CHAPTER 9

Capital-Budgeting Techniques
and Practice
CHAPTER ORIENTATION
Capital budgeting involves the decision-making process with respect to investment in fixed
assets; specifically, it involves measuring the incremental cash flows associated with investment
proposals and evaluating the attractiveness of these cash flows relative to the project’s costs.
This chapter focuses on the various decision criteria. It also examines how to deal with
complications in the capital budgeting process including mutually exclusive projects and capital
rationing.

CHAPTER OUTLINE

I. Methods for evaluating projects

A. The payback period method
1. The payback period of an investment tells the number of years required to
recover the initial investment. The payback period is calculated by adding
up the cash flows until they are equal to the initial fixed investment.
2. Although this measure does, in fact, deal with cash flows and is easy to
calculate and understand, it ignores any cash flows that occur after the
payback period and does not consider the time value of money within the
payback period.
B. Present-value methods
1. The net present value of an investment project is the present value of the
cash inflows less the present value of the cash outflows. By assigning
negative values to cash outflows, it becomes
n
FCFt
NPV = ∑ (1 + k )
t =1
t
- IO

where FCFt = the annual free cash flow in time period t (this can
take on either positive or negative values)

274
 k = the required rate of return or appropriate discount
rate or cost of capital
IO = the initial cash outlay
n = the project’s expected life
a. The acceptance criteria are:

accept if NPV ≥ 0

reject if NPV < 0

b. The advantage of this approach is that it takes the time value of
money into consideration in addition to dealing with cash flows.
2. The profitability index is the ratio of the present value of the expected
future net cash flows to the initial cash outlay, or
n
FCFt
∑ (1 + k )
t −1
t
profitability index =
IO
a. The acceptance criteria are:
accept if PI ≥ 1.0
reject if PI < 1.0
b. The advantages of this method are the same as those for the net
present value.
c. Either of these present-value methods will give the same accept-
reject decisions to a project.
C. The internal rate of return is the discount rate that equates the present value of the
project’s future net cash flows with the project’s initial outlay. Thus, the internal
rate of return is represented by IRR in the equation below:
n
FCFt
IO = ∑ (1 +
t =1 IRR )
t

1. The acceptance-rejection criteria are:

accept if IRR ≥ required rate of return
reject if IRR < required rate of return
The required rate of return is often taken to be the firm’s cost of capital.
2. The advantages of this method are that it deals with cash flows and
recognizes the time value of money; however, the procedure is rather
complicated and time-consuming.
3. One disadvantage is that the IRR implicitly assumes cash flows received
over the project’s life can be reinvested at the IRR.

275
 D. The MIRR is similar to the IRR except it relies on the assumption that all free
cash flows over the life of the project are reinvested at the required rate of return
until the termination of the project. Thus, to calculate the MIRR, we:
Step 1: Determine the present value of the project’s free cash outflows. We do
this by discounting all the free cash outflows, back to the present at the required
rate of return. If the initial outlay is the only free cash outflow, then the initial
outlay is the present value of the free cash outflows.
Step 2: Determine the present value of the project’s free cash inflows. Take all the
annual free cash inflows and find their future value at the end of the project’s life,
compounded forward at the required rate of return. We will call this the project’s
terminal value, or TV.
Step 3: Calculate the MIRR. The MIRR is the discount rate that equates the
present value of the free cash outflows with the present value of the project’s
terminal value.
1. The modified internal rate of return is defined as the value of MIRR in the
following equation:
PVoutflows = TVinflows (9-4)
n
(1 + MIRR)

Where PVoutflows = the present value of the project’s free cash outflows
TVinflows = the project’s terminal value, calculated by taking all the annual free
cash inflows and find their future value at the end of the project’s life,
compounded forward at the required rate of return
n = the project’s expected life
MIRR = the project’s modified internal rate of return
E. The easiest way to understand the relationship between the IRR and the NPV is to
view it graphically through the use of a net present value profile. A net present
value profile is simply a graph showing how a project’s NPV changes as the
discount rate changes. From the net present value profile you can easily see how
a project’s NPV varies inversely with the discount rate, and you can also see how
sensitive the project is to your selection of the discount rate.
II. Mutually exclusive projects: Although the IRR and the present-value methods will, in
general, give consistent accept-reject decisions, they may not rank projects identically.
This becomes important in the case of mutually exclusive projects.
A. A project is mutually exclusive if acceptance of it precludes the acceptance of one
or more projects. Then, in this case, the project’s relative ranking becomes
important.
B. Ranking conflicts come as a result of the different assumptions about the
reinvestment rate of funds released from the proposals.

276
 C. Thus, when conflicting ranking of mutually exclusive projects results from the
different reinvestment assumptions, the decision boils down to which assumption
is best.
D. In general, the net present value method is considered to be theoretically superior.
III. Capital rationing is the situation in which a budget ceiling or constraint is placed upon the
amount of funds that can be invested during a time period.
A. Theoretically, a firm should never reject a project that yields more than the required
rate of return. Although there are circumstances that may create complicated
situations in general, an investment policy limited by capital rationing is less than
optimal.
IV. Without question the key to success in capital budgeting is identifying good projects, and
for many companies these good projects are overseas. In fact, Coca-Cola, Xerox,
Hewlett-Packard, and IBM all earn more than 50% of their profits from abroad.

ANSWERS TO
END-OF-CHAPTER QUESTIONS

9-1. Capital-budgeting decisions involve investments requiring rather large cash outlays at the
beginning of the life of the project and commit the firm to a particular course of action
over a relatively long time horizon. As such, they are both costly and difficult to reverse,
both because of: (1) their large cost and (2) the fact that they involve fixed assets which
cannot be liquidated easily.
9-2. The criticisms of using the payback period as a capital-budgeting technique are:
1. It ignores the timing of the flows that occur during the payback period.
2. It ignores all flows occurring after the payback period.
The advantages associated with the payback period are:
1. It deals with cash flows rather than accounting profits and, therefore, focuses on
the true timing of the project’s benefits and costs.
2. It is easy to calculate and understand.
3. It can be used as a rough screening device, eliminating projects whose returns do
not materialize until later years.
These final two advantages are the major reasons why it is used frequently.
9-3. Yes. The payback period eliminates projects whose returns do not materialize until later
years and, thus, emphasizes the earliest returns, which in a country experiencing frequent
expropriations would certainly have the most amount of uncertainty surrounding them.
In this case, the payback period could be used as a rough screening device to filter out
those riskier projects, which have long lives.

277
9-4. The three discounted cash flow capital, budgeting criteria are the net present value, the
profitability index, and the internal rate of return. The net present value method gives an
absolute dollar value for a project by taking the present value of the benefits and
subtracting the present value of the costs. The profitability index compares these benefits
and costs through division and comes up with a measure of the project’s relative value—a
benefit/cost ratio. On the other hand, the internal rate of return tells us the rate of return
that the project earns. In the capital-budgeting area, these methods generally give us the
same accept-reject decision on projects but many times rank them differently. As such,
they have the same general advantages and disadvantages, although the calculations
associated with the internal rate of return method can become quite tedious. The
advantages associated with these discounted cash flow methods are:
1. They deal with cash flows rather than accounting profits.
2. They recognize the time value of money.
3. They are consistent with the firm’s goal of shareholder wealth maximization.
9-5. Mutually exclusive projects involve two or more projects where the acceptance of one
project will necessarily mean the rejection of the other project. This usually occurs when
the set of projects perform essentially the same task. Relating this to our discounted cash
flow criteria, it means that not all projects with positive NPVs, profitability indexes
greater than 1.0, and IRRs greater than the required rate of return will be accepted.
Moreover, since our discounted cash flow criteria do not always yield the same ranking
of projects, one criterion may indicate that the mutually exclusive project A should be
accepted, while another criterion may indicate that the mutually exclusive project B
should be accepted.
9-6. There are three principal reasons for imposing a capital-rationing constraint. First, the
management may feel that market conditions are temporarily adverse. In the early- and
mid-seventies, this reason was fairly common, because interest rates were at an all-time
high and stock prices were at a depressed level. The second reason is a manpower
shortage; that is, there is shortage of qualified managers to direct new projects. The final
reason involves intangible considerations. For example, the management may simply
fear debt and so will avoid interest payments at any cost. Or the common stock issuance
may be limited in order to allow the current owners to maintain strict voting control over
the company or to maintain a stable dividend policy.
Whether or not this is a rational move depends upon the extent of the rationing. If it is
minor and noncontinuing, then the firm’s share price will probably not suffer to any great
extent. However, it should be emphasized that capital rationing and rejection of projects
with positive net present values is contrary to the firm’s goal of maximization of
shareholders’ wealth.
9-7. When two mutually exclusive projects of unequal size are compared, the firm should
select the project or set of projects with the largest net present value, whether there is
capital rationing or not.

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9-8. The time disparity problem and the conflicting rankings that accompany it result from the
differing reinvestment assumptions made by the net present value and internal rate of
return decision criteria. The net present value criterion assumes that cash flows over the
life of the project can be reinvested at the required rate of return; the internal rate of
return implicitly assumes that the cash flows over the life of the project can be reinvested
at the internal rate of return.
9-9. The problem of incomparability of projects with different lives is not directly a result of
the projects having different lives but of the fact that future profitable investment
proposals are being affected by the decision currently being made. Again the key is:
"Does the investment decision being made today affect future profitable investment
proposals?" If so, the projects are not comparable. While the most theoretically proper
approach is to make assumptions as to investment opportunities in the future, this method
is probably too difficult to be of any value in most cases. Thus, the most common
method used to deal with this problem is the creation of a replacement chain to equalize
life spans. In effect, the reinvestment opportunities in the future are assumed to be
similar to the current ones.

SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

9-1. a. IO = FCFt [PVIFIRR%,t yrs]

$10,000 = $17,182 [PVIFIRR%,8 yrs]

0.582 = PVIFIRR%,8 yrs

Or:
N = 8
CPT I/Y = 7
PV = -10,000
PMT = 0
FV = $17,182

Thus, IRR = 7%
b. $10,000 = $48,077 [PVIFIRR%,10 yrs]

0.208 = PVIFIRR%,10 yrs

Thus, IRR = 17%

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 Or:
N = 10
CPT I/Y = 17
PV = -10,000
PMT = 0
FV = $48,077
c. $10,000 = $114,943 [PVIFIRR%,20 yrs]

0.087 = PVIFIRR%,20 yrs

Thus, IRR = 13%

Or:
N = 20
CPT I/Y = 13
PV = -10,000
PMT = 0
FV = $114,943
d. $10,000 = $13,680 [PVIFIRR%,3 yrs]

.731 = PVIFIRR%,3 yrs

Thus, IRR = 11%

Or:
N = 3
CPT I/Y = 11
PV = -10,000
PMT = 0
FV = $13,680
9-2. a. I0 = FCFt [PVIFAIRR%,t yrs]

$10,000 = $1,993 [PVIFAIRR%,10 yrs]

5.018 = PVIFAIRR%,10 yrs

Thus, IRR = 15%

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Or:
N = 10
CPT I/Y = 15
PV = -10,000
PMT = 1,993
FV = 0
b. $10,000 = $2,054 [PVIFAIRR%,20 yrs]
4.869 = PVIFAIRR%,20 yrs
Thus, IRR = 20%
Or:
N = 20
CPT I/Y = 20
PV = -10,000
PMT = 2,054
FV = 0
c. $10,000 = $1,193 [PVIFAIRR%,12 yrs]
8.382 = PVIFAIRR%,12 yrs
Thus, IRR = 6%
Or:
N = 12
CPT I/Y = 6
PV = -10,000
PMT = 1,193
FV = 0
d. $10,000 = $2,843 [PVIFAIRR%,5 yrs]
3.517 = PVIFAIRR%,5 yrs
Thus, IRR = 13%
Or:
N = 5
CPT I/Y = 13
PV = -10,000
PMT = 2,843
FV = 0

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 $2,000 $5,000 $8,000
9-3. a. $10,000 = + +
(1 + IRR )1 (1 + IRR ) 2 (1 + IRR ) 3
Try 18%
$10,000 = $2,000(0.847) + $5,000 (0.718) + $8,000 (0.609)
= $1,694 + $3,590 + $4,872
= $10,156
Try 19%
$10,000 = $2,000 (0.840) + $5,000 (0.706) + $8,000 (0.593)
= $1,680 + $3,530 + $4,744
= $9,954
Thus, IRR = approximately 19%

$8,000 $5,000 $2,000

b. $10,000 = + +
1 2
(1 + IRR ) (1 + IRR ) (1 + IRR ) 3
Try 30%
$10,000 = $8,000 (0.769) + $5,000 (0.592) + $2,000 (0.455)
= $6,152 + $2,960 + $910
= $10,022
Try 31%
$10,000 = $8,000 (0.763) + $5,000 (0.583) + $2,000 (0.445)
= $6,104 + $2,915 + $890
= $9,909
Thus, IRR = approximately 30%
5 $2,000 $5,000
c. $10,000 = ∑ +
t = 1 (1 + IRR )
t
(1 + IRR ) 6
Try 11%
$10,000 = $2,000 (3.696) + $5,000 (0.535)
= $7,392 + $2,675
= $10,067

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 Try 12%
$10,000 = $2,000 (3.605) + $5,000 (0.507)
= $7,210 + $2,535
= $9,745
Thus, IRR = approximately 11%
6 $450,000
9-4. a. NPV = ∑ - $1,950,000
t = 1 (1 + .09)

= $450,000 (4.486) - $1,950,000

= $2,018,700 - $1,950,000 = $68,700

$2,018,700
b. PI =
$1,950,000
= 1.0352
c. $1,950,000 = $450,000 [PVIFAIRR%,6 yrs]

4.333 = PVIFAIRR%,6 yrs

IRR = about 10% (10.1725%)

d. Yes, the project should be accepted.
9-5. a. Payback Period = $80,000/$20,000 = 4 years
6 $20,000
b. NPV = ∑ - $80,000
t = 1 (1 + .10 )
t

= $20,000 (4.355) - $80,000

= $87,100 - $80,000 = $7,100

$87,100
c. PI =
$80,000
= 1.0888
d. $80,000 = $20,000 [PVIFAIRR%,6 yrs]

4.000 = PVIFAIRR%,6 yrs

IRR = about 13% (12.978%)

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 6 $12,000
9-6. NPVA = ∑ - $50,000
t = 1 (1 + .12 )
t

= $12,000 (4.111) - $50,000

= $49,332 - $50,000 = -$668
6 $13,000
NPVB = ∑ - $70,000
t =1 (1 + .12) t
= $13,000 (4.111) - $70,000
= $53,443 - $70,000 = -$16,557
$49,332
PIA =
$50,000

= 0.9866
$53,443
PIB =
$70,000

= 0.7635
$50,000 = $12,000 [PVIFAIRR%,6 yrs]

4.1667 = PVIFAIRR%,6 yrs

IRRA = 11.53%

$70,000 = $13,000 [PVIFAIRR%,6 yrs]

5.3846 = PVIFAIRR%,6 yrs

IRRB = 3.18%

Neither project should be accepted.

9-7. Project A:
Payback Period = 2 years + $100/$200 = 2.5 years
Project B:
Payback Period = 2 years + $2,000/$3,000 = 2.67 years
Project C:
Payback Period = 3 years + $1,000/$2,000 = 3.5 years
Projects A and B should be accepted using the payback period criteria.

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 8 $1,000,000
9-8. NPV9% = ∑ - $5,000,000
t = 1 (1 + .09 )
t

= $1,000,000 (5.535) - $5,000,000

= $5,535,000 - $5,000,000 = $535,000
8 $1,000,000
NPV11% = ∑ - $5,000,000
t =1 (1 + .11)t
= $1,000,000 (5.146) - $5,000,000
= $5,146,000 - $5,000,000 = $146,000
8 $1,000,000
NPV13% = ∑ - $5,000,000
t =1 (1 + .13) t
= $1,000,000 (4.799) - $5,000,000
= $4,799,000 - $5,000,000 = -$201,000
8 $1,000,000
NPV15% = ∑ - $5,000,000
t =1 (1 + .15) t

= $1,000,000 (4.487) - $5,000,000

= $4,487,000 - $5,000,000 = -$513,000
9-9. Project A:

$10,000 $15,000 $20,000

$50,000 = + +
(1 + IRR A ) 1 (1 + IRR A ) 2 (1 + IRR A ) 3

$25,000 $30,000
+ +
(1 + IRR A ) 4
(1 + IRR A ) 5
Try 23%
$50,000 = $10,000(.813) + $15,000(.661) + $20,000(.537)
+ $25,000(.437) + $30,000(.355)
= $8,130 + $9,915 + $10,740 + $10,925 + $10,650
= $50,360

285
 Try 24%
$50,000 = $10,000(.806) + $15,000(.650) +$20,000(.524)
+ $25,000(.423) + $30,000(.341)
= $8,060 + $9,750 + $10,480 + $10,575 + $10,230
= $49,095
Thus, IRR = just over 23%
Project B:
$100,000 = $25,000 [PVIFAIRR%,5 yrs]

4.00 = PVIFAIRR%,5 yrs

Thus, IRR = 8%
Project C:
$450,000 = $200,000 [PVIFAIRR%,3 yrs]

2.25 = PVIFAIRR%,3 yrs

Thus, IRR = 16%

10 $18,000
9-10. a. NPV = ∑ - $100,000
t =1 (1 + .10 ) t
= $18,000(6.145) - $100,000
= $110,610 - $100,000
= $10,610
10 $18,000
b. NPV = ∑ - $100,000
t =1 (1 + .15 ) t
= $18,000(5.019) - $100,000
= $90,342 - $100,000
= -$9,658
c. If the required rate of return is 10%, the project is acceptable as in part a.
d. $100,000 = $18,000 [PVIFAIRR%,10 yrs]

5.5556 = PVIFAIRR%,10 yrs

IRR = Between 12% and 13% (12.41%)

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9-11. Calculator Solution (using a Texas Instruments BA-II Plus):

Data and Key Input Display

CF; -653,803; ENTER CF0 = -653,803.00
↓; 300,000; ENTER C01 = 300,000.00
↓; 2; ENTER F01 = 2.00
↓; 200,000; ENTER C02 = 200,000.00
↓; 1; ENTER F02 = 1.00
↓; 100,000; ENTER C03 = 100,000.00
↓; 1; ENTER F03 = 1.00
IRR; CPT IRR = 17.00

Trial and Error Solution:

Try different discount rates, and the one that makes the present value of the free cash
inflows equal to the initial outlay, that is makes the NPV equal to zero, is the IRR.

Discount Rate Guesses NPV

15% $22,588.
20% -$31,504.
17% $0

Thus, 17 percent is the project’s IRR.

9-12. Calculator Solution (using a Texas Instruments BA-II Plus):
Data and Key Input Display
CF; -927,917; ENTER CF0 = -927,917.00
↓; 200,000; ENTER C01 = 200,000.00
↓; 1; ENTER F01 = 1.00
↓; 300,000; ENTER C02 = 300,000.00
↓; 2; ENTER F02 = 2.00
↓; 200,000; ENTER C03 = 200,000.00
↓; 2; ENTER F03 = 2.00
↓; 160,000; ENTER C04 = 160,000.00
↓; 1; ENTER F04 = 1.00
IRR; CPT IRR = 13.00

Trial and Error Solution:

Try different discount rates, and the one that makes the present value of the free cash
inflows equal to the initial outlay, that is makes the NPV equal to zero, is the IRR.
Discount Rate Guesses NPV
10% $78,332.
15% -$46,947.
13% $0
Thus, 13 percent is the project’s IRR.

287
 TV inflows
9-13. (a) PVoutflows =
(1 + MIRR) n
$2,000,000(FVIFA10%,8years )
$8,000,000 =
(1 + MIRR)8
$2,000,000(11.436)
$8,000,000 =
(1 + MIRR)8
$22,872000
$8,000,000 =
(1 + MIRR)8
MIRR = 14.0320%
$2,000,000(FVIFA12%,8years )
b) $8,000,000 =
(1 + MIRR)8
$2,000,000(12.300)
$8,000,000 =
(1 + MIRR)8
$24,600,000
$8,000,000 =
(1 + MIRR)8
MIRR = 15.0749%
$2,000,000(FVIFA14%,8years )
c) $8,000,000 =
(1 + MIRR)8
$2,000,000(13.233)
$8,000,000 =
(1 + MIRR)8
$26,466,000
$8,000,000 =
(1 + MIRR)8
MIRR = 16.1312%
$700
9-14. a. NPVA = - $500
(1 + 0.10)1
= $636.30 - $500
= $136.30
$6,000
NPVB = - $5,000
(1 + 0.10)1
= $5,455 - $5,000
= $455

288
 $636.30
b. PIA =
$500.00
= 1.2726

$5,455
PIB =
$5,000
= 1.0910
c. $500 = $700 [PVIFIRR%,1 yr]

0.714 = PVIFIRR%,1 yr

Thus, IRRA = 40%

$5,000 = $6,000 [PVIFIRR%,1 yr]

0.833 = [PVIFIRR%,1 yr]

Thus, IRRB = 20%

d. If there is no capital rationing, project B should be accepted because it has a larger

net present value. If there is a capital constraint, the problem then focuses on what
can be done with the additional $4,500 freed up if project A is chosen. If Dorner
Farms can earn more on project A, plus the project financed with the additional
$4,500, than it can on project B, then project A and the marginal project should be
accepted.
9-15. a. Payback A = 3.2 years
Payback B = 4.5 years
B assumes even cash flow throughout year 5.
5 $15,625
b. NPVA = ∑ - $50,000
t = 1 (1 + 0.10 )
t

= $15,625 (3.791) - $50,000

= $59,234 - $50,000
= $9,234
$100,000
NPVB = - $50,000
5
(1 + 0.10)
= $100,000 (0.621) - $50,000
= $62,100 - $50,000
= $12,100

289
 c. $50,000 = $15,625 [PVIFAIRR %,5 yrs]
A
3.2 = PVIFAIRR%,5 yrs
Thus, IRRA = 17%
$50,000 = $100,000 [PVIFIRR %,5 yrs]
B
.50 = PVIFAIRR %,5 yrs
B
Thus, IRRB = 15%
d. The conflicting rankings are caused by the differing reinvestment assumptions
made by the NPV and IRR decision criteria. The NPV criteria assumes that cash
flows over the life of the project can be reinvested at the required rate of return or
cost of capital, while the IRR criterion implicitly assumes that the cash flows over
the life of the project can be reinvested at the internal rate of return.
e. Project B should be taken because it has the largest NPV. The NPV criterion is
preferred because it makes the most acceptable assumption for the wealth-
maximizing firm.

9-16. a. Present Value

Profitability of Future
Project Cost Index Cash Flows NPV
A $4,000,000 1.18 $4,720,000 $ 720,000
B 3,000,000 1.08 3,240,000 240,000
C 5,000,000 1.33 6,650,000 1,650,000
D 6,000,000 1.31 7,860,000 1,860,000
E 4,000,000 1.19 4,760,000 760,000
F 6,000,000 1.20 7,200,000 1,200,000
G 4,000,000 1.18 4,720,000 720,000

Combinations with Total Costs Below $12,000,000

Projects Costs NPV

A&B $ 7,000,000 $ 960,000
A&C 9,000,000 2,370,000
A&D 10,000,000 2,580,000
A&E 8,000,000 1,480,000
A&F 10,000,000 1,920,000
A&G 8,000,000 1,440,000
B&C 8,000,000 1,890,000
B&D 9,000,000 2,100,000
B&E 7,000,000 1,000,000
B&F 9,000,000 1,440,000
B&G 7,000,000 960,000
C&D 11,000,000 3,510,000

290
 C&E 9,000,000 2,410,000
C&F 11,000,000 2,850,000
C&G 9,000,000 2,370,000
D&E 10,000,000 2,620,000
D&F 12,000,000 3,060,000
D&G 10,000,000 2,580,000
E&F 10,000,000 1,960,000
E&G 8,000,000 1,480,000
F&G 10,000,000 1,920,000
A&B&C 12,000,000 2,610,000
A&B&E 11,000,000 1,720,000
A&B&G 11,000,000 1,680,000
A&E&G 12,000,000 2,200,000
B&C&E 12,000,000 2,650,000
B&C&G 12,000,000 2,610,000
Thus, projects C&D should be selected under strict capital rationing as they
provide the combination of projects with the highest net present value.
b. Because capital rationing forces the rejection of profitable projects, it is not an
optimal strategy.

SOLUTION TO MINI CASE

a. Capital-budgeting decisions involve investments requiring rather large cash outlays at the
beginning of the life of the project and commit the firm to a particular course of action
over a relatively long time horizon. As such, they are both costly and difficult to reverse,
both because of: (1) their large cost and (2) the fact that they involve fixed assets, which
cannot be liquidated easily.
b. Axiom 5: “The Curse of Competitive Markets—Why It’s Hard to Find Exceptionally
Profitable Projects” deals with the problems associated with finding profitable projects.
When we introduced that axiom, we stated that exceptionally successful investments
involve the reduction of competition by creating barriers to entry either through product
differentiation or cost advantages. In effect, without barriers to entry, whenever
extremely profitable projects are found, competition rushes in, driving prices and profits
down unless there is some barrier to entry.
20,000
c. Payback periodA = 3 years + years = 3.4years
50,000
110,000
Payback PeriodB = years = 2.75 years
40,000
Project B should be accepted, while project A should be rejected.
d. The disadvantages of the payback period are: (1) ignores the time value of money, (2)
ignores cash flows occurring after the payback period, (3) selection of the maximum
acceptable payback period is arbitrary.

291
 n
FCFt
e. NPVA = ∑ (1 + k )
t =1
t
- IO

= $20,000(PVIF12%, 1 year) + $30,000 (PVIF12%, 2 years)

+ $40,000(PVIF12%, 3 years) + $50,000 (PVIF12%, 4 years)
+ $70,000(PVIF12, 5 years) - $110,000
= $20,000(.893) + $30,000 (.797) + $40,000 (.712) + $50,000 (.636)
+ $70,000 (.567) - $110,000
= $17,860 + $23,910 + $28,480 + $31,800 + $39,690 - $110,000
= $141,740-$110,000
= $31,740
NPVB = $40,000(PVIFA12%, 5 years) - $110,000
= $40,000(3.605) - $110,000
= $144,200-$110,000
= $34,200
Both projects should be accepted

f. The net present value technique discounts all the benefits and costs in terms of cash flows
back to the present and determines the difference. If the present value of the benefits
outweighs the present value of the costs, the project is accepted; if not, it is rejected.
 n 
 ∑ FCFt 
 t =1 
 (1 + k )t 
 
g. PIA =  
IO
$141,740
=
$110,000
= 1.2885
$144,200
PIB =
$110,000
= 1.3109
Both projects should be accepted

292
h. The net present value and the profitability index always give the same accept reject-
decision. When the present value of the benefits outweighs the present value of the costs,
the profitability index is greater than one, and the net present value is positive. In that
case, the project should be accepted. If the present value of the benefits is less than the
present value of the costs, then the profitability index will be less than one; thus, the net
present value will be negative, and the project will be rejected.
i. For both projects A and B, all of the costs are already in present dollars and, as such, will
not be affected by any change in the required rate of return or discount rate. All the
benefits for these projects are in the future, and thus when there is a change in the
required rate of return or discount rate, their present value will change. If the required
rate of return increased, the present value of the benefits would decline which would in
turn result in a decrease in both the net present value and the profitability index for each
project.
j. IRRA = 20.9698%
IRRB = 23.9193%
k. The required rate of return does not change the internal rate of return for a project, but it
does affect whether a project is accepted or rejected. The required rate of return is the
hurdle rate that the project’s IRR must exceed in order to accept the project.
l. The net present value assumes that all cash flows over the life of the project are
reinvested at the required rate of return, while the internal rate of return implicitly
assumes that all cash flows over the life of the project are reinvested over the remainder
of the project’s life at the IRR. The net present value method makes the most acceptable
and conservative assumption and, thus, is preferred.
$240,000
m. 1. NPVA = - $195,000
(1 + 0.10)1
= $218,182 - $195,000
= $23,182
$1,650,000
NPVB = - $1,200,000
1
(1 + 0.10)
= $1,500,000 - $1,200,000
= $300,000
$218,182
2. PIA =
$195,000
= 1.1188
$1,499,850
PIB =
$1,200,000
= 1.25

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 3. $195,000 = $240,000 [PVIFIRR %,1 yr]
A
0.8125 = PVIFIRR %,1 yr
A
Thus, IRRA = 23%
$1,200,000 = $1,650,000 [PVIFIRR %,1 yr]
B
0.7273 = [PVIFIRR %,1 yr]
B
Thus, IRRB = 38%
4. If there is no capital rationing, project B should be accepted because it has a larger
net present value. If there is a capital constraint, the problem then focuses on
what can be done with the additional $1,005,000 freed up if project A is chosen.
If Caledonia can earn more on project A, plus the project financed with the
additional $1,005,000, than it can on project B, then project A and the marginal
project should be accepted.
n. Two answers are provided, one assuming an initial outlay of $100,000 (the initial outlay
that should have appeared in the text) and one an initial outlay of $10,000 (the value of
the initial outlay that did appear in the book).
If the initial outlay for project A was $100,000, the answers for project A would be as
follows:
1. Payback A = 3.125 years
Payback B = 4.5 years
B assumes even cash flow throughout year 5.
5 $32,000
2. NPVA = ∑ - $100,000
t = 1 (1 + 0.11)
t

= $32,000 (3.696) - $100,000

= $118,272 - $100,000
= $18,272
$200,000
NPVB = - $100,000
(1 + 0.11) 5
= $200,000 (0.593) - $100,000
= $118,600 - $100,000
= $18,600

294
3. $100,000 = $32,000 [PVIFAIRR %,5 yrs]
A
3.125 = PVIFAIRR %,5 yrs
A
Thus, IRRA = 18.03%
$100,000 = $200,000 [PVIFIRR %,5 yrs]
B
.50 = PVIFIRR %,5 yrs
B
Thus, IRRB is just under 15% (14.87%).
4. The conflicting rankings are caused by the differing reinvestment assumptions
made by the NPV and IRR decision criteria. The NPV criteria assume that cash
flows over the life of the project can be reinvested at the required rate of return or
cost of capital, while the IRR criterion implicitly assumes that the cash flows over
the life of the project can be reinvested at the internal rate of return.
5. Project B should be taken because it has the largest NPV. The NPV criterion is
preferred because it makes the most acceptable assumption for the wealth-
maximizing firm.
If the initial outlay for project A was $10,000, the answers for project A would become:
1. Payback A = 0.31 years
5 $32,000
2. NPVA = ∑ - $10,000
t =1 (1 + 0.11) t
= $32,000 (3.696) - $10,000
= $118,272 - $10,000
= $18,272
$200,000
NPVB = - $10,000
5
(1 + 0.11)
= $200,000 (0.593) - $10,000
= $118,600 - $10,000
= $108,600
3. IRR = 319.75%
4. In this case there is no ranking conflict.
5. Accept project A.

295
o. 1. Payback A = 1.5385 years
Payback B = 3.0769 years
3 $65,000
2. NPVA = ∑ - $100,000
t =1 (1 + 0.14 ) t
= $65,000 (2.322) - $100,000
= $150,930 - $100,000
= $50,930
9 $32,500
NPVB = ∑ - $100,000
t =1 (1 + 0.14 ) t
= $32,500 (4.946) - $100,000
= $160,745 - $100,000
= $60,745
3. $100,000 = $65,000 [PVIFAIRR %,3 yrs]
A
Thus, IRRA = over 40% (42.57%)
$100,000 = $32,500 [PVIFAIRR %,9 yrs]
B
Thus, IRRB = 29%
4. These projects are not comparable because future profitable investment proposals
are affected by the decision currently being made. If project A is taken, at its
termination the firm could replace the machine and receive additional benefits,
while acceptance of project B would exclude this possibility.

5. Using 3 replacement chains, project A’s cash flows would become:

Year Cash flow
0 -$100,000
1 65,000
2 65,000
3 -35,000
4 65,000
5 65,000
6 - 35,000
7 65,000
8 65,000
9 65,000

296
 9 $65,000 $100,000 $100,000
NPVA = ∑ - $100,000 - -
t = 1 (1 + 0.14 )
t
(1 + 0.14) 3 (1 + 0.14) 6
= $65,000(4.946) - $100,000 - $100,000 (0.675)
- $100,000 (0.456)
= $321,490 - $100,000 - $67,500 - $45,600
= $108,390
The replacement chain analysis indicated that project A should be selected, since the
replacement chain associated with it has a larger NPV than project B.
Project A’s EAA:
Step 1: Calculate the project’s NPV (from part b):
NPVA = $50,930
Step 2: Calculate the EAA:
EAAA = NPV / PVIFA14%, 3 yr.
= $50,930/ 2.322
= $21,934
Project B’s EAA:
Step 1: Calculate the project’s NPV (from part b):
NPVB = $60,745
Step 2: Calculate the EAA:
EAAB = NPV / PVIFA14%, 9 yr.
= $60,745 / 4.946
= $12,282
Project A should be selected because it has a higher EAA.

297
FORD PINTO

ETHICS CASE: THE VALUE OF LIFE

There was a time when the “made in Japan” label brought a predictable smirk of superiority to
the face of most Americans. The quality of most Japanese products usually was as low as their
price. In fact, few imports could match their domestic counterparts, the proud products of
"Yankee know-how." But by the late 1960s, an invasion of foreign-made goods chiseled a few
worry lines into the countenance of American industry. And in Detroit, worry was fast fading to
panic as the Japanese, not to mention the Germans, began to gobble up more and more of the
subcompact auto market.
Never one to take a back seat to the competition, Ford Motor Company decided to meet the
threat from abroad head-on. In 1968, Ford executives decided to produce the Pinto. Known
inside the company as "Lee’s car," after Ford president Lee Iacocca, the Pinto was to weigh no
more than 2,000 pounds and cost no more than $2,000.
Eager to have its subcompact ready for the 1971 model year, Ford decided to compress the
normal drafting-board-to-showroom time of about three-and-a-half years into two. The
compressed schedule meant that any design changes typically made before production-line
tooling would have to be made during it.
Before producing the Pinto, Ford crash-tested eleven of them, in part to learn if they met the
National Highway Traffic Safety Administration (NHTSA) proposed safety standard that all
autos be able to withstand a fixed-barrier impact of 20 miles per hour without fuel loss. Eight
standard-design Pintos failed the tests. The three cars that passed the test all had some kind of
gas-tank modification. One had a plastic baffle between the front of the tank and the differential
housing; the second had a piece of steel between the tank and the rear bumper; and the third had
a rubber-lined gas tank.
Ford officials faced a tough decision. Should they go ahead with the standard design, thereby
meeting the production timetable but possibly jeopardizing consumer safety? Or should they
delay production of the Pinto by redesigning the gas tank to make it safer and thus concede
another year of subcompact dominance to foreign companies?
To determine whether to proceed with the original design of the Pinto fuel tank, Ford decided to
use a capital-budgeting approach, examining the expected costs and the social benefits of making
the change. Would the social benefits of a new tank design outweigh design costs, or would they
not?
To find the answer, Ford had to assign specific values to the variables involved. For some factors
in the equation, this posed no problem. The costs of design improvement, for example, could be
estimated at eleven dollars per vehicle. But what about human life? Could a dollar-and-cents
figure be assigned to a human being?
NHTSA thought it could. It had estimated that society loses $200,725 every time a person is
killed in an auto accident. It broke down the costs as follows:

298
 Future productivity losses
Direct $132,000
Indirect 41,300
Medical costs
Hospital 700
Other 425
Property damage 1,500
Insurance administration 4,700
Legal and court expenses 3,000
Employer losses 1,000
Victim’s pain and suffering 10,000
Funeral 900
Assets (lost consumption) 5,000
Miscellaneous accident costs 200
1
Total per fatality $200,725

Ford used NHTSA and other statistical studies in its cost-benefit analysis, which yielded the
following estimates:

Benefits
Savings: 180 burn deaths; 180 serious burn injuries;
2,100 burned vehicles
Unit cost: $200,000 per death; $67,000 per injury;
$700 per vehicle
Total benefit: (180 x $200,000) + (180 x $67,000)
+ (2,100 x $700) = $49.5 million

Costs
Sales: 11 million cars, 1.5 million light trucks
Unit cost: $11 per car, $11 per truck
2
Total cost: 12.5 million x $11 = $137.5 million

Since the costs of the safety improvement outweighed its benefits, Ford decided to push ahead
with the original design.
Here is what happened after Ford made this decision:

1
Ralph Drayton, "One Manufacturer's Approach to Automobile Safety Standards," CTLA News 8 (February 1968),
p. 11.
2
Mark Dowie, "Pinto Madness,'' Mother Jones, September–October 1977, p. 20. See also Russell Mokhiber,
Corporate Crime and Violence (San Francisco: Sierra Club Books, 1988), pp. 373-382; and Francis T. Cullen,
William J. Maakestad, and Gary Cavender, Corporate Crime Under Attack: The Ford Pinto Case and Beyond
(Cincinnati: Anderson Publishing, 1987).

299
Between 700 and 2,500 persons died in accidents involving Pinto fires between 1971 and 1978.
According to sworn testimony of Ford engineer Harley Copp, 95% of them would have survived
if Ford had positioned the fuel tank over the axle (as it had done on its Capri automobiles).
NHTSA’s standard was adopted in 1977. The Pinto then acquired a rupture-proof fuel tank. The
following year Ford was obliged to recall all 1971-1976 Pintos for fuel-tank modifications.
Between 1971 and 1978, approximately fifty lawsuits were brought against Ford in connection
with rear-end accidents involving the Pinto. In the Richard Grimshaw case, in addition to
awarding over $3 million in compensatory damages to the victims of a Pinto crash, the jury
awarded a landmark $125 million in punitive damages against Ford. The judge reduced punitive
damages to $3.5 million.
On August 10, 1978, 18-year-old Judy Ulrich, her 16-year-old sister Lynn, and their 18-year-old
cousin Donna, in their 1973 Ford Pinto, were struck from the rear by a van near Elkhart, Indiana.
The gas tank of the Pinto exploded on impact. In the fire that resulted, the three teenagers were
burned to death. Ford was charged with criminal homicide. The judge presiding over the 20-
week trial advised jurors that Ford should be convicted if it had clearly disregarded the harm that
might result from its actions, and that disregard represented a substantial deviation from
acceptable standards of conduct. On March 13, 1980, the jury found Ford not guilty of criminal
homicide.
For its part, Ford has always denied that the Pinto is unsafe compared with other cars of its type
and era. The company also points out that in every model year the Pinto met or surpassed the
government’s own standards. But what the company does not say is that successful lobbying by
it and its industry associates was responsible for delaying for 9 years the adoption of NHTSA’s
20-miles-per-hour crash standard. And Ford’s critics claim that there were more than forty
European and Japanese models in the Pinto price and weight range with safer gas-tank position.
"Ford made an extremely irresponsible decision," concludes auto safety expert Byron Bloch,
"when they placed such a weak tank in such a ridiculous location in such a soft rear end."

QUESTIONS
1. Do you think Ford approached this question properly?
2. What responsibilities to its customers do you think Ford had? Were their actions ethically
appropriate?
3. Would it have made a moral or ethical difference if the $11 savings had been passed on
to Ford’s customers? Could a rational customer have chosen to save $11 and risk the
more dangerous gas tank? Would that have been similar to making air bags optional?
What if Ford had told potential customers about its decision?
4. Should Ford have been found guilty of criminal homicide in the Ulrich case?
5. If you, as a financial manager at Ford, found out about what had been done, what would
you do?

Adapted by permission from William Shaw and Vincent Barry, Moral Issues in Business, 7th
ed., pp. 84–87. Copyright 1992 by Wadsworth, Inc.

300
FORD PINTO
(Ethics in Capital Budgeting)
OBJECTIVE: To force the students to recognize the role ethical behavior plays in all
areas of Finance.

DEGREE OF DIFFICULTY: Easy

Case Solution:

With ethics cases, there are no right or wrong answers—just opinions. Try to bring out as
many opinions as possible without being judgmental.

301
HARDING PLASTIC MOLDING COMPANY

CAPITAL BUDGETING: RANKING PROBLEMS

On January 11, 1993, the finance committee of Harding Plastic Molding Company (HPMC) met
to consider 8 capital-budgeting projects. Present at the meeting were Robert L. Harding,
president and founder, Susan Jorgensen, comptroller, and Chris Woelk, head of research and
development. Over the past 5 years, this committee met every month to consider and make final
judgment on all proposed capital outlays brought up for review during the period.
Harding Plastic Molding Company was founded in 1965 by Robert L. Harding to produce plastic
parts and molding for the Detroit automakers. For the first 10 years of operations, HPMC worked
solely as a subcontractor for the automakers, but since then has made strong efforts to diversify
in an attempt to avoid the cyclical problems faced by the auto industry. By 1993, this
diversification attempt led HPMC into the production of over 1,000 different items, including
kitchen utensils, camera housings, and phonographic and recording equipment. It also led to an
increase in sales of 800% during the 1975–1993 period. As this dramatic increase in sales was
paralleled by a corresponding increase in production volume, HPMC was forced, in late 1991, to
expand production facilities. This plant and equipment expansion involved capital expenditures
of approximately $10.5 million and resulted in an increase of production capacity of about 40%.
Because of this increased production capacity, HPMC made a concerted effort to attract new
business and consequently recently entered into contracts with a large toy firm and a major
discount department store chain. While non-auto-related business has grown significantly, it still
represents only 32% of HPMC’s overall business. Thus, HPMC has continued to solicit non-
automotive business, and, as a result of this effort and its internal research and development, the
firm has four sets of mutually exclusive projects to consider at this month’s finance committee
meeting.
Over the past 10 years, HPMC’s capital-budgeting approach evolved into a somewhat elaborate
procedure in which new proposals are categorized into three areas: profit, research and
development, and safety. Projects falling into the profit or research and development areas are
evaluated using present value techniques, assuming a 10 percent opportunity rate; those falling
into the safety classification are evaluated in a more subjective framework. Although research
and development projects have to receive favorable results from the present value criteria, there
is also a total dollar limit assigned to projects of this category, typically running about $750,000
per year. This limitation was imposed by Harding primarily because of the limited availability of
quality researchers in the plastics industry. Harding felt that if more funds than this were
allocated, “we simply couldn’t find the manpower to administer them properly.” The benefits
derived from safety projects, on the other hand, are not in terms of cash flows; hence, present
value methods are not used at all in their evaluation. The subjective approach used to evaluate
safety projects is a result of the pragmatically difficult task of quantifying the benefits from these
projects in dollar terms. Thus, these projects are subjectively evaluated by a management-worker
committee with a limited budget. All 8 projects to be evaluated in January are classified as profit
projects.

302
The first set of projects listed on the meeting’s agenda for examination involve the utilization of
HPMC’s precision equipment. Project A calls for the production of vacuum containers for
thermos bottles produced for a large discount hardware chain. The containers would be
manufactured in 5 different size and color combinations. This project would be carried out over a
3-year period, for which HPMC would be guaranteed a minimum return plus a percentage of the
sales. Project B involves the manufacture of inexpensive photographic equipment for a national
photography outlet. Although HPMC currently has excess plant capacity, each of these projects
would utilize precision equipment of which the excess capacity is limited. Thus, adopting either
project would tie up all precision facilities. In addition, the purchase of new equipment would be
both prohibitively expensive and involve a time delay of approximately 2 years, thus making
these projects mutually exclusive. (The cash flows associated with these 2 projects are given in
Exhibit 1.)
The second set of projects involves the renting of computer facilities over a 1-year period to aid
in customer billing and, perhaps, inventory control. Project C entails the evaluation of a customer
billing system proposed by Advanced Computer Corporation. Under this system, all the
bookkeeping and billing presently being done by HPMC’s accounting department would be done
by Advanced. In addition to saving costs involved in bookkeeping, Advanced would provide a
more efficient billing system and do a credit analysis of delinquent customers, which could be
used in the future for in-depth credit analysis. Project D is proposed by International Computer
Corporation and includes a billing system similar to that offered by Advanced. In addition, an
inventory control system that will keep track of all raw materials and parts in stock and reorder
when necessary. Thereby, reducing the likelihood of material stockouts, which have become
more and more frequent over the past 3 years. (The cash flows for these projects are given in
Exhibit 2.)

EXHIBIT 1.
Harding Plastic Molding Company
Cash Flows:
Year Project A Project B
0 $-75,000 $-75,000
1 10,000 43,000
2 30,000 43,000
3 100,000 43,000

EXHIBIT 2.
Harding Plastic Molding Company
Cash Flows:
Year Project C Project D
0 $-8,000 $-20,000
1 11,000 25,000

The third decision that faces the financial directors of HPMC involves a newly developed and
patented process for molding hard plastics. HPMC can either manufacture and market the
equipment necessary to mold such plastics or it can sell the patent rights to Polyplastics
Incorporated, the world’s largest producer of plastics products. (The cash flows for projects E

303
and F are shown in Exhibit 3.) At present, the process has not been fully tested, and if HPMC is
going to market it itself, it will be necessary to complete this testing and begin production of
plant facilities immediately. On the other hand, the selling of these patent rights to Polyplastics
would involve only minor testing and refinements, which could be completed within the year.
Thus, a decision as to the proper course of action is necessary immediately.
The final set of projects up for consideration revolve around the replacement of some of the
machinery. HPMC can go in one of two directions. Project G suggests the purchase and
installation of moderately priced, extremely efficient equipment with an expected life of 5 years;
project H advocates the purchase of a similarly priced, although less efficient, machine with a
life expectancy of 10 years. (The cash flows for these alternatives are shown in Exhibit 4.)
As the meeting opened, debate immediately centered on the most appropriate method for
evaluating all the projects. Harding suggested that, as the projects to be considered were
mutually exclusive, perhaps their usual capital-budgeting criteria of net present value was
inappropriate. He felt that, in examining these projects, perhaps they should be more concerned
with relative profitability or some measure of yield. Both Jorgensen and Woelk agreed with
Harding’s point of view, with Jorgensen advocating a profitability index approach and Woelk
preferring the use of the internal rate of return. Jorgensen argued that the use of the profitability
index would provide a benefit-cost ratio, directly implying relative profitability. Thus, they
merely need to rank these projects and select those with the highest profitability index. Woelk
agreed with Jorgensen’s point of view but suggested that the calculation of an internal rate of
return would also give a measure of profitability and perhaps be somewhat easier to interpret. To
settle the issue, Harding suggested they calculate all three measures, as they would undoubtedly
yield the same ranking.

EXHIBIT 3.
Harding Plastic Molding Company
Cash Flows:
Year Project E Project F
0 $-30,000 $-271,500
1 210,000 100,000
2 100,000
3 100,000
4 100,000
5 100,000
6 100,000
7 100,000
8 100,000
9 100,000
10 100,000

304
EXHIBIT 4.
Harding Plastic Molding Company
Cash Flows:
Year Project G Project H
0 $-500,000 $-500,000
1 225,000 150,000
2 225,000 150,000
3 225,000 150,000
4 225,000 150,000
5 225,000 150,000
6 150,000
7 150,000
8 150,000
9 150,000
10 150,000

From here, the discussion turned to an appropriate approach to the problem of differing lives
among mutually exclusive projects E and F, and G and H. Woelk argued that there really was not
a problem here at all that as all the cash flows from these projects can be determined, any of the
discounted cash flow methods of capital budgeting will work well. Jorgensen argued that,
although this was true, some compensation should be made for the fact that the projects being
considered did not have equal lives.

QUESTIONS
1. Was Harding correct in stating that the NPV, PI, and IRR necessarily will yield
the same ranking order? Under what situations might the NPV, PI, and IRR
methods provide different rankings? Why is it possible?
2. What are the NPV, PI, and IRR for projects A and B? What has caused the
ranking conflicts? Should project A or B be chosen? Might your answer change if
project B is a typical project in the plastic molding industry? For example, if
projects for HPMC generally yield approximately 12%, is it logical to assume that
the IRR for project B of approximately 33% is a correct calculation for ranking
purposes?
3. What are the NPV, PI, and IRR for projects C and D? Should project C or D be
chosen? Does your answer change if these projects are considered under a capital
constraint? What return on the marginal $12,000 not employed in project C is
necessary to make one indifferent to choosing one project over the other under a
capital-rationing situation?
4. What are the NPV, PI, and IRR for projects E and F? Are these projects
comparable even though they have unequal lives? Why? Which project should be
chosen? Assume that these projects are not considered under a capital constraint.
5. What are the NPV, PI, and IRR for projects G and H? Are these projects
comparable even though they have unequal lives? Why? Which project should be
chosen? Assume that these projects are not considered under a capital constraint.

305
HARDING PLASTIC MOLDING COMPANY
(Capital Budgeting: Ranking Problems)
OBJECTIVE: The objective of this case is to explore the ranking differences that may
result from using the PI, NPV, and IRR evaluation techniques. It
illustrates the time disparity, size disparity, and life disparity problems and
the appropriate approaches to the resolution of these problems. This case
works well either as a homework problem coinciding with the introduction
of project ranking and capital-rationing material or as an in-class problem
lecture.

DEGREE OF DIFFICULTY: Moderately Difficult

Question Answers
1. No. While, in general, it is true that when one discounted cash flow method (NPV, PI, or
IRR) gives a project an acceptable rating, the other two methods also give this project an
acceptable rating; it is not necessarily true that these discounted cash flow methods will
rank these acceptable projects in the same order. Ranking differences may occur as a
result of (a) the time disparity problem resulting from differences in the cash inflow
patterns over time between two projects; (b) the size disparity problem, resulting from the
comparison of projects requiring initial cash outflows of differing size; or (c) the life
disparity problem, resulting from projects with differing lives. These problems are
illustrated in the case with Projects A and B representing the time disparity problem, C
and D, the size disparity problem, and with E, F, G, and H, the life disparity problem.
The ranking problems incurred using the discounted cash flow methods are generally a
function of the different assumptions made about the reinvestment opportunities for cash
inflows over the life of the project.

2. Project A Project B
NPV = $34,015.40 NPV = $31,932.40
PI = 1.4535 PI = 1.4258
IRR = 27.1949% IRR = 32.9189%

In this case, the ranking conflicts have come as a result of the different assumptions made
as to the reinvestment opportunities available for cash inflows over the life of the project.
The NPV and PI methods assume that these cash inflows can be reinvested at the cost of
capital, while the IRR method assumes they can be reinvested at the IRR rate. Thus, the
correct investment decision as to acceptance of Project A or B becomes a function of
which assumption is more accurate. When the reinvestment rate is unknown, the more
conservative approach is to use the net present value criterion as it uses the required rate
of return as its reinvestment rate. Since no project will be accepted returning less than
this value, this must be at least a minimum reinvestment rate, and, for this reason, is
preferred. Here Project A should be selected as it has a

306
 higher NPV. If, however, Project B is a typical project, then its IRR of 33% becomes a
good approximation for the reinvestment rate for ranking purposes, and Project B should
then be selected as the IRR assumption now appears more valid. Finally, if it is true that
HPMC’s projects typically yield approximately 12%, then the 33% IRR of Project B is
somewhat overstated for ranking purposes.

3. Project C Project D
NPV = $2,000.00 NPV = $2,727.25
PI = 1.25 PI = 1.136
IRR = 37.5% IRR = 25.0%

In the absence of capital rationing, Project D should be selected as it has the largest net
present value, representing the largest increase to shareholders’ wealth. The net present
value of a project is the net increase in value to the firm provided this project is accepted.
Thus, when there is no explicit limitation on the size of the firm’s capital budget, (i.e., in
the absence of capital rationing) the net present value criterion should be used to solve
the size disparity problem. However, in the case of capital rationing, the decision-making
process is more difficult and becomes a function of the investment opportunities available
for the funds freed up by the acceptance of the smaller project (in this case, the
investment opportunities available on the marginal $12,000). In effect, when a capital-
rationing constraint is imposed upon this problem, the acceptance of Project C provides
the firm with $12,000 more to invest on other projects than would have been available if
the firm had chosen Project D. If the firm can invest this $12,000 in marginal projects
(that is, projects that would have been rejected had the firm accepted Project D) and earn
a return of more than $14,000 on this investment, Project C should be chosen; if it cannot
earn a return of $14,000, Project D should be selected. In effect, the firm should be
indifferent between the selection of Project C (initial outlay of $8,000, cash inflow in
year 1 of $11,000) in conjunction with a marginal project with an initial outlay of
$12,000 and a cash inflow in year 1 of $14,000 and Project D (initial outlay of $20,000
and cash inflow of $25,000 in year 1). In other words, if the firm can earn more than
16.667% on the marginal $12,000, Project C should be selected.

($20,000 - $8,000) = [PVIFIRR%,1 yr] ($25,000 - $11,000)

$12,000 = [PVIFIRR%,1 yr] $14,000

.85714 = [PVIFIRR%,1 yr]

IRR = 16.667%

307
4. Project E Project F
NPV = 160,908.90 NPV = 342,960.00
PI = 6.3636 PI = 2.2632
IRR = 600.0% IRR = 35.0006%
1
(Calculation of IRR for Project E: $30,000 = $210,000
1+ i
(1+ i) = 7
(as i = 6.0 or 600%)
The problem of incomparability of projects with different lives is not directly a result of
the projects having different lives but of the fact that future profitable investment
proposals are affected by the decision currently being made. This can easily be seen in
the replacement problem where two machine replacements with different lives are being
considered. In this case, a comparison of the net present values alone on each of these
projects would be misleading because, if the project with the shorter life is taken, at its
end it would be possible to replace this machine and receive additional benefits, while
acceptance of the project with the longer life would prohibit this possibility. This
situation is portrayed in the next example dealing with Projects G and H.
In the case at hand, the decision to accept one project as opposed to the other does not
affect the ability to accept or reject future projects. Thus, although these projects have
unequal lives, they are comparable. Acceptance of the project with the longer life does
not eliminate any other projects from consideration as is the case in the replacement
problem; thus, while these projects have different lives, they are comparable. As Project
F has the largest net present value, it should be taken.

5. Project G Project H
NPV = $352,930.00 NPV = $421,690.00
PI = 1.7059 PI = 1.8434
IRR = 034.9433% IRR = 27.3198%

In this case, the projects are not comparable because acceptance of the project with the
shorter life provides the firm with the opportunity to replace this machine after five years
and reap additional benefits, while acceptance of the project with the longer life prohibits
this opportunity. In effect, the investment decision made today affects future profitable
investment proposals; thus, the projects are not comparable. There are several methods
to deal with this situation. The first method is to assume that cash inflows will be
reinvested at the discount rate (cost of capital). While this approach is the simplest,
merely calculating the net present value, it actually avoids the problem at hand, that of
allowing for participation in another replacement opportunity with a positive net present
value. The proper solution thus becomes the projection of reinvestment opportunities
into the future, that is, making assumptions as to possible investment opportunities
available in the future. Unfortunately, while the first method is too simplistic to be of any
value, the second method is pragmatically difficult, requiring extensive forecasts. The
final method of dealing with the problem is to assume that reinvestment opportunities in
the future will be similar to the current ones. The most common way of doing this is the

308
creation of a replacement chain to equalize life spans. In this case, it would call for the
creation of a 2-chain cycle for Project G, assuming Project G can be replaced with a
project similar to itself at the end of 5 years. Alternatively, this can be solved through the
creation of annual equivalents (i.e., the annuity value over the life of the project that is
equivalent to the project’s NPV. In the case of Project G, it is the 5-year annuity given
the discount rate of 10% that has a NPV of $352,930.00 As these two approaches make
identical assumptions, they will provide identical results. These values for Projects G
and H are as follows:

Replacement Chain NPV

Project G Project H
Year Cash Flow PV Year Cash Flow PV
0 -$500,000 -$500,000 0 -$500,000 -$500,000
1-5 225,000 852,930 1-10 150,000 921,690
5 - 500,000 - 310,460 NPV $421,690
6-10 225,000 529,605
NPV $572,075

Annual Equivalents
Project G Project H
NPV = $352,930.00 NPV = $421,690.00
Present Value factor 10% Present Value factor 10%
for 5 years = 3.7908 for 10 years = 6.1446
Annual Equivalent = X Annual Equivalent = X

$352,930 = 3.7908 (X) $421,690 = 6.1446 (X)

X = $93,101.72 X = $68,627.74

Thus, the appropriate decision is the acceptance of Project G.

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 ALTERNATIVE PROBLEMS AND SOLUTIONS
ALTERNATIVE PROBLEMS

9-1A. (IRR Calculation) Determine the internal rate of return on the following projects:
a. An initial outlay of $10,000 resulting in a single cash flow of $19,926 after 8 years
b. An initial outlay of $10,000 resulting in a single cash flow of $20,122 after 12
years
c. An initial outlay of $10,000 resulting in a single cash flow of $121,000 after 22
years
d. An initial outlay of $10,000 resulting in a single cash flow of $19,254 after 5 years
9-2A. (IRR Calculation) Determine the internal rate of return on the following projects:
a. An initial outlay of $10,000 resulting in a cash flow of $2,146 at the end of each
year for the next 10 years
b. An initial outlay of $10,000 resulting in a cash flow of $1,960 at the end of each
year for the next 20 years
c. An initial outlay of $10,000 resulting in a cash flow of $1,396 at the end of each
year for the next 12 years
d. An initial outlay of $10,000 resulting in a cash flow of $3,197 at the end of each
year for the next 5 years
9-3A. (IRR Calculation) Determine the internal rate of return to the nearest percent on the
following projects:
a. An initial outlay of $10,000 resulting in a cash flow of $3,000 at the end of year 1,
$5,000 at the end of year 2, and $7,500 at the end of year 3.
b. An initial outlay of $12,000 resulting in a cash flow of $9,000 at the end of year 1,
$6,000 at the end of year 2, and $2,000 at the end of year 3.
c. An initial outlay of $8,000 resulting in a cash flow of $2,000 at the end of years 1
through 5, and $5,000 at the end of year 6.
9-4A. (NPV, PI, and IRR Calculations) Gecewich, Inc. is considering a major expansion of its
product line and has estimated the following cash flows associated with such an
expansion. The initial outlay associated with the expansion would be $2,500,000, and the
project would generate incremental after-tax cash flows of $750,000 per year for 6 years.
The appropriate required rate of return is 11%.
a. Calculate the net present value.
b. Calculate the profitability index.
c. Calculate the internal rate of return.
d. Should this project be accepted?
9-5A. No alternative problem available.

310
9-6A. No alternative problem available.
9-7A. No alternative problem available.
9-8A. No alternative problem available.
9-9A. (Internal Rate of Return Calculation) Given the following cash flows, determine the
internal rate of return for projects A, B, and C.

Project A Project B Project C

Initial Investment: $75,000 $95,000 $395,000
Cash Inflows:
Year 1 $10,000 25,000 150,000
Year 2 10,000 25,000 150,000
Year 3 30,000 25,000 150,000
Year 4 25,000 25,000 —
Year 5 30,000 25,000
9-10A. (NPV with Varying Required Rates of Return) Bert’s, makers of gourmet corn dogs, is
considering the purchase of a new plastic stamping machine. This investment requires an
initial outlay of $150,000 and will generate after-tax cash inflows of $25,000 per year for
10 years. For each of the listed required rates of return, determine the project’s net
present value.
a. The required rate of return is 9%.
b. The required rate of return is 15%.
c. Would the project be accepted under part a or b?
d. What is the project’s internal rate of return?
9-11A. (Size Disparity Ranking Problem) The Unk’s Farms Corporaton is considering
purchasing one of two fertilizer-herbicides for the upcoming year. The more expensive of
the two is the better and will produce a higher yield. Assume these projects are mutually
exclusive and that the required rate of return is 10%. Given the following after-tax net
cash flows:

Year Project A Project B

0 –$650 –$4,000
1 800 5,500
a. Calculate the net present value.
b. Calculate the profitability index.
c. Calculate the internal rate of return.
d. If there is no capital-rationing constraint, which project should be selected? If there
is a capital-rationing constraint, how should the decision be made?

311
9-12A. (Time Disparity Ranking Problem) The Z. Bello Corporation is considering two mutually
exclusive projects. The cash flows associated with those projects are as follows:
Year Project A Project B
0 –$50,000 –$50,000
1 16,000 0
2 16,000 0
3 16,000 0
4 16,000 0
5 16,000 $100,000

The required rate of return on these projects is 11%.

a. What is each project’s payback period?
b. What is each project’s net present value?
c. What is each project’s internal rate of return?
d. What has caused the ranking conflict?
e. Which project should be accepted? Why?

9-13A. (Unequal Lives Ranking Problem) The Battling Bishops Corporation is considering two
mutually exclusive pieces of machinery that perform the same task. The two alternatives
available provide the following set of after-tax net cash flows:

Year Equipment A Equipment B

0 –$20,000 –$20,000
1 13,000 6,500
2 13,000 6,500
3 13,000 6,500
4 6,500
5 6,500
6 6,500
7 6,500
8 6,500
9 6,500

Equipment A has an expected life of 3 years, whereas equipment B has an expected life
of 9 years. Assume a required rate of return of 14%.
a. Calculate each project’s payback period.
b. Calculate each project’s net present value.
c. Calculate each project’s internal rate of return.
d. Are these projects comparable?
e. Compare these projects using replacement chains and EAAs. Which project should
be selected? Support your recommendation.

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9-14A. (EAAs) The Anduski Corporation is considering two mutually exclusive projects, one
with a 5-year life and one with a 7-year life. The after-tax cash flows from the two
projects are as follows:

Year Project A Project B

0 –$40,000 –40,000
1 20,000 25,000
2 20,000 25,000
3 20,000 25,000
4 20,000 25,000
5 20,000 25,000
6 20,000
7 20,000
a. Assuming a 10% required rate of return on both projects, calculate each project’s
EAA. Which project should be selected?
b. Calculate the present value of an infinite-life replacement chain for each project.

9-15A. (Capital Rationing) The Taco Toast Company is considering seven capital investment
proposals, for which the funds available are limited to a maximum of $12 million. The
projects are independent and have the following costs and profitability indexes
associated with them:

Profitability
Project Cost Index
A $4,000,000 1.18
B 3,000,000 1.08
C 5,000,000 1.33
D 6,000,000 1.31
E 4,000,000 1.19
F 6,000,000 1.20
G 4,000,000 1.18
a. Under strict capital rationing, which projects should be selected?
b. What problems are associated with imposing capital rationing?

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SOLUTIONS TO ALTERNATIVE PROBLEMS
9-1A. a. IO = FCFt [PVIFIRR%,t yrs]

$10,000 = $19,926 [PVIFIRR%,8 yrs]

0.502 = PVIFIRR%,8 yrs

Thus, IRR = 9%
b. $10,000 = $20,122 [PVIFIRR%,12 yrs]

0.497 = PVIFIRR%,12 yrs

Thus, IRR = 6%
c. $10,000 = $121,000 [PVIFIRR%,22 yrs]

0.083 = PVIFIRR%,22 yrs

Thus, IRR = 12%

d. $10,000 = $19,254 [PVIFIRR%,5 yrs]

.519 = PVIFIRR%,5 yrs

Thus, IRR = 14%

9-2A. a. IO = ACFt [PVIFAIRR%,t yrs]

$10,000 = $2,146 [PVIFAIRR%,10 yrs]

4.659 = PVIFAIRR%,10 yrs

Thus, IRR = 17%

b. $10,000 = $1,960 [PVIFAIRR%,20 yrs]

5.102 = PVIFAIRR%,20 yrs

Thus, IRR = 19%

c. $10,000 = $1,396 [PVIFAIRR%,12 yrs]

7.163 = PVIFAIRR%,12 yrs]

Thus, IRR = 9%
d. $10,000 = $3,197 [PVIFAIRR%,5 yrs]

3.128 = PVIFAIRR%,5 yrs

Thus, IRR = 18%

314
 $3,000 $5,000 $7,500
9-3A. a. $10,000 = + +
(1 + IRR )1 (1 + IRR) 2 (1 + IRR ) 3
Try 21%:
$10,000 = $3,000(0.826) + $5,000 (0.683) + $7,500 (0.564)
= $2,478+ $3,415 + $4,230
= $10,123
Try 22%
$10,000 = $3,000 (0.820) + $5,000 (0.672) + $7,500 (0.551)
= $2,460 + $3,360 + $4,132.50
= $9,952.50
Thus, IRR = approximately 22%
$9,000 $6,000 $2,000
b. $12,000 = + +
(1 + IRR )1 (1 + IRR ) 2 (1 + IRR) 3
Try 25%
$12,000 = $9,000 (0.800) + $6,000 (0.640) + $2,000 (0.512)
= $7,200 + $3,840 + $1,024
= $12,064
Try 26%:
$12,000 = $9,000 (0.794) + $6,000 (0.630) + $2,000 (0.500)
= $7,146 + $3,780 + $1,000
= $11,926
Thus, IRR = approximately 25% - 26%
5 $2,000 $5,000
c. $8,000 = ∑ +
t = 1 (1 + IRR )
t
(1 + IRR) 6
Try 18%
$8,000 = $2,000 (3.127) + $5,000 (0.370)
= $6,254 + $1,850
= $8,104
Try 19%
$8,000 = $2,000 (3.058) + $5,000 (0.352)
= $6,116 + $1,760
= $7,876
Thus, IRR = approximately 18%-19%

315
 6 $750,000
9-4A. a. NPV = ∑ - $2,500,000
t = 1 (1 + .11)
t

= $750,000 (4.231) - $2,500,000

= $3,173,250 - $2,500,000
= $673,250
$3,173,250
b. PI =
$2,500,000
= 1.2693
c. $2,500,000 = $750,000 [PVIFAIRR%,6 yrs]

3.333 = PVIFAIRR%,6 yrs

IRR = about 20% (19.90%)

d. Yes, the project should be accepted.

9-5A. No alternative problem available.

9-6A. No alternative problem available.

9-7A. No alternative problem available.

9-8A. No alternative problem available.

9-9A. Project A:

$10,000 $10,000 $30,000

$75,000 = + +
(1 + IRR A )1 (1 + IRR A ) 2 (1 + IRR A ) 3
$25,000 $30,000
+ +
(1 + IRR A ) 4 (1 + IRR A ) 5
Try 10%
$75,000 = $10,000(.909) + $10,000(.826) + $30,000(.751)
+ $25,000(.683) + $30,000(.621)
= $9,090 + $8,260 + $22,530 + $17,075 + $18,630
= $75,585
Try 11%
$75,000 = $10,000(.901) + $10,000(.812) +$30,000(.731)
+ $25,000(.659) + $30,000(.593)
= $9,010 + $8,120 + $21,930+ $16,475 + $17,790
= $73,325

316
 Thus, IRR = just over 10%

Project B:
$95,000 = $25,000 [PVIFAIRR%,5 yrs]

3.80 = PVIFAIRR%,5 yrs

Thus, IRR = just below 10%

Project C:
$395,000 = $150,000 [PVIFAIRR%,3 yrs]

2.633 = PVIFAIRR%,3 yrs

Thus, IRR = just below 7%

10 $25,000
9-10A. a. NPV = ∑ - $150,000
t = 1 (1 + .09 )
t

= $25,000(6.418) - $150,000
= $160,450 - $150,000
= $10,450
10 $25,000
b. NPV = ∑ - $150,000
t = 1 (1 + .15 )
t

= $25,000(5.019) - $150,000
= $125,475 - $150,000
= -$24,525
c. If the required rate of return is 9%, the project is acceptable in part a. It should be
rejected in part b with a negative NPV.
d. $150,000 = $25,000 [PVIFAIRR%,10 yrs]

6.000 = PVIFAIRR%,10 yrs

IRR = Between 10% and 11% (10.558%)

$800
9-11A. a. NPVA = - $650
(1 + 0.10)1
= $727.20 - $650
= $77.20

317
 $5,500
NPVB = - $4,000
(1 + 0.10)1
= $5,000 - $4,000
= $1,000
$727.20
b. PIA =
$650.00
= 1.1188
$5,000
PIB =
$4,000
= 1.25
c. $650 = $800 [PVIFIRR %,1 yr]
A
0.8125 = PVIFIRR %,1 yr
A
Thus, IRRA = 23%
$4,000 = $5,500 [PVIFIRR %,1 yr]
B
0.7273 = [PVIFIRR %,1 yr]
B
Thus, IRRB = 38%
d. If there is no capital rationing, project B should be accepted because it has a
larger net present value. If there is a capital constraint, the problem then focuses
on what can be done with the additional $3,350 freed up if project A is chosen. If
Unk’s Farms can earn more on project A, plus the project financed with the
additional $3,350, than it can on project B, then project A and the marginal
project should be accepted.
9-12A. a. Payback A = 3.125 years
Payback B = 4.5 years
B assumes even cash flow throughout year 5.
5 $16,000
b. NPVA = ∑ - $50,000
t = 1 (1 + 0.11)
t

= $16,000 (3.696) - $50,000

= $59,136 - $50,000
= $9,136

318
 $100,000
NPVB = - $50,000
(1 + 0.11) 5
= $100,000 (0.593) - $50,000
= $59,300 - $50,000
= $9,300
c. $50,000 = $16,000 [PVIFAIRR %,5 yrs]
A
3.125 = PVIFAIRR %,5 yrs
A
Thus, IRRA = 18%
$50,000 = $100,000 [PVIFIRR %,5 yrs]
B
.50 = PVIFIRR %,5 yrs
B
Thus, IRRB is just under 15%.
d. The conflicting rankings are caused by the differing reinvestment assumptions
made by the NPV and IRR decision criteria. The NPV criteria assume that cash
flows over the life of the project can be reinvested at the required rate of return or
cost of capital, while the IRR criterion implicitly assumes that the cash flows over
the life of the project can be reinvested at the internal rate of return.
e. Project B should be taken, because it has the largest NPV. The NPV criterion is
preferred because it makes the most acceptable assumption for the wealth-
maximizing firm.
9-13A. a. Payback A = 1.5385 years
Payback B = 3.0769 years
3 $13,000
b. NPVA = ∑ - $20,000
t = 1 (1 + 0.14 )
t

= $13,000 (2.322) - $20,000

= $30,186 - $20,000
= $10,186
9 $6,500
NPVB = ∑ - $20,000
t = 1 (1 + 0.14 )
t

= $6,500 (4.946) - $20,000

= $32,149 - $20,000
= $12,149

319
c. $20,000 = $13,000 [PVIFAIRR %,3 yrs]
A
Thus, IRRA = over 40% (42.75%)
$20,000 = $6,500 [PVIFAIRR %,9 yrs]
B
Thus, IRRB = 29%
d. These projects are not comparable, because future profitable investment proposals
are affected by the decision currently being made. If project A is taken, at its
termination, the firm could replace the machine and receive additional benefits,
while acceptance of project B would exclude this possibility.
e. Using 3 replacement chains, project A’s cash flows would become:
Year Cash flow
0 -$20,000
1 13,000
2 13,000
3 - 7,000
4 13,000
5 13,000
6 - 7,000
7 13,000
8 13,000
9 13,000
9 $13,000 $20,000 $20,000
NPVA = ∑ - $20,000 - -
t = 1 (1 + 0.14 )
t
(1 + 0.14) 3 (1 + 0.14) 6
= $13,000(4.946) - $20,000 - $20,000 (0.675)
- $20,000 (0.456)
= $64,298 - $20,000 - $13,500 - $9,120
= $21,678
The replacement chain analysis indicated that project A should be selected since the
replacement chain associated with it has a larger NPV than project B.
Project A’s EAA:
Step 1: Calculate the project’s NPV (from part b):
NPVA = $10,186
Step 2: Calculate the EAA:
EAAA = NPV / PVIFA14%, 3 yr.
= $10,186 / 2.322
= $4,387
Project B’s EAA:
Step 1: Calculate the project’s NPV (from part b):
NPVB = $12,149

320
 Step 2: Calculate the EAA:
EAAB = NPV / PVIFA14%, 9 yr.

= $12,149 / 4.946
= $2,256
Project B should be selected because it has a higher EAA.
9-14A. a. Project A’s EAA:
Step 1: Calculate the project’s NPV:
NPVA = $20,000 (PVIFA10%, 7 yr.) - $40,000
= $20,000 (4.868) - $40,000
= $97,360 - $40,000
= $57,360
Step 2: Calculate the EAA:
EAAA = NPV / PVIFA10%, 7 yr.
= $57,360 / 4.868
= $11,783
Project B’s EAA:
Step 1: Calculate the project’s NPV:
NPVB = $25,000 (PVIFA10%, 5 yr.) - $40,000

= $25,000 (3.791) - $40,000

= $94,775 - $40,000
= $54,775
Step 2: Calculate the EAA:
EAAB = NPV / PVIFA10%, 5 yr.
= $54,775 / 3.791
= $14,449
Project B should be selected because it has a higher EAA.
b. NPV∞,A = $11,783 / .10
= $117,830
NPV∞,B = $14,449 / .10
= $144,490

321
9-15A. a.
Present Value
Profitability of Future
Project Cost Index Cash Flows NPV
A $4,000,000 1.18 $4,720,000 $ 720,000
B 3,000,000 1.08 3,240,000 240,000
C 5,000,000 1.33 6,650,000 1,650,000
D 6,000,000 1.31 7,860,000 1,860,000
E 4,000,000 1.19 4,760,000 760,000
F 6,000,000 1.20 7,200,000 1,200,000
G 4,000,000 1.18 4,720,000 720,000

Combinations with Total Costs Below $12,000,000

Projects Costs NPV

A&B $ 7,000,000 $ 960,000
A&C 9,000,000 2,370,000
A&D 10,000,000 2,580,000
A&E 8,000,000 1,480,000
A&F 10,000,000 1,920,000
A&G 8,000,000 1,440,000
B&C 8,000,000 1,890,000
B&D 9,000,000 2,100,000
B&E 7,000,000 1,000,000
B&F 9,000,000 1,440,000
B&G 7,000,000 960,000
C&D 11,000,000 3,510,000
C&E 9,000,000 2,410,000
C&F 11,000,000 2,850,000
C&G 9,000,000 2,370,000
D&E 10,000,000 2,620,000
D&F 12,000,000 3,060,000
D&G 10,000,000 2,580,000
E&F 10,000,000 1,960,000
E&G 8,000,000 1,480,000
F&G 10,000,000 1,920,000
A&B&C 12,000,000 2,610,000
A&B&E 11,000,000 1,720,000
A&B&G 11,000,000 1,680,000
A&E&G 12,000,000 2,200,000
B&C&E 12,000,000 2,650,000
B&C&G 12,000,000 2,610,000
Thus, projects C&D should be selected under strict capital rationing as they provide the
combination of projects with the highest net present value.
b. Because capital rationing forces the rejection of profitable projects, it is not an
optimal strategy.

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