheoristswouldarguethatB
issuperiorsinceithasthehighestNPV.AdoptingBadds$448.15moretothevalueof
thefirmthandoesadoptingA.
P1024. AlltechniqueswithNPVprofilemutuallyexclusiveprojects
LG 2, 3, 4, 5, 6; Challenge
a.
ProjectA
Paybackperiod
Year1Year2Year3 $60,000
Year4
$20,000
Initialinvestment
$80,000
Payback3years($20,00030,000)
Payback3.67years
ProjectB
Paybackperiod
$50,000$15,0003.33years
b. ProjectA
CF0$80,000;CF1$15,000;CF2$20,000;CF3$25,000;CF4$30,000;
CF5$35,000
SetI13%
ProjectB
CF0$50,000;CF1$15,000;F15
SetI13%
SolveforNPVB$2,758.47
c.
ProjectA
CF0$80,000;CF1$15,000;CF2$20,000;CF3$25,000;CF4$30,000;
CF5$35,000
SolveforIRRA14.61%
ProjectB
CF0$50,000;CF1$15,000;F15
SolveforIRRB15.24%
d.
DataforNPVProfiles
NPV
DiscountRate
0%
13%
14.6%
15.2%
$45,000
$3,655
0
$25,000
2,755
Intersectionapproximately14%
Ifcostofcapitalisabove14%,conflictingrankingsoccur.
Thecalculatorsolutionis13.87%.
e.
Bothprojectsareacceptable.Bothhavesimilarpaybackperiods,positiveNPVs,and
equivalentIRRsthataregreaterthanthecostofcapital.AlthoughProjectBhasa
slightlyhigherIRR,theratesareveryclose.SinceProjectAhasahigherNPV,accept
ProjectA.
P1025. IntegrativeMultipleIRRs
LG6;Basic
a.
Firsttheprojectdoesnothaveaninitialcashoutflow.Ithasaninflow,sothepaybackis
immediate.However,therearecashoutflowsinlateryears.After2years,theprojects
outflowsaregreaterthanitsinflows,butthatreversesinyear3.Theoscillatingcash
flows(positivenegativepositivenegativepositive)makeitdifficulttoeventhinkabout
howthepaybackperiodshouldbedefined.
b. CF0$200,000,CF1920,000,CF2$1,592,000,CF3$1,205,200,CF4$343,200
SetI0%;SolveforNPV$0.00
SetI35%,SolveforNPV$39.51
c.
TherearemultipleIRRsbecausethereareseveraldiscountratesatwhichtheNPVis
zero.
d. ItwouldbedifficulttousetheIRRapproachtoanswerthisquestionbecauseitisnot
clearwhichIRRshouldbecomparedtoeachcostofcapital.Forinstance,at5%,the
NPVisnegative,sotheprojectwouldberejected.However,atahigher15%discount
ratetheNPV
ispositiveandtheprojectwouldbeaccepted.
e.
ItisbestsimplytouseNPVinacasewheretherearemultipleIRRsduetothechanging
signsofthecashflows.
P1026. IntegrativeConflictingRankings
LG3,4,5;Intermediate
a.
PlantExpansion
CF0$3,500,000,CF11,500,000,CF2$2,000,000,CF3$2,500,000,CF4
$2,750,000
SetI20%;SolveforNPV$1,911,844.14
SolveforIRR43.70%
CF11,500,000,CF2$2,000,000,CF3$2,500,000,CF4$2,750,000
SetI20%;SolveforNPV$5,411,844.14(ThisisthePVofthecashinflows)
PI$5,411,844.14$3,500,0001.55
ProductIntroduction
CF0$500,000,CF1250,000,CF2$350,000,CF3$375,000,CF4$425,000
SetI20%;SolveforNPV$373,360.34
SolveforIRR52.33%
CF1250,000,CF2$350,000,CF3$375,000,CF4$425,000
SetI20%;SolveforNPV$873,360.34(ThisisthePVofthecashinflows)
PI$873,360.34$500,0001.75
b.
Rank
Project
PlantExpansion
ProductIntroduction
c.
NPV
IRR
PI
1
2
2
1
2
1
TheNPVishigherfortheplantexpansion,butboththeIRRandthePIarehigherfor
theproductintroductionproject.Therankingsdonotagreebecausetheplantexpansion
hasamuchlargerscale.TheNPVrecognizesthatitisbettertoacceptalowerreturnon
alargerprojecthere.TheIRRandPImethodssimplymeasuretherateofreturnonthe
projectandnotitsscale(andthereforenothowmuchmoneyintotalthefirmmakes
fromeachproject).
d. BecausetheNPVoftheplantexpansionprojectishigher,thefirmsshareholderswould
bebetteroffifthefirmpursuedthatproject,eventhoughithasalowerrateofreturn.
P1027. Ethicsproblem
LG1,6;Intermediate
Expenses are almost sure to increase for Gap. The stock price would almost surely decline in the
immediate future, as cash expenses rise relative to cash revenues. In the long run, Gap may be able to
attract and retain better employees (as does Chick-fil-A, interestingly enough, by being closed on
Sundays), new human rights and environmentally conscious customers, and new investor demand from
the burgeoning socially responsible investing mutual funds. This long-run effect is not assured, and we
are again reminded that its not merely shareholder wealth maximization were afterbut
maximizing shareholder wealth subject to ethical constraints. In fact, if Gap was unwilling to
renegotiate worker conditions, Calvert Group (and others) might sell Gap shares and thereby decrease
shareholder wealth.
Case
Casestudiesareavailableonwww.myfinancelab.com.
Making Norwich Tools Lathe Investment Decision

ThestudentisfacedwithatypicalcapitalbudgetingsituationinChapter10scase.NorwichToolmust
selectoneoftwolathesthathavedifferentinitialinvestmentsandcashinflowpatterns.Aftercalculating
bothunsophisticatedandsophisticatedcapitalbudgetingtechniques,thestudentmustreevaluatethe
decisionbytakingintoaccountthehigherriskofonelathe.
a.
Payback period
LatheA:
$644,000
Years14
Payback4years($16,000$450,000) 4.04years
LatheB:
$304,000
Years13
Payback3years($56,000$86,000) 3.65years
LatheAwillberejectedsincethepaybackislongerthanthe4yearmaximumaccepted,and
LatheBisacceptedbecausetheprojectpaybackperiodislessthanthe4yearpaybackcutoff.
b.
1.
NPV
Year
0
Discount
Rate
13%
1
2
3
4
5
LatheA
CashFlow
$660,000
128,000
182,000
166,000
168,000
450,000
PV
$58,132.88
LatheB
CashFlow
$360,000
PV
$43,483.24
$88,000
120,000
96,000
86,000
207,000
2. IRR
LatheA
$0
$128,000 $182,000 $166,000 $168,000 $450,000
$660,000
(1 IRR)1 (1 IRR)2 (1 IRR)3 (1 IRR)4 (1 IRR)5
IRR15.95%
LatheB
$0
$88,000
$120,000
$96,000
$86,000
$207,000
$360,000
1
2
3
4
(1 IRR) (1 IRR) (1 IRR) (1 IRR) (1 IRR)5
IRR17.34%
UndertheNPVrulebothlathesareacceptablesincetheNPVsforAandBaregreaterthan
zero.LatheAranksaheadofBsinceithasalargerNPV.Thesameacceptdecisionapplies
tobothprojectswiththeIRR,sincebothIRRsaregreaterthanthe13%costofcapital.
However,therankingreverseswiththe17.34%IRRforBbeinggreaterthanthe15.95%
IRRforLatheA.
c.
Summary
Paybackperiod
NPV
IRR
LatheA
LatheB
4.04years
$58,158
15.95%
3.65years
$43,487
BothprojectshavepositiveNPVsandIRRsabovethefirmscostofcapital.LatheA,however,
exceedsthemaximumpaybackperiodrequirement.Becauseitissoclosetothe4year
maximum
andthisisanunsophisticatedcapitalbudgetingtechnique,LatheAshouldnotbeeliminated
fromconsiderationonthisbasisalone,particularlysinceithasamuchhigherNPV.
Ifthefirmhasunlimitedfunds,itshouldchoosetheprojectwiththehighestNPV,LatheA,in
ordertomaximizeshareholdervalue.Ifthefirmissubjecttocapitalrationing,LatheB,withits
shorterpaybackperiodandhigherIRR,shouldbechosen.TheIRRconsiderstherelativesize
oftheinvestment,whichisimportantinacapitalrationingsituation.
d.
To create an NPV profile it is best to have at least 3 NPV data points. To create the third point an 8% discount
rate was arbitrarily chosen. With the 8% rate the NPV for Lathe A is $176,078 and the NPV for Lathe B is
$104,663
LatheBispreferredoverLatheAbasedontheIRR.However,ascanbeseenintheNPV
profile,
totheleftofthecrossoverpointofthetwolinesLatheAispreferred.Theunderlyingcauseof
thisconflictinrankingsarisesfromthereinvestmentassumptionofNPVversusIRR.NPV
assumestheintermediatecashflowsarereinvestedatthecostofcapital,whiletheIRRhascash
flowsbeingreinvestedattheIRR.Thedifferenceinthesetworatesandthetimingofthecash
flowswilldeterminethecrossoverpoint.
e.
On a theoretical basis Lathe A should be preferred because of its higher NPV and thus its known impact on
shareholder wealth. From a practical perspective Lathe B may be selected due to its higher IRR and its
faster payback. This difference results from managers preferences for evaluating decisions based on
percent returns rather than dollar returns, and on the desire to get a return of cash flows as quickly as
possible.
Spreadsheet Exercise
TheanswertoChapter10sDrillagoCompanyspreadsheetproblemislocatedontheInstructors
ResourceCenteratwww.pearsonhighered.com/ircundertheInstructorsManual.
Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Thisassignmentcontinuesthelongterminvestmentprojectsdesignedinthepreviouschapter.Studentswere
requiredtomakeestimatesofrelevantcashflowsbeforereadingthischapter.Thismeansthatsomeoftheir
numbersmayhavetobealteredtoalloweachprojecttohaveapositivepaybackperiod.Allowingstudents
torevisittheirpreviousestimatesshouldmaketheirnumbersmorerealisticandbettertoworkwith.
Thefirsttaskistocalculatethepaybackperiodsforeachoftheprojects.TheNPVisthencalculatedfor
eachproject,wheretheNPVsshouldbothbegreaterthanzero.Thecrucialpartofthisstepistheestimate
ofthediscountrateusedtocalculatetheNPVs.Eachgroupmustdefendtheirchosenrateofdiscount.
ThefinalcalculationistheIRRforeachproject.
Giventhecalculationsregardingthepaybackperiod,NPV,andIRRofeachproject,thegroupsareasked
tochoosethemoredesirableproject.Thischoosingprocessshouldbedetailed,givingthereaderasense
ofthereasonsforchoosingbetweentheprojects.Asummaryofeachmethodandadefensefortheinterpretation
oftheseresultsshouldbeincludedineachgroupswriteup.Givinggroupsanexampleofavarietyof
potentialprojectswillhelpstudentsstayfocusedonthecapitalbudgetingtechniquespresentedinthis
chapter.

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Part5

Integrative Case 5: Lasting Impressions Company

Suggested Answers to Opener in Review Questions

Answers to Review Questions

Suggested Answer to Focus on Practice Box:

Suggested Answer to Focus on Ethics Box: Nonfinancial

Answers to Warm-Up Exercises

PaybackPeriod: ProjectA:$60,000$20,000 3years

Making Norwich Tools Lathe Investment Decision

$128,000 $182,000 $166,000 $168,000 $450,000

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