Problems

1. Payback [Link] the cash flows of the four projects, A, B, C, and D, and using
the payback period decision model, which projects do you accept and which projects
do you reject with a three-year cutoff period for recapturing the initial cash outflow?
Assume that the cash flows are equally distributed over the year.

ANSWER
Project A:
Year One: -$10,000 + $4,000 = $6,000 left to recover
Year Two: -$6,000 + $4,000 = $2,000 left to recover
Year Three: -$2,000 + $4,000 = fully recovered
Year Three: $2,000 / $4,000 = ½ year needed for recovery
Payback Period for Project A: 2 and ½ years, ACCEPT!
Project B:
Year One: -$25,000 + $2,000 = $23,000 left to recover
Year Two: -$23,000 + $8,000 = $15,000 left to recover
Year Three: -$15,000 + $14,000 = $1,000 left to recover
Year Four: -$1,000 + $20,000 = fully recovered
Year Four: $1,000 / $20,000 = 1/20 year needed for recovery
Payback Period for Project B: 3 and 1/20 years, REJECT!
Project C:
Year One: -$45,000 + $10,000 = $35,000 left to recover
Year Two: -$35,000 + $15,000 = $20,000 left to recover
Year Three: -$20,000 + $20,000 = fully recovered
Year Three: $20,000 / $20,000 = full year needed

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Payback Period for Project B: 3 years, ACCEPT!

Project D:
Year One: -$100,000 + $40,000 = $60,000 left to recover
Year Two: -$60,000 + $30,000 = $30,000 left to recover
Year Three: -$30,000 + $20,000 = $10,000 left to recover
Year Four: -$10,000 + $10,000 = fully recovered
Year Four: $10,000 / $10,000 = full year needed
Payback Period for Project B: 4 years, REJECT!

2. Payback [Link] are the payback periods of Projects E, F, G and H? Assume all
the cash flows are evenly spread throughout the year. If the cutoff period is three
years, which projects do you accept?

ANSWER
Project E:
Year One: -$40,000 + $10,000 = $30,000 left to recover
Year Two: -$30,000 + $10,000 = $20,000 left to recover
Year Three: -$20,000 + $10,000 = $10,000 left to recover
Year Four: -$10,000 + $10,000 = fully recovered
Year Four: $10,000 / $10,000 = full year needed
Payback Period for Project E: 4 years
Project F:
Year One: -$250,000 + $40,000 = $210,000 left to recover
Year Two: -$210,000 + $120,000 = $90,000 left to recover
Year Three: -$90,000 + $200,000 = fully recovered
Year Three: $90,000 / $200,000 = 0.45 year needed

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Payback Period for Project F: 2.45 years

Project G:
Year One: -$75,000 + $20,000 = $55,000 left to recover
Year Two: -$55,000 + $35,000 = $20,000 left to recover
Year Three: -$20,000 + $40,000 = fully recovered
Year Three: $20,000 / $40,000 = 0.5 year needed
Payback Period for Project G: 2.5 years
Project H:
Year One: -$100,000 + $30,000 = $70,000 left to recover
Year Two: -$70,000 + $30,000 = $40,000 left to recover
Year Three: -$40,000 + $30,000 = $10,000 left to recover
Year Four: -$10,000 + $20,000 = fully recovered
Year Four: $10,000 / $20,000 = 0.5 year needed
Payback Period for Project H: 3.5 years
With a three year cut-off period, ACCEPT F and G, REJECT E and H.

3. Discounted payback [Link] the following four projects and their cash flows,
calculate the discounted payback period with a 5% discount rate, 10% discount rate,
and 20% discount rate. What do you notice about the payback period as the discount
rate rises? Explain this relationship.

ANSWER
Solution at 5% discount rate
Project A:
PV Cash flow year one -- $4,000 / 1.05 = $3,809.52
PV Cash flow year two -- $4,000 / 1.052 = $3,628.12

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PV Cash flow year three -- $4,000 / 1.053 = $3,455.35

PV Cash flow year four -- $4,000 / 1.054 = $3,290.81
PV Cash flow year five -- $4,000 / 1.055 = $3,134.10
PV Cash flow year six -- $4,000 / 1.056 = $2,984.86
Discounted Payback Period: -$10,000 + $3,809.52 + $3,628.12 + $3,455.35 = $892.99
and fully recovered
Discounted Payback Period is 3 years.
Project B:
PV Cash flow year one -- $2,000 / 1.05 = $1,904.76
PV Cash flow year two -- $8,000 / 1.052 = $7,256.24
PV Cash flow year three -- $14,000 / 1.053 = $12,093.73
PV Cash flow year four -- $20,000 / 1.054 = $16,454.05
PV Cash flow year five -- $26,000 / 1.055 = $20,371.68
PV Cash flow year six -- $32,000 / 1.056 = $23,878.89
Discounted Payback Period: -$25,000 + $1,904.76 + $7,256.24 + $12,093.73 +
$16,454.05 = $12,708.78 and fully recovered
Discounted Payback Period is 4 years.
Project C:
PV Cash flow year one -- $10,000 / 1.05 = $9,523.81
PV Cash flow year two -- $15,000 / 1.052 = $13,605.44
PV Cash flow year three -- $20,000 / 1.053 = $17,276.75
PV Cash flow year four -- $20,000 / 1.054 = $16,454.05
PV Cash flow year five -- $15,000 / 1.055 = $11,752.89
PV Cash flow year six -- $10,000 / 1.056 = $7,462.15
Discounted Payback Period: -$45,000 + $9,523.81 + $13,605.44 + $17,276.75 +
$16,454.05 = $11,860.05 and fully recovered
Discounted Payback Period is 4 years.
Project D:
PV Cash flow year one -- $40,000 / 1.05 = $38,095.24
PV Cash flow year two -- $30,000 / 1.052 = $27,210.88
PV Cash flow year three -- $20,000 / 1.053 = $17,276.75
PV Cash flow year four -- $10,000 / 1.054 = $8,227.02
PV Cash flow year five -- $10,000 / 1.055 = $7,835.26
PV Cash flow year six -- $0 / 1.056 = $0

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Discounted Payback Period: -$100,000 + $38,095.24 + $27,210.88 + $17,276.75 +

$8,227.02 + $7,835.26 = -$1,354.84 i.e. This project’s cost is NEVER fully recovered.
Solution at 10% discount rate
Project A:
PV Cash flow year one -- $4,000 / 1.10 = $3,636.36
PV Cash flow year two -- $4,000 / 1.102 = $3,307.79
PV Cash flow year three -- $4,000 / 1.103 = $3,005.26
PV Cash flow year four -- $4,000 / 1.104 = $2,732.05
PV Cash flow year five -- $4,000 / 1.105 = $2,483.69
PV Cash flow year six -- $4,000 / 1.106 = $2,257.90
Discounted Payback Period: -$10,000 + $3,636.36 + $3,307.79 + $3,005.26 + $2,732.05
= $2,679.46 and fully recovered
Discounted Payback Period is 4 years.
Project B:
PV Cash flow year one -- $2,000 / 1.10 = $1,818.18
PV Cash flow year two -- $8,000 / 1.102 = $6,611.57
PV Cash flow year three -- $14,000 / 1.103 = $10,518.41
PV Cash flow year four -- $20,000 / 1.104 = $13,660.27
PV Cash flow year five -- $26,000 / 1.105 = $16,143.95
PV Cash flow year six -- $32,000 / 1.106 = $18,063.17
Discounted Payback Period: -$25,000 + $1,818.18 + $6,611.57 + $10,518.41 +
$13,660.27 = $7,608.43 and fully recovered
Discounted Payback Period is 4 years.
Project C:
PV Cash flow year one -- $10,000 / 1.10 = $9,090.91
PV Cash flow year two -- $15,000 / 1.102 = $12,396.69
PV Cash flow year three -- $20,000 / 1.103 = $15,026.30
PV Cash flow year four -- $20,000 / 1.104 = $13,660.27
PV Cash flow year five -- $15,000 / 1.105 = $9,313.82
PV Cash flow year six -- $10,000 / 1.106 = $5,644.74
Discounted Payback Period: -$45,000 + $9,090.91 + $12,396.69 + $15,026.20 +
$13,660.27 = $5174.07 and fully recovered
Discounted Payback Period is 4 years.

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Project D:
PV Cash flow year one -- $40,000 / 1.10 = $36,363.64
PV Cash flow year two -- $30,000 / 1.102 = $24,793.39
PV Cash flow year three -- $20,000 / 1.103 = $15,026.30
PV Cash flow year four -- $10,000 / 1.104 = $6,830.13
PV Cash flow year five -- $10,000 / 1.105 = $6,209.21
PV Cash flow year six -- $0 / 1.106 = $0
Discounted Payback Period: -$100,000 + $36,363.64 + $24,793.29 + $15,026.30 +
$6,830.13 + $6,209.21 = -$10,777.3 and never recovered.
Initial cash outflow is never recovered.
Solution at 20% discount rate
Project A:
PV Cash flow year one -- $4,000 / 1.20 = $3,333.33
PV Cash flow year two -- $4,000 / 1.202 = $2,777.78
PV Cash flow year three -- $4,000 / 1.203 = $2,314.81
PV Cash flow year four -- $4,000 / 1.204 = $1,929.01
PV Cash flow year five -- $4,000 / 1.205 = $1,607.51
PV Cash flow year six -- $4,000 / 1.206 = $1,339.59
Discounted Payback Period: -$10,000 + $3,333.33 + $2,777.78 + $2,314.81+ $1,929.01 =
$354.93 and fully recovered
Discounted Payback Period is 4 years.
Project B:
PV Cash flow year one -- $2,000 / 1.20 = $1,666.67
PV Cash flow year two -- $8,000 / 1.202 = $5,555.56
PV Cash flow year three -- $14,000 / 1.203 = $8,101.85
PV Cash flow year four -- $20,000 / 1.204 = $9,645.06
PV Cash flow year five -- $26,000 / 1.205 = $10,448.82
PV Cash flow year six -- $32,000 / 1.206 = $10,716.74
Discounted Payback Period: -$25,000 + $1,666.67 + $5,555.56 + $8,101.85 + $9,645.06
+ $10,448.82 = $10,417.96 and fully recovered
Discounted Payback Period is 5 years.
Project C:
PV Cash flow year one -- $10,000 / 1.20 = $8,333.33

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PV Cash flow year two -- $15,000 / 1.202 = $10,416.67

PV Cash flow year three -- $20,000 / 1.203 = $11,574.07
PV Cash flow year four -- $20,000 / 1.204 = $9,645.06
PV Cash flow year five -- $15,000 / 1.205 = $6,028.16
PV Cash flow year six -- $10,000 / 1.206 = $3,348.97
Discounted Payback Period: -$45,000 + $8,333.33 + $10,416.67 + $11,574.07 +
$9,645.06 + $6,028.16 = $997.29 and fully recovered
Discounted Payback Period is 5 years.
Project D:
PV Cash flow year one -- $40,000 / 1.20 = $33,333.33
PV Cash flow year two -- $30,000 / 1.202 = $20,833.33
PV Cash flow year three -- $20,000 / 1.203 = $11,574.07
PV Cash flow year four -- $10,000 / 1.204 = $4,822.53
PV Cash flow year five -- $10,000 / 1.205 = $4,018.78
PV Cash flow year six -- $0 / 1.206 = $0
Discounted Payback Period: -$100,000 + $33,333.33 + $20,833.33+ $11,574.07 +
$4,822.53 + $4,018.78 = -$25,417.95 and initial cost is never recovered.
Discounted Payback Period is infinity.
As the discount rate increases, the Discounted Payback Period also increases. The reason
is that the future dollars are worth less in present value as the discount rate increases,
requiring more future dollars to recover the present value of the outlay.

4. Discounted payback [Link] Inc. uses discounted payback period for projects
under $25,000 and has a cut off period of 4 years for these small value projects. Two
projects, R and S, are under consideration. The anticipated cash flows for these two
projects are listed below. If Becker Incorporated uses an 8% discount rate on these
projects, are they accepted or rejected? If it uses 12% discount rate? A 16% discount
rate? Why is it necessary to only look at the first four years of the projects’ cash
flows?

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ANSWER
Solution at 8%
Project R:
PV Cash flow year one -- $6,000 / 1.08 = $5,555.56
PV Cash flow year two -- $8,000 / 1.082 = $6,858.71
PV Cash flow year three -- $10,000 / 1.083 = $7,938.32
PV Cash flow year four -- $12,000 / 1.084 = $8,820.36
Discounted Payback Period: -$24,000 + $5,555.56 + $6,858.71 + $7,938.32 + $8,820.36
= $5,172.95 and initial cost is recovered in first four years, project accepted.
Project S:
PV Cash flow year one -- $9,000 / 1.08 = $8,333.33
PV Cash flow year two -- $6,000 / 1.082 = $5,144.03
PV Cash flow year three -- $6,000 / 1.083 = $4,762.99
PV Cash flow year four -- $3,000 / 1.084 = $2,205.09
Discounted Payback Period: -$18,000 + $8,333.33 + $5,144.03 + $4,762.99 = $240.36
and initial cost is recovered in first three years, project accepted.
Solution at 12%
Project R:
PV Cash flow year one -- $6,000 / 1.12 = $5,357.14
PV Cash flow year two -- $8,000 / 1.122 = $6,377.55
PV Cash flow year three -- $10,000 / 1.123 = $7,117.80
PV Cash flow year four -- $12,000 / 1.124 = $7,626.22
Discounted Payback Period: -$24,000 + $5,357.14 + $6,377.55 + $7,117.8 + $7,626.22 =
$2,478.71 and initial cost is recovered in first four years, project accepted.
Project S:
PV Cash flow year one -- $9,000 / 1.12 = $8,035.71
PV Cash flow year two -- $6,000 / 1.122 = $4,783.16
PV Cash flow year three -- $6,000 / 1.123 = $4,270.68
PV Cash flow year four -- $3,000 / 1.124 = $1,906.55
Discounted Payback Period: -$18,000 + $8,035.71 + $4,783.16 + $4,270.68 + $1,906.55
= $996.10 and initial cost is recovered in first four years, project accepted.
Solution at 16%
Project R:
PV Cash flow year one -- $6,000 / 1.16 = $5,172.41

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PV Cash flow year two -- $8,000 / 1.162 = $5,945.30

PV Cash flow year three -- $10,000 / 1.163 = $6,406.58
PV Cash flow year four -- $12,000 / 1.164 = $6,627.49
Discounted Payback Period: -$24,000 + $5,172.41 + $5,945.30 + $6,406.58 + $6,627.49
= $151.78 and initial cost is recovered in first four years, project accepted.
Project S:
PV Cash flow year one -- $9,000 / 1.16 = $7,758.62
PV Cash flow year two -- $6,000 / 1.162 = $4,458.98
PV Cash flow year three -- $6,000 / 1.163 = $3,843.95
PV Cash flow year four -- $3,000 / 1.164 = $1,656.87
Discounted Payback Period: -$18,000 + $7,758.62 + $4,458.98 + $3,843.95 + $1,656.87
= -$281.58 and initial cost is not recovered in first four years, project rejected. Because
Becker Inc. is using a four year cut-off period, only the first four years of cash flow
matter. If the first four years of anticipated cash flows are insufficient to cover the initial
outlay of cash, the project is rejected regardless of the cash flows in years five and
forward.

5. Comparing payback period and discounted payback [Link] Inc. is debating

using the payback period versus the discounted payback period for small-dollar
projects. The company's information officer has submitted a new computer project
with a $15,000 cost. The cash flow will be $5,000 each year for the next five years.
The cutoff period used by the company is three years. The information officer states
that it doesn't matter which model the company uses for the decision; the project is
clearly acceptable. Demonstrate for the information officer that the selection of the
model does matter.

ANSWER
Calculate the Payback Period for the project:
Payback Period = –$15,000 + $5,000 + $5,000 + $5,000 = 0
So the payback period is 3 years and the project is a go!
Calculate the Discounted Payback Period for the project at any positive discount rate, say
1%...
Present Value of cash flow year one = $5,000 / 1.01 = $4,950.50
Present Value of cash flow year two = $5,000 / 1.012 = $4,901.48
Present Value of cash flow year three = $5,000 / 1.013 = $4,852.95
Discounted Payback Period = -$15,000 + $4,950.50 + $4,901.48 + $4,852.95 = -$295.04
so the payback period is over 3 years and the project is a no-go!

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6. Comparing payback period and discounted payback [Link] Inc. is switching

from the payback period to the discounted payback period for small-dollar projects.
The cutoff period will remain at three years. Given the following four projects' cash
flows and using a 10% discount rate, determine which projects it would have
accepted under the payback period and which it will now reject under the discounted
payback period.

ANSWER
Under the payback period approach, all 4 projects would be accepted since they all had
payback periods that were under 3 years.
Calculate the Discounted Payback Periods of each project at 10% discount rate:
Project One
Present Value of cash flow year one = $4,000 / 1.10 = $3,636.36
Present Value of cash flow year two = $4,000 / 1.102 = $3,305.78 Present Value of cash
flow year three = $4,000 / 1.103 = $3,005.26
Discounted Payback Period = -$10,000 + $3,636.36 + $3,305.78 + $3,005.26 = -$52.60
so the discount payback period is over 3 years and the project is a no-go!
Project Two
Present Value of cash flow year one = $7,000 / 1.10 = $6,363.64
Present Value of cash flow year two = $5,500 / 1.102 = $4,545.46
Present Value of cash flow year three = $4,000 / 1.103 = $3,005.26
Discounted Payback Period = -$15,000 + $6363.64 + $4.545.46 + $3,005.26 = -1,085.64
so the discount payback period is over 3 years and the project is a no-go!
Project Three
Present Value of cash flow year one = $3,000 / 1.10 = $2,272.73
Present Value of cash flow year two = $3,500 / 1.102 = $2,892.56
Present Value of cash flow year three = $4,000 / 1.103 = $3,005.26
Discounted Payback Period = -$8,000 + $2,272.73+ $2,892.56 + $3,005.26 =
$625.55 so the discount payback period is under 3 years and the project is a go!
Project Four
Present Value of cash flow year one = $10,000 / 1.10 = $9,090.91

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Present Value of cash flow year two = $11,000 / 1.102 = $9,090.91

Present Value of cash flow year three = $0 / 1.103 = $0
Discounted Payback Period = -$18,000 + $9,090.91 + $9,090.91 + $0 = $181.82 so the
discount payback period is under 3 years and the project is a go!
Projects one and two will now be rejected using discounted payback period with a
discount rate of 10%.

7. Net present [Link] has a project with the following projected cash
flows:
Initial Cost, Year 0: $240,000
Cash flow year one: $25,000
Cash flow year two: $75,000
Cash flow year three: $150,000
Cash flow year four: $150,000
a. Using a 10% discount rate for this project and the NPV model, determine whether the
company should accept or reject this project?
b. Should the company accept or reject it using a 15% discount rate?
c. Should the company accept or reject it using a 20% discount rate?

ANSWER
(a)
NPV = -$240,000 + $25,000/1.10 + $75,000/1.102 + $150,000/1.103 + $150,000/1.104
NPV = -$240,000 + $22,727.27 + $61,983.47 + $112,697.22 + $102,452.02
NPV = $59,859.98 and accept the project.
(b)
NPV = -$240,000 + $25,000/1.15 + $75,000/1.152 + $150,000/1.153 + $150,000/1.154
NPV = -$240,000 + $21,739.13 + $56,710.76 + $98,627.43 + $85,762.99
NPV = $22,840.31 and accept the project.
(c)
NPV = -$240,000 + $25,000/1.20 + $75,000/1.202 + $150,000/1.203 + $150,000/1.204
NPV = -$240,000 + $20,833.33 + $52,083.33 + $86,805.56 + $72,337.96
NPV = -$7,939.82 and reject the project.

8. Net present [Link] Industries has a project with the following projected cash
flows:
Initial Cost, Year 0: $468,000
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Cash flow year one: $135,000

Cash flow year two: $240,000
Cash flow year three: $185,000
Cash flow year four: $135,000

a. Using an 8% discount rate for this project and the NPV model, determine whether the
company should accept or reject this project?
b. Should the company accept or reject it using a 14% discount rate?
c. Should the company accept or reject it using a 20% discount rate?

ANSWER
(a)
NPV = -$468,000 + $135,000/1.08 + $240,000/1.082 + $185,000/1.083 + $135,000/1.084
NPV = -$468,000 + $125,000.00 + $205,761.32 + $146,858.96 + $99,229.03
NPV = $108,849.31 and accept the project.
(b)
NPV = -$468,000 + $135,000/1.14 + $240,000/1.142 + $185,000/1.143 + $135,000/1.144
NPV = -$468,000 + $118,421.05 + $184,672.21 + $124,869.73 + $79,930.84
NPV = $39,893.83 and accept the project.
(c)
NPV = -$468,000 + $135,000/1.20 + $240,000/1.202 + $185,000/1.203 + $135,000/1.204
NPV = -$468,000 + $112,500.00 + $166,666.67 + $107,060.19 + $65,104.17
NPV = -$16,668.97 and reject the project.

9. Net present [Link] Industries has four potential projects, all with an initial cost
of $2,000,000. The capital budget for the year will allow Quark Industries to accept
only one of the four projects. Given the discount rates and the future cash flows of
each project, determine which project Quark should accept.

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ANSWER
Find the NPV of each project and compare the NPVs.
Project M’s NPV = -$2,000,000 + $500,000/1.06 + $500,000/1.062 + $500,000/1.063 +
$500,000/1.064 + $500,000/1.065
Project M’s NPV = -$2,000,000 + $471,698.1 + $444,998.2 + $419,809.60 + $396,046.8
+ $373,629.1
Project N’s NPV = $106,181.9
Project N’s NPV = -$2,000,000 + $600,000/1.09 + $600,000/1.092 + $600,000/1.093 +
$600,000/1.094 + $600,000/1.095
Project N’s NPV = -$2,000,000 + $550,458.72 + $505,008.00 + $463,331.09 +
$425,055.13 + $389,958.83
Project N’s NPV = $333,790.77
Project O’s NPV = -$2,000,000 + $1,000,000/1.15 + $800,000/1.152 + $600,000/1.153 +
$400,000/1.154 + $200,000/1.155
Project O’s NPV = -$2,000,000 + $869,565.22 + $604,914.93 + $394,509.74 +
$228,701.30 + $99,435.34
Project O’s NPV = $197,126.53
Project P’s NPV = -$2,000,000 + $300,000/1.22 + $500,000/1.222 + $700,000/1.223 +
$900,000/1.224 + $1,100,000/1.225
Project P’s NPV = -$2,000,000 + $245,901.64 + $335,931.20 + $385,494.82 +
$406,259.18 + $406,999.18
Project P’s NPV =-$219,413.98 (would reject project regardless of budget)
And the ranking order based on NPVs is,
Project N – NPV of $333,790.77
Project O – NPV of $197,126.53
Project M – NPV of $164,738.34
Project P – NPV of -$219,413.98
Swanson Industries should pick Project N.

10. Net present [Link] Industries has four potential projects, all with an initial cost
of $1,500,000. The capital budget for the year will allow Lepton to accept only one of
the four projects. Given the discount rates and the future cash flows of each project,
determine which project Lepton should accept.

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ANSWER
Find the NPV of each project and compare the NPVs.
Project Q’s NPV = -$1,500,000 + $350,000/1.04 + $350,000/1.042 + $350,000/1.043 +
$350,000/1.044 + $350,000/1.045
Project Q’s NPV = -$1,500,000 + $336,538.46 + $323,594.67 + $311,148.73 +
$299,181.47 + $287,674.49
Project Q’s NPV = $58,137.84
Project R’s NPV = -$1,500,000 + $400,000/1.08 + $400,000/1.082 + $400,000/1.083 +
$400,000/1.084 + $400,000/1.085
Project R’s NPV = -$2,000,000 + $370,370.37 + $342,935.53 + $317,532.90 +
$294,011.94 + $272,233.28
Project R’s NPV = $97,084.02
Project S’s NPV = -$1,500,000 + $700,000/1.13 + $600,000/1.132 + $500,000/1.133 +
$400,000/1.134 + $300,000/1.135
Project S’s NPV = -$1,500,000 + $619,469.03 + $469,888.01 + $346,525.08 +
$245,327.49 + $162,827.98
Project S’s NPV = $344,037.59
Project T’s NPV = -$1,500,000 + $200,000/1.18 + $400,000/1.182 + $600,000/1.183 +
$800,000/1.184 + $1,000,000/1.185
Project T’s NPV = -$1,500,000 + $169,491.53 + $287,273.77 + $365,178.52 +
$412,631.10 + $437,109.22
Project T’s NPV = $171,684.14
And the ranking order based on NPVs is,
Project S – NPV of $344,037.59
Project T – NPV of $171,684.14
Project R – NPV of $97,084.02
Project Q – NPV of $58,137.84

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Lepton Industries should pick Project S.

11. NPV unequal lives. Grady Enterprises is looking at two project opportunities for a
parcel of land that the company currently owns. The first project is a restaurant, and
the second project is a sports facility. The projected cash flow of the restaurant is an
initial cost of $1,500,000 with cash flows over the next six years of $200,000 (Year
one), $250,000 (Year two), $300,000 (Years three through five), and $1,750,000 in
Year six, when Grady plans on selling the restaurant. The sports facility has the
following cash outflow: initial cost of $2,400,000 with cash flows over the next three
years of $400,000 (Years one to three) and $3,000,000 in Year four, when Grady
plans on selling the facility. If the appropriate discount rate for the restaurant is 11%
and the appropriate discount rate for the sports facility is 13%, using NPV, determine
which project Grady should choose for the parcel of land. Adjust the NPV for
unequal lives with the equivalent annual annuity. Does the decision change?

ANSWER
Find the NPV of both projects and then solve for EAA with respective discount rates.
NPV (Restaurant) = -$1,500,000 + $200,000 / (1.11)1 + $250,000 / (1.11)2 + $300,000 /
(1.11)3 + $300,000 / (1.11)4 + $300,000 / (1.11)5 + $1,750,000 /
(1.11)6= $413,719.36
EAA Restaurant
P/Y = 1 and C/Y = 1
Input 6 11.0 -413,719.36 ? 0
Keys N I/Y PV PMT FV
CPT 97,793.56
NPV (Sports Facility) = -$2,400,000 + $400,000 / (1.13)1 + $400,000 / (1.13)2 +
$400,000 / (1.13)3 + $3,000,000 / (1.13)4= $384,417.22
EAA Sports Facility
P/Y = 1 and C/Y = 1
Input 4 13.0 -384,417.22 ? 0
Keys N I/Y PV PMT FV
CPT 129,238.84
The decision changes from the higher NPV of the restaurant to the higher EAA of the
sports facility.

12. NPV unequal [Link] Fish Fine Foods has $2,000,000 for capital investments
this year and is considering two potential projects for the funds. Project one is
updating the deli section of the store for additional food service. The estimated annual
after-tax cash flow of this project is $600,000 per year for the next five years. Project

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two is updating the wine section of the store. Estimated annual after-tax cash flow for
this project is $530,000 for the next six years. If the appropriate discount rate for the
deli expansion is 9.5% and the appropriate discount rate for the wine section is 9.0%,
using NPV, determine which project Singing Fish should choose for the parcel of
land. Adjust the NPV for unequal lives with the equivalent annual annuity. Does the
decision change?

ANSWER
Find the NPV of both projects and then solve for EAA with respective discount rates.
NPV (Deli Section) = -$2,000,000 + $600,000 / (1.095)1 + $600,000 / (1.095)2 +$600,000
/ (1.095)3 + $600,000 / (1.095)4 + $600,000 / (1.095)5 =
$303,825.27
EAA Deli Section
P/Y = 1 and C/Y = 1
Input 5 9.5 -303,825.27 ? 0
Keys N I/Y PV PMT FV
CPT 79,127.16
NPV (Wine Section) = -$2,000,000 + $530,000 / (1.09)1 + $530,000 / (1.09)2 +
$530,000 / (1.09)3 + $530,000 / (1.09)4 +$530,000 / (1.09)5 +
$530,000 / (1.09)6= $377,536.85
EAA Wine Section
P/Y = 1 and C/Y = 1
Input 6 9.0 -377,536.85 ? 0
Keys N I/Y PV PMT FV
CPT 84,160.43
The decision does not change as the higher NPV of the wine section also has the higher
EAA.

13. Internal rate of return and modified internal rate of [Link] are the IRRs and
MIRRs of the four projects for Quark Industries in Problem 9?

ANSWER
This is an iterative process but can be solved quickly on a calculator or spreadsheet.

Cash
Flow Project M Project N Project O Project P
s
CF0 ($2,000,000) ($2,000,000) ($2,000,000) ($2,000,000)

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CF1 $500,000 $600,000 $1,000,000 $300,000

CF2 $500,000 $600,000 $800,000 $500,000
CF3 $500,000 $600,000 $600,000 $700,000
CF4 $500,000 $600,000 $400,000 $900,000
CF5 $500,000 $600,000 $200,000 $1,100,000
Disc. 6% 9% 15% 22%
rate
IRR 7.93% 15.24% 20.27% 17.72%
MIR
R 7.10% 12.42% 17.18% 19.20%

14. Internal rate of return and modified internal rate of [Link] are the IRRs and
MIRRs of the four projects for Lepton Industries in Problem 10?

ANSWER
This is an iterative process but can be solved quickly on a calculator or spreadsheet.
Cash
Project Q Project R Project S Project T
Flows
CF0 ($1,500,000) ($1,500,000) ($1,500,000) ($1,500,000)
CF1 $350,000 $400,000 $700,000 $200,000
CF2 $350,000 $400,000 $600,000 $400,000
CF3 $350,000 $400,000 $500,000 $600,000
CF4 $350,000 $400,000 $400,000 $800,000
CF5 $350,000 $400,000 $300,000 $1,000,000
[Link] 4% 8% 13% 18%
te
IRR 5.37% 10.42% 23.57% 21.86%
MIRR 4.79% 9.36% 17.76% 20.59%

15. MIRR unequal [Link] is the MIRR for Grady Enterprises in Problem 11? What
is the MIRR when you adjust for the unequal lives? Does the adjusted MIRR for
unequal lives change the decision based on MIRR?Hint: Take all cash flows to the
same ending period as the longest project.

Year Restauran Sports

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t Facility
0 -1500000 -2400000
1 200000 400000
2 250000 400000
3 300000 400000
4 300000 3000000
5 300000
6 1750000
Disc.
Rate 11% 13%

ANSWER
FV (Restaurant) = $200,000×(1.11)5 + $250,000×(1.11)4 + $300,000×(1.11)3 +
$300,000×(1.11)2 + $300,000×(1.11)1 + $1,750.000×(1.11)0 =
$3,579,448.53
MIRR = ($3,579,448.53 / $1,500,000)1/6 – 1 = 15.6%
FV (Sports Facility) = $400,000×(1.13)3 + $400,000×(1.13)2 + $400,000×(1.13)1 +
$3,000,000×(1.13)0 = $4,539,918.80
MIRR = ($4,539,918.80 / $2,400,000)1/4 – 1 = 17.3%
Adjust the shorter project to the longer projects life:
FV (Sports Facility) = $400,000×(1.13)5 + $400,000×(1.13)4 + $400,000×(1.13)3 +
$3,000,000×(1.13)2 = $5,797,022.32
MIRR = ($5,797,022.32 / $2,400,000)1/6 – 1 = 15.8%
Adjusting for unequal lives does not change the decision as the sports facility still has a
higher MIRR but the rates are almost similar with the adjustment.

16. MIRR unequal [Link] is the MIRR for Singing Fish Fine Foods in Problem 12?
What is the MIRR when you adjust for the unequal lives? Does the adjusted MIRR
for unequal lives change the decision based on MIRR?Hint: Take all cash flows to the
same ending period as the longest project.
Deli Wine
Year
Section Section
0 -2000000 -2000000
1 600000 530000
2 600000 530000
3 600000 530000

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4 600000 530000
5 600000 530000
6 530000
Disc.
9.5% 9%
Rate

ANSWER
Take the cash flows out to each project’s ending point and calculate the MIRR.
FV (Deli Section) = $600,000×(1.095)4 + $600,000×(1.095)3 + $600,000×(1.095)2 +
$600,000×(1.095)1 + $600,000×(1.095)0 = $3,626,771
MIRR = ($3,626, 771 / $2,000,000)1/5 – 1 = 12.64%
FV (Wine Section) = $530,000×(1.09)5 + $530,000×(1.09)4 + $530,000×(1.09)3 +
$530,000×(1.09)2 + $530,000×(1.09)1 +$530,000×(1.09)0 =
$3,987,367.32
MIRR = ($3,987,367.32 / $2,000,000)1/6 – 1 = 12.19%
Adjust the shorter project (deli section) to the longer projects life:
FV (Deli Section) = $600,000×(1.095)5 + $600,000×(1.095)4 + $600,000×(1.095)3 +
$600,000×(1.095)2 + $600,000×(1.095)1 = $3,971,314.24
MIRR = ($3,971, 314.24 / $2,000,000)1/6 – 1 = 12.11%
Adjusting for unequal lives does change the decision as the wine section will now have a
slightly higher MIRR, i.e. 12.19% versus 12.11% for the deli section.

17. Comparing NPV and [Link] and Joey were having a discussion about which
financial model to use for their new business. Chandler supports NPV and Joey
supports IRR. The discussion starts to get heated when Ross steps in and states,
“Gentlemen, it doesn’t matter which method we choose, they give the same answer
on all projects.” Is Ross correct? Under what conditions will IRR and NPV be
consistent when accepting or rejecting projects?

ANSWER
Ross is partially right as NPV and IRR both reject or both accept the same projects under
the following conditions:
 The projects have standard cash flows
 The hurdle rate for IRR is the same as the discount rate for NPV
 All projects are available for acceptance regardless of the decision made on another
project (projects are not mutually exclusive)

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18. Comparing NPR and [Link] and Rachel are having a discussion about IRR and
NPV as a decision model for Monica’s new restaurant. Monica wants to use IRR
because it gives a very simple and intuitive answer. Rachel states that IRR can cause
errors, unlike NPV. Is Rachel correct? Show one type of error can be made with IRR
and not with NPV.

ANSWER
The most typical example here is with two mutually exclusive projects where the IRR of
one project is higher than the IRR of the other project but the NPV of the second project
is higher than the NPV of the first project. When comparing two projects using only IRR
this method fails to account for the level of risk of the project cash flows. When the
discount rate is below the cross-over rate one project is better under NPV while the other
project is better if the discount rate is above the cross-over rate and still below the IRR.

19. Profitability [Link] the discount rates and the future cash flows of each project,
which projects should they accept using profitability index?

ANSWER
Find the present value of benefits and divide by the present value of the costs for each
project.
Project U’s PV Benefits = $500,000/1.05 + $500,000/1.052 + $500,000/1.053 +
$500,000/1.054 + $500,000/1.055
Project U’s PV Benefits = $476,190.48 + $453,514.74 + $431,918.8 + $411,351.24 +
$391,763.08=$2,164,738.34
Project U’s PV Costs = $2,000,000
Project U’s PI = $2,164,738.34 / $2,000,000 = $1.08 accept project.
Project V’s PV Benefits = $600,000/1.09 + $600,000/1.092 + $600,000/1.093 +
$600,000/1.094 + $600,000/1.095
Project V’s PV Benefits = -$2,000,000 + $550,458.72 + $505,008.00 + $463,331.09 +
$425,055.13 + $389,958.83 = $2,333,790.77

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Project V’s PV Costs = $2,500,000

Project V’s PI = $2,333,790.77 / $ 2,500,000 = 0.9335 and reject project.
Project W’s PV Benefits = $1,000,000/1.15 + $800,000/1.152 + $600,000/1.153 +
$400,000/1.154 + $200,000/1.155
Project W’s PV Benefits = $869,565.22 + $604,914.93 + $394,509.74 + $228,701.30 +
$99,435.34 = $2,197,126.53
Project W’s PV Costs = $2,400,000
Project W’s PI = $2,197,126.53 / $2,400,000 = 0.9155 and reject project.
Project X’s PV Benefits= $300,000/1.22 + $500,000/1.222 + $700,000/1.223 +
$900,000/1.224 + $1,100,000/1.225
Project X’s PV Benefits= $245,901.64 + $335,931.20 + $385,494.82 + $406,259.18 +
$406,999.18 = $1,780,586.02
Project X’s PV Cost = $1,750,000
Project X’s PI = $1,780,586.02 / $1,750,000 = 1.0175 and accept project.

20. Profitability [Link] the discount rates and the future cash flow of each project
listed, use the PI to determine which projects the company should accept.

ANSWER
Find the present value of benefits and divide by the present value of the costs for each
project.
Project A’s PV Benefits = $350,000/1.04 + $350,000/1.042 + $350,000/1.043 +
$350,000/1.044 + $350,000/1.045
Project A’s PV Benefits = $336,538.46 + $323,594.67 + $311,148.73 + $299,181.47 +
$287,674.49 = $1,558,137.84
Project A’s PV Costs = $1,500,000
Project A’s PI = $1,558,137.84 / $1,500,000 = 1.0388 and accept project.

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Project B’s PV Benefits = $400,000/1.08 + $400,000/1.082 + $400,000/1.083 +

$400,000/1.084 + $400,000/1.085
Project B’s NPV = -$2,000,000 + $370,370.37 + $342,935.53 + $317,532.90 +
$294,011.94 + $272,233.28 = $1,597,084.02
Project B’s PV Costs = $1,500,000
Project B’s PI = $1,597,084.02 / $1,500,000 = 1.0647 and accept project.
Project C’s PV Benefits = $700,000/1.13 + $600,000/1.132 + $500,000/1.133 +
$400,000/1.134 + $300,000/1.135
Project C’s PV Benefits = $619,469.03 + $469,888.01 + $346,525.08 + $245,327.49 +
$162,827.98 = $1,844,037.59
Project C’s PV Costs = $2,000,000
Project C’s PI = $1,844,037.59 / $2,000,000 = 0.9220 and reject project.
Project D’s PV Benefits = $200,000/1.18 + $400,000/1.182 + $600,000/1.183 +
$800,000/1.184 + $1,000,000/1.185
Project D’s PV Benefits = $169,491.53 + $287,273.77 + $365,178.52 + $412,631.10 +
$437,109.22 = $1,671,684.14
Project D’s PV Costs = $2,000,000
Project D’s PI = $1,671,684.14 / $2,000,000 = 0.8358 and reject project.

21. Comparing all [Link] the following after-tax cash flows on a new toy for
Tyler's Toys, find the project's payback period, NPV, and IRR. The appropriate
discount rate for the project is 12%. If the cutoff period is six years for major projects,
determine whether management will accept or reject the project under the three
different decision models.
Year 0 cash outflow: $10,400,000
Years 1 to 4 cash inflow: $2,600,000 each year
Year 5 cash outflow: $1,200,000
Years 6 to 8 cash inflow: $750,000 each year

ANSWER
Payback Period: -$10,400,000 + $2,600,000 + $2,600,000 + $2,600,000 + $2,600,000 =
$0 (Four years but year five is also an outflow so we need to continue) -$1,200,000 +
$750,000 + $750,000 = $300,000 so we only need part of year seven, $450,000 /
$750,000 = 0.6 so total Payback is 6.6 years and project is rejected with six year cut-off.
Net Present Value: -$10,400,000 + $2,600,000/1.12 + $2,600,000/1.122 +
$2,600,000/1.123 + $2,600,000/1.124 - $1,200,000/1.125 +
$750,000/1.126 + $750,000/1.127 + $750,000/1.128

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NPV = -$10,400,000 + $2,321,428.57 + $2,072,704.08 + $1,850,628.64 + $1,652,347.00

- $680,912.23 + $379,973.34 + $339,261.91 + $302,912.42
NPV = -$2,161,656.25 and reject project under NPV rules.
IRR = (discount rate where NPV = 0) 0 = -$10,400,000 + $2,600,000/(1+r) +
$2,600,000/(1+r)2 + $2,600,000/(1+r)3 + $2,600,000/(1+r)4 -
$1,200,000/(1+r)5 + $750,000/(1+r)6 + $750,000/(1+r)7 +
$750,000/(1+r)8
In calculator solve for r, CF0 = -10,400,000
C01 = 2,600,000 and F01 = 4
C02 = - 1,200,000 and F02 = 2
C03 = 750,000 and F03 = 3
CPT IRR = 3.1955%
Reject project as IRR is less than 12%
Present Value of Benefits = $2,600,000/1.12 + $2,600,000/1.122 + $2,600,000/1.123 +
$2,600,000/1.124 - + $7,500,000/1.126 + $7,500,000/1.127 +
$750,000/1.128 = $2,321,428.57 + $2,072,704.08 + $1,850,628.64
+ $1,652,347.00 + $379,973.34 + $339,261.91 + $302,912.42 =
$8,919,255.73
Present Value of Costs: $10,400,000 + $1,200,000/1.125 = $10,400,000 + $680,912.23 =
$11,080,912.23
Profitability Index = $8,919,255.73 / $11,080,912.23 = 0.8049 and reject.

22. Comparing all [Link] Business is looking at a project with the estimated
cash flows as follows:
Initial Investment at start of project: $3,600,000
Cash Flow at end of Year 1: $500,000
Cash Flow at end of Years 2 through 6: $625,000 each year
Cash Flow at end of Year 7 through 9: $530,000 each year
Cash Flow at end of Year 10: $385,000
Risky Business wants to know payback period, NPV, IRR, MIRR, and PI of this
project. The appropriate discount rate for the project is 14%. If the cutoff period is six
years for major projects, determine whether management at Risky Business will
accept or reject the project under the five different decision models.

ANSWER
Payback Period = -$3,600,000 + $500,000 + $625,000 + $625,000 + $625,000 +
$625,000 + $625,000 = $ 25,000 and we only need part of year 6
so,
$600,000 / $625,000 = 0.96 and Payback Period is 5.96 years and project is accepted.

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NPV = -$3,600,000 + $500,000 / 1.14 + $625,000/1.142 + $625,000/1.143 +

$625,000/1.144 + $625,000/1.145 + $625,000/1.146 +
$530,000/1.147+ $530,000 /1.148 + $530,000/1.149 +
$385,000/1.1410
NPV = -$3,600,000 + $438,596.49 + $480,917.21 + $421,857.20 + $370,050.17 +
$324,605.42 + $284,741.59 + $211,807.78 + $185,796.30 +
$162,979.21 + $103,851.37 = -$614,797.27 and project is rejected
using NPV rules.
IRR In calculator solve for r, CF0 = -3,600,000
C01 = 500,000 and F01 = 1
C02 = 625,000 and F02 = 5
C03 = 530,000 and F03 = 3
C04 = $385,000 and F04 = 1
CPT IRR = 9.3349%
Reject project as IRR is less than 14%
MIRR solution with the 14% cost of capital as the investment rate for the annual cash
flows.
Take all positive cash flows to year 10 and find the future value of the cash flow at the
end of year ten.
$500,000 × 1.149 = $1,625,974
$625,000×1.148 = $1,782,866
$625,000×1.147 = $1,563,918
$625,000×1.146 = $1,371,858
$625,000×1.145 = $1,203,384
$625,000×1.144 = $1,055,600
$530,000×1.143 = $ 785,218
$530,000×1.142 = $ 688,788
$530,000×1.141 = $ 604,200
$385,000 × 1.140 = $ 385,000
Future Cash Flow Value $11,066,806
Now find the discount rate that equates the future cash flow value to the original
investment:
MIRR = ($11,066,806 /$3,600,000)1/10 – 1 = 11.885%
Present Value of Benefits = $500,000 / 1.14 + $625,000/1.142 + $625,000/1.143 +
$625,000/1.144 + $625,000/1.145 + $625,000/1.146 +
$530,000/1.147+ $530,000 /1.148 + $530,000/1.149 +
$385,000/1.1410

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Present Value of Benefits = $438,596.49 + $480,917.21 + $421,857.20 + $370,050.17 +

$324,605.42 + $284,741.59 + $211,807.78 + $185,796.30 +
$162,979.21+ $103,851.37 = $2,985,202.73
Present Value of Costs: $3,600,000
Profitability Index = $2,985,202.73 / $3,600,000 = 0.8292 and reject.

23. NPV profile of a [Link] the following cash flows of Project L-2, draw the
NPV profile. Hint:use a discount rate of zero for one intercept (y-axis) and solve for
the IRR for the other intercept (x-axis).
Cash flows: Year 0 = -$250,000
Year 1 = $45,000
Year 2 = $75,000

Year 3 = $115,000
Year 4 = $135,000

ANSWER
NPV (discount rate = 0) = -$250,000 + $45,000 + $75,000 + $115,000 + $135,000
= $120,000 (y-axis intercept)
NPV (discount rate = 5%) = -$250,000 + $45,000/1.05 + $75,000/1.052 + $115,000/1.053
+ $135,000/1.054 = $71,290.51
NPV (discount rate = 10%) = -$250,000 + $45,000/1.10 + $75,000/1.102 +
$115,000/1.103 + $135,000/1.104 = $31,500.58
NPV (discount rate = 15%) = -$250,000 + $45,000/1.15 + $75,000/1.152 +
$115,000/1.153 + $135,000/1.154 = -$1,357.74
NPV (discount rate = 20%) = -$250,000 + $45,000/1.20 + $75,000/1.202 +
$115,000/1.203 + $135,000/1.204 = -$28,761.57
IRR = 14.77%

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NPV Dollars

$120,000 NPV Profile

$90,000 Of Project L-2
$60,000
$30,000
$0
-$30,000

5% 10% 15% 20%

Discount Rates

24. NPVprofiles of two mutually exclusive [Link] Industries has two potential
projects for the coming year, Project B-12 and Project F-4. The two projects are
mutually exclusive. The cash flows are listed below. Draw the NPV profile of each
project and determine the cross-over rate of the two projects. If the appropriate hurdle
rate is 10% for both projects which project, does Moulton Industries choose?

ANSWER
Draw the NPV profile select different discount rates such as 0% for y-axis intercept and
then 5%, 10%, 15%, and 20%. Also find the IRR of the projects for the x-axis intercept.
Project B-12 NPVs at different discount rates:
At 0% discount rate, NPV = -$4,250,000 + $2,000,000 + $2,000,000 + $2,000,000 =
$1,750,000
At 5% discount rate, NPV = -$4,250,000 + $2,000,000 / 1.051+ $2,000,000 / 1.052 +
$2,000,000 / 1.053 = $1,196,496

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At 10% discount rate, NPV = -$4,250,000 + $2,000,000 / 1.101+ $2,000,000 / 1.102 +

$2,000,000 / 1.103 = $723,704
At 15% discount rate, NPV = -$4,250,000 + $2,000,000 / 1.151+ $2,000,000 / 1.152 +
$2,000,000 / 1.153 = $316,450
At 20% discount rate, NPV = -$4,250,000 + $2,000,000 / 1.201+ $2,000,000 / 1.202 +
$2,000,000 / 1.203 = -$37,037
IRR of Project B-12 = 19.44%
Project F-4 NPVs at different discount rates :
At 0% discount rate, NPV = -$3,800,000 + $1,000,000 + $1,500,000 + $2,000,000 +
$2,500,000 = $3,200,000
At 5% discount rate, NPV = -$3,800,000 + $1,000,000 / 1.052 + $1,500,000 /1.053 +
$2,000,000 / 1.054 + $2,500,000 / 1.055 = $2,007,006
At 10% discount rate, NPV = -$3,800,000 + $1,000,000 / 1.102 + $1,500,000 /1.103 +
$2,000,000 / 1.104 + $2,500,000 / 1.105 = $1,071,749
At 15% discount rate, NPV = -$3,800,000 + $1,000,000 / 1.152 + $1,500,000/1.153 +
$2,000,000 / 1.154 + $2,500,000 / 1.155 = $328,866
At 20% discount rate, NPV = -$3,800,000 + $1,000,000 / 1.202 + $1,500,000/1.203 +
$2,000,000 / 1.204 + $2,500,000 / 1.205 = -$268,300
IRR of Project F-4 = 17.62%
Cross-over rate of the two projects is found by setting the cash flows equal to each other
(as the NPV is same at this discount rate) and solving for r. The simple way is to move all
cash flows to one side of the equation and solve for the IRR with the difference in cash
flows for each year.

Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

B-12 -$4.250 $2.000 $2.000 $2.000 $0.000 $0.000
F-4 -$3.800 $0.000 $1.000 $1.500 $2.000 $2.500
Difference -$0.450 $2.000 $1.000 $0.500 -$2.000 -$2.500
Dollars in Millions
IRR of the differences in cash flows is:
$0 = -$450,000 + $2,000,000 / (1+r) + $1,000,000 / (1+r)2 + $500,000 / (1+r)3 -
$2,000,000 / (1+r)4 - $2,500,000 / (1+r)5
And solving for r, r = 15.2195%
To verify this answer substitute 15.2195% in the NPV calculations for both projects:
At 15.2195% discount rate, NPV = -$4,250,000 + $2,000,000 / 1.1521951+ $2,000,000 /
1.1521952 + $2,000,000 / 1.1521953 = $299,879

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At 15.2195% discount rate, NPV = -$3,800,000 + $1,000,000 / 1.1521952 +

$1,500,000/1.1521953 + $2,000,000 / 1.1521954 + $2,500,000 /
1.1521955= $299,879
NPV Profiles of B-12 and F-4

$ in Millions F-4
3.0
2.0
1.0
0.0
- B-12
1.0

5% 10% 15% 20%

Discount Rates

At 10% Discount Rate F-4 is above B-12 and is the better of the two projects.

Solutions for Advanced Problems for Spreadsheet Application

1. NPV Profile:

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NPV Profile Siesta Company

$70.0000

$60.0000

$50.0000

$40.0000

$30.0000
NPV Profile Siesta Company
$20.0000

$10.0000

$-
10%
12%
14%
16%
18%
20%
22%
24%
26%
28%
30%
32%
34%
36%
38%
40%
0%
2%
4%
6%
8%

$(10.0000)

$(20.0000)

Year 0 1 2 3 4 5 6 7 8
CF ($ millions) $(35.0500) $3.4400 $5.7900 $9.2300 $14.6800 $18.3900 $21.0700 $16.4200 $11.6800
Calculated NPV Using
Discount Rates PV of Cfo PV CF1 PV CF2 PV CF3 PV CF4 PV CF5 PV CF6 PV CF7 PV CF8 NPV of Project NPV Function
0% $ (35.0500) $ 3.4400 $ 5.7900 $ 9.2300 $ 14.6800 $ 18.3900 $ 21.0700 $ 16.4200 $ 11.6800 $ 65.6500 $ 65.6500
2% $ (35.0500) $ 3.3725 $ 5.5652 $ 8.6976 $ 13.5621 $ 16.6564 $ 18.7096 $ 14.2946 $ 9.9688 $ 55.7767 $ 55.7767
4% $ (35.0500) $ 3.3077 $ 5.3532 $ 8.2054 $ 12.5485 $ 15.1152 $ 16.6519 $ 12.4779 $ 8.5345 $ 47.1443 $ 47.1443
6% $ (35.0500) $ 3.2453 $ 5.1531 $ 7.7497 $ 11.6279 $ 13.7421 $ 14.8535 $ 10.9202 $ 7.3282 $ 39.5700 $ 39.5700
8% $ (35.0500) $ 3.1852 $ 4.9640 $ 7.3271 $ 10.7902 $ 12.5159 $ 13.2777 $ 9.5809 $ 6.3103 $ 32.9013 $ 32.9013
10% $ (35.0500) $ 3.1273 $ 4.7851 $ 6.9346 $ 10.0266 $ 11.4187 $ 11.8935 $ 8.4261 $ 5.4488 $ 27.0107 $ 27.0107
12% $ (35.0500) $ 3.0714 $ 4.6158 $ 6.5697 $ 9.3294 $ 10.4350 $ 10.6747 $ 7.4276 $ 4.7174 $ 21.7909 $ 21.7909
14% $ (35.0500) $ 3.0175 $ 4.4552 $ 6.2300 $ 8.6917 $ 9.5512 $ 9.5992 $ 6.5620 $ 4.0945 $ 17.1515 $ 17.1515
16% $ (35.0500) $ 2.9655 $ 4.3029 $ 5.9133 $ 8.1076 $ 8.7557 $ 8.6480 $ 5.8099 $ 3.5627 $ 13.0156 $ 13.0156
18% $ (35.0500) $ 2.9153 $ 4.1583 $ 5.6177 $ 7.5718 $ 8.0384 $ 7.8050 $ 5.1546 $ 3.1073 $ 9.3184 $ 9.3184
20% $ (35.0500) $ 2.8667 $ 4.0208 $ 5.3414 $ 7.0795 $ 7.3905 $ 7.0563 $ 4.5825 $ 2.7164 $ 6.0042 $ 6.0042
22% $ (35.0500) $ 2.8197 $ 3.8901 $ 5.0830 $ 6.6265 $ 6.8043 $ 6.3901 $ 4.0818 $ 2.3799 $ 3.0254 $ 3.0254
24% $ (35.0500) $ 2.7742 $ 3.7656 $ 4.8410 $ 6.2093 $ 6.2730 $ 5.7961 $ 3.6427 $ 2.0896 $ 0.3414 $ 0.3414
26% $ (35.0500) $ 2.7302 $ 3.6470 $ 4.6141 $ 5.8243 $ 5.7907 $ 5.2655 $ 3.2567 $ 1.8386 $ (2.0829) $ (2.0829)
28% $ (35.0500) $ 2.6875 $ 3.5339 $ 4.4012 $ 5.4687 $ 5.3522 $ 4.7908 $ 2.9168 $ 1.6209 $ (4.2780) $ (4.2780)
30% $ (35.0500) $ 2.6462 $ 3.4260 $ 4.2012 $ 5.1399 $ 4.9530 $ 4.3652 $ 2.6168 $ 1.4318 $ (6.2699) $ (6.2699)
32% $ (35.0500) $ 2.6061 $ 3.3230 $ 4.0131 $ 4.8354 $ 4.5889 $ 3.9831 $ 2.3516 $ 1.2672 $ (8.0817) $ (8.0817)
34% $ (35.0500) $ 2.5672 $ 3.2245 $ 3.8361 $ 4.5531 $ 4.2565 $ 3.6394 $ 2.1166 $ 1.1236 $ (9.7329) $ (9.7329)
36% $ (35.0500) $ 2.5294 $ 3.1304 $ 3.6693 $ 4.2911 $ 3.9526 $ 3.3299 $ 1.9081 $ 0.9980 $ (11.2411) $ (11.2411)
38% $ (35.0500) $ 2.4928 $ 3.0403 $ 3.5121 $ 4.0477 $ 3.6744 $ 3.0506 $ 1.7227 $ 0.8880 $ (12.6214) $ (12.6214)
40% $ (35.0500) $ 2.4571 $ 2.9541 $ 3.3637 $ 3.8213 $ 3.4193 $ 2.7983 $ 1.5577 $ 0.7914 $ (13.8870) $ (13.8870)

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2. IRR and MIRR:

Year 0 1 2 3 4 5 6 7 8
CF ($millions) $ (35.0500) $3.4400 $5.7900 $9.2300 $14.6800 $18.3900 $21.0700 $16.4200 $11.6800

IRR by Function
24.270%

NPV at 24.270% discount rate

$0.00

Rates MIRR
2.0% 14.89%
4.0% 15.69%
6.0% 16.50%
8.0% 17.32%
10.0% 18.14%
12.0% 18.98%
14.0% 19.82%
16.0% 20.67%
18.0% 21.53%
20.0% 22.40%
22.0% 23.27%
24.0% 24.15%
26.0% 25.04%
28.0% 25.93%
30.0% 26.84%

Solutions to Mini-Case
BioCom Inc : Part 1
This mini-case provides a review of the methodology, and rationale associated with the
various capital budgeting evaluation methods such as Payback Period, Discounted PPB,
NPV, IRR, MIRR, and PI.
1. Compute the payback period for each project.

Payback for Nano: cash flows for the first 3 years total $9,000.
(11,000-9000)/4,000=.5, so payback for Nano is 3.5 years. For Microsurgery: cash

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flows for the first 2 years total $8,000. (11,000-8,000)/4000 = .75, so payback for
Microsurgery is 2.75 years.
a. Explain the rationale behind the payback method.
The payback simply computes the break-even point for a project in terms of time
rather than units or dollars. It is the amount of time required for a project to recover
the initial investment.
b. State and explain the decision rule for the payback method.
The payback method implies that the sooner a project recovers the initial investment,
the better. The choice of an acceptable payback period is arbitrary.
c. Explain how the payback method would be used to rank mutually exclusive
projects.
For acceptable mutually exclusive projects, the one with the shortest payback period
would be chosen.
d. Comment on the advantages and shortcomings of this method.
Payback is simple to compute and the logic is obvious, even to people with no
background in finance. The method does not formally recognize the time value of
money, it ignores cash flows that occur after the payback period, it does not
necessarily select projects that add value to the company, or discriminate between
projects that add more or less value.
2. Compute the discounted payback period for each project using a discount rate
of 10%.

Nano Test
Tubes
Remaining cost
Year PV of CF at 10% to recover
0 $ (11.000.00)
1,818.1
1 1
2,000/1.10 = 8 –9,181.82
2,479.3
2
3,000/1.102= 4 –6,702.48
3,005.2
3 3
4,000/1.10 = 6 –3,697.22
3,415.0
4
5,000/1.104= 7 –282.15
4,346.4
5 5
7,000/1.10 = 5 4,064.30
In (000’s)

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Microsurgery
Kit
Remaining
cost to
Year PV of CF at 10% recover

0 ($11,000.00)
3,636.3
1 1
4,000/1.10 = 6 –7,363.64
3,305.7
2
4,000/1.102= 9 –4,057.85
3,005.2
3 3
4,000/1.10 6 –1,052.59
2,732.0
4
4,000/1.104 5 1,679.46
2,483.6
5
4,000/1.105 9 4,163.15
Discounted PP (Nano) = 4.04 years; Discounted PP (Micro) = 3.385 years
With the discounted payback method, the Nano Test Tube project does not break even
until the 5th year. The Microsurgery Kit project breaks even in the 4th year.
a. Explain the rationale behind the discounted payback method.
The discounted payback method tells us how long it will take for a project to break
even if we include the time value of money.
b. Comment on the advantages and shortcomings of this method.
By including the time value of money, the discounted payback method indicates that
any project with a payback period shorter than its useful life will add value. For this
reason, the method could be helpful if the useful life of the project is uncertain. Other
than that, the disadvantages are the same as for the simple payback method, and of
course the simplicity of the basic method is lost.
3. Compute the net present value (NPV) for each [Link] uses a discount
rate of9% for projects of average risk.
NPV(Nano Test Tubes) @9% = $4,540.28
NPV(Microsurgery Kit) @9% = $4,558.61
a. Explain the rationale behind the NPV method.
The net present value method discounts all cash flows so that they can be treated as if
they were all received at the same point in time. For example, the Microsurgery Kit
project is equivalent to spending $11 million immediately in order to receive $15.56
million immediately.

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b. State and explain the decision rule behind the NPV method.
The decision rule for the NPV method is fairly obvious. Any NPV greater than $0.00
means the project is acceptable.
c. Explain how the NPV method would be used to rank mutually exclusive
projects.
For mutually exclusive projects, one should simply choose the one with the largest
NPV.
d. Comment on the advantages and shortcomings of this method.
Because the NPV method considers all cash flows through the life of the project and
specifically incorporates the time value of money, and adjusts for risk, it is considered
to be the most reliable capital budgeting method.
e. Without performing any calculations, explain what happens to NPV if the
discount rate is adjusted upward for projects of higher risk or downward for
projects of lower risk.
The NPV computation requires cash flows to be divided by (1+r). Therefore, so as
long as negative cash flows are followed only by positive cash flows, higher values of
r will lead to lower NPVs and vice versa.
4. Compute the internal rate of return (IRR) for each project.
For Nano Test Tubes, the IRR is
$(11,000)+2,000/1.20971+3,000/1.20972+4,000/1.20973+5,000/1.20974+7,000/1.20975
= $0.00
For the Microsurgery Kit, the IRR is
$(11,000)+4,000/1.23921+4,000/1.23922+4,000/1.23923+4,000/1.23924+4,000/1.23925
= $0.00
By trial and error, the IRR is found to be 20.97%. for Nano Test Tubes, and 23.92%
for the Microsurgery Kit. The solutions can be found effortlessly with a financial
calculator or a spreadsheet such as EXCEL.
a. Explain the rationale behind the IRR method.
By computing the highest discount rate at which a project will have a positive NPV,
the IRR method is supposed to assure that the actual rate of return on an accepted
project is higher than the required rate of return.
b. State and explain the decision rule behind the IRR [Link] a hurdle
rate of 9%.
If the IRR exceeds the required rate of return (9%), the project should be accepted.
Otherwise, it should be rejected.
c. Explain how the IRR method would be used to rank mutually exclusive
projects.
When choosing between projects with acceptable IRRs, the one with the highest IRR
should be chosen.
d. Comment on the advantages and shortcomings of this method.

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IRR uses all cash flows and incorporates the time value of money. When evaluating
independent projects, IRR will always lead to the same decision as NPV.
Because IRR assumes that cash flows will be reinvested at the internal rate of return,
which is not always or even usually the case, it can rank mutually exclusive projects
incorrectly. With certain patterns of cash flows, the IRR equation has more than one
solution, which confuses the decision rule. IRR is slightly more difficult to compute
than NPV, but this consideration is irrelevant in the age of specialized calculators and
electronic spreadsheets.
5. Compute the modified internal rate of return (MIRR) for each project.
For Nano Test Tubes, we find the MIRR by first reinvesting all cash flows at the
reinvestment rate, which we assume to be the same as the required rate of return, 9%.
2,000×1.094+3,000×1.093+4,000×1.092+5,000×1.091+7,000×1.090 = $23,910.65
MIRR = ($23,910.65/$11,000)1/5-1=16.80%
For the Microsurgery Kit, the IRR is
4,000×1.094+4,000×1.093+4,000×1.092+4,000×1.091+4,000×1.090 = $23,938.84
MIRR = ($23,938.84/$11,000)1/5-1=16.83%
a. Explain the rationale behind the MIRR method.
The MIRR method computes the rate of return on invested capital when intermediate
cash flows are reinvested at a predetermined rate, which is typically the same as the
required rate of return.
b. State and explain the decision rule behind the MIRR [Link] a
hurdle rate of 9%.
The decision rule for MIRR is the same as for IRR: If the IRR exceeds the required
rate of return (9%), the project should be accepted. Otherwise, it should be rejected.
c. Explain how the MIRR method would be used to choose between mutually
exclusive projects.
As with IRR, choose the project with the highest MIRR.
d. Explain how this method corrects for some of the problems inherent in the
IRR method.
The MIRR method corrects the two major disadvantages of IRR, the reinvestment rate
problem and the multiple solution problem. When projects are adjusted for a common
economic life, MIRR should lead to the same decision as NPV, but the criterion is
stated as a percentage rate rather than in dollars (or other currency).
6. Explain to the R & D staff why BioCom uses the NPV method as its primary
project selection criterion.
Bi-Com uses the NPV method because it wishes to choose those projects which most
increase the value of the company. NPV provides a decision criterion stated directly
in terms of value in present dollars.
7. Challenge [Link] NPV profiles for both projects using discount rates
of 1% through 15% at one percentage point [Link] approximately what

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discount rate does the Nano test tube project become superior to the micro
surgery kits?This problem is best solved using an electronic spreadsheet.
Discount NPV NPV
Rate NANO MICRO
1% $9,268.61 $8,413.72
2% $8,572.92 $7,853.84
3% $7,910.80 $7,318.83
4% $7,280.24 $6,807.29
5% $6,679.40 $6,317.91
6% $6,106.53 $5,849.46
7% $5,560.05 $5,400.79
8% $5,038.43 $4,970.84
9% $4,540.28 $4,558.61
10% $4,064.30 $4,163.15
11% $3,609.25 $3,783.59
12% $3,174.00 $3,419.10
13% $2,757.47 $3,068.93
14% $2,358.66 $2,732.32
15% $1,976.63 $2,408.62

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Because the Nano project brings in a greater total amount of money, it has a higher
NPV at lower discount rates. Because the Microsurgery Kit project brings the money
in faster, it has a higher NPV at higher discount rates. The crossover rate is just under
9%.

Additional Problems with Solutions (Slides 9-54 to 9-67)

1. Computing Payback Period and Discounted Payback Period.
Regions Bank is debating between two the purchase of two software systems; the initial
costs and annual savings of which are listed [Link] of the directors are convinced
that given the short lifespan of software technology, the best way to decide between the
two options is on the basis of a payback period of 2 years or [Link] the payback
period of each option and state which one should be [Link] of the directors
states, “I object!Given our hurdle rate of 10%, we should be using a discounted payback
period of 2 years or less.”Accordingly, evaluate the projects on the basis of the DPP and
state your decision.

ANSWER

Software Software
Year PVCF@10% PVCF@10%
Option A Option B

$ $
0
($1,875,000) (1,875,000.00) ($2,000,000) (2,000,000.00)
1 $1,050,000 $954,545.45 1,250,000 $1,136,363.64
2 $900,000 $743,801.65 $800,000 $661,157.02
3 $450,000 $338,091.66 $600,000 $450,788.88
Payback period of Option A = 1 year + (1,875,000-1,050,000)/900,000 = 1.92 years
Payback period of Option B = 1year + (2,000,000-1,250,000)/800,000 = 1.9375 years.
Based on the Payback Period, Option A should be chosen.
For the discounted payback period, we first discount the cash flows at 10% for the
respective number of years and then add them up to see when we recover the investment.
DPP A = -1,875,000 + 954,545.45+743,801.65=-176652.9 ==> still to be recovered in
Year 3 DPP = 2 + (176652.9/338091.66) = 2.52 years
DPP B = -2,000,000+1, 136,363.64+661157.02 = -202479.34 still to be recovered in
Year 3  DPPB = 2 + (202479.34/450788.88) = 2.45 years.
Based on the Discounted Payback Period and a 2 year cutoff, neither option is acceptable.

2. Computing Net Present Value –Independent projects.

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Locey Hardware Products is expanding its product line and its production capacity. The
costs and expected cash flows of the two projects are given below. The firm typically
uses a discount rate of 15.4 percent.
a. What are the NPVs of the two projects?
b. Which of the two projects should be accepted (if any) and why?
Production
Product Line
Year Capacity
Expansion
Expansion
$ $
0
(2,450,000) (8,137,250)
1 $ 500,000 $ 1,250,000
2 $ 825,000 $ 2,700,000
3 $ 850,000 $ 2,500,000
4 $ 875,000 $ 3,250,000
5 $ 895,000 $ 3,250,000

ANSWER
NPV @15.4% = $86,572.61; $20,736.91
Decision: Both NPVs are positive, and the projects are independent, so assuming that
Locey Hardware has the required capital, both projects are acceptable.

3. Computing IRR.
KLS Excavating needs a new [Link] has received two proposals from [Link]
A costs $ 900,000 and generates cost savings of $325,000 per year for 3 years, followed
by savings of $200,000 for an additional 2 [Link] B costs $1,500,000 and
generates cost savings of $400,000 for 5 [Link] KLS has a discount rate of 12%, and
prefers using the IRR criterion to make investment decisions, which proposal should it
accept?

ANSWER (Slides 9-59 to 9-60)

Year Crane A Crane B

0 $(900,000) $(1,500,000)
1 $325,000 $400,000
2 $325,000 $400,000
3 $325,000 $400,000

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308Brooks Financial Management: Core Concepts, 3e

4 $200,000 $400,000
5 $200,000 $400,000
Required rate of return 12%

IRR 17.85% 10.42%

Decision Accept Crane A IRR>12%

Decision: Accept Crane T

4. Using MIRR.
The New Performance Studio is looking to put on a new [Link] figure that the set-up
and publicity will cost $400,[Link] show will go on for 3 years and bring in after-tax
net cash flows of $200,000 in Year 1; $350,000 in Year 2; -$50,000 in Year [Link] the firm
has a required rate of return of 9% on its investments, evaluate whether the show should
go on using the MIRR approach.

ANSWER (Slides 9-61 to 9-63)

The forecasted after-tax net cash flows are as follows:
Year After–tax cash flow
0. –$400,000
1. 200,000
2. 350,000
3. –$50,000
The formula for MIRR is as follows:

Where
FV = Compounded value of cash inflows at end of project’s life
(Year 3)using realistic reinvestment rate (9%);
PV = Discounted value of all cash outflows at Year 0;
N = number of years until the end of the project’s life= 3.
FV3 = $200,000*(1.09)2 + $350,000*(1.09)1 = $237,620 + $381,500 = $619,120
PV0 = $400,000 + $50,000/(1.09)3 =$438,609.17
MIRR = (619,120/$438,609.17)1/3 – 1 = (1.411552)1/3 -1 = 12.18%
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 Chapter 9  Capital Budgeting Decision Models 309

The show must go on, since the MIRR = 12.18% > Hurdle rate = 9%

5. Using multiple methods with mutually exclusive projects.

The Upstart Corporation is looking to invest one of 2 mutually exclusive projects, the
cash flows for which are listed [Link] directoris really not sure about the hurdle rate
that he should use when evaluating them and wants you to look at the projects’ NPV
profiles to better assess the situation and make the right decision.

Year A B
0 -454,000 ($582,000)
1 $130,000 $143,333
2 $126,000 $168,000
3 $125,000 $164,000
4 $120,000 $172,000
5 $120,000 $122,000

ANSWER (Slides 9-64 to 9-67)

To get some idea of the range of discount rates we should include in the NPV profile, it is
a good idea to first compute each project’s IRR and the crossover rate, i.e. , the IRR of
the cash flows of Project B-A as shown below:
Year A B B-A
(454,00 ($582,00 ($128,00
0
0) 0) 0)
$130,00 $143,333
1
0 $13,333
$126,00 $168,000
2
0 $42,000
$125,00 $164,000
3
0 $39,000
$120,00 $172,000
4
0 $52,000
$120,00 $122,000
5
0 $2,000

IRR 0.116 0.102 0.052375

So, it’s clear that the NPV profiles will cross-over at a discount rate of 5.2375%.
Project A has a higher IRR than Project B, so at discount rates higher than 5.2%, it would
be the better investment, and vice-versa (higher NPV and IRR), but if the firm can raise

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310Brooks Financial Management: Core Concepts, 3e

funds at a rate lower than 5.2%, then Project B will be better, since its NPV would be
higher.
To check this let’s compute the NPVs of the 2 projects at 0%, 3%, 5.24%, 8%,
10.2441%, and 11.624%...

Rate NPV(A) NPV(B)

0.00% 167,000 187,333
3.00% 115,505 123,656
5.24% 81,318 81,309
8.00% 43,498 34,393
10.2441% 15,811 0
11.624% 0 -19,323

Note that the two projects have equal NPVs at the cross-over rate of
approximately5.24%. At rates below 5.24%, Project B’s NPVs are higher; whereas at
rates higher than 5.24%, Project A has the higher NPV

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