Chapter 11

The Basics of Capital Budgeting

ANSWERS TO END-OF-CHAPTER QUESTIONS

11-1 a. The capital budget outlines the planned expenditures on fixed assets.
Capital budgeting is the whole process of analyzing projects and
deciding whether they should be included in the capital budget. This
process is of fundamental importance to the success or failure of the
firm as the fixed asset investment decisions chart the course of a
company for many years into the future. Strategic business plan is a
long-run plan which outlines in broad terms the firm’s basic strategy
for the next 5 to 10 years.

b. The payback, or payback period, is the number of years it takes a

firm to recover its project investment. Payback may be calculated
with either raw cash flows (regular payback) or discounted cash flows
(discounted payback). In either case, payback does not capture a
project's entire cash flow stream and is thus not the preferred
evaluation method. Note, however, that the payback does measure a
project's liquidity, and hence many firms use it as a risk measure.

c. Mutually exclusive projects cannot be performed at the same time. We

can choose either Project 1 or Project 2, or we can reject both, but
we cannot accept both projects. Independent projects can be accepted
or rejected individually.

d. The net present value (NPV) and internal rate of return (IRR)
techniques are discounted cash flow (DCF) evaluation techniques.
These are called DCF methods because they explicitly recognize the
time value of money. NPV is the present value of the project's
expected future cash flows (both inflows and outflows), discounted at
the appropriate cost of capital. NPV is a direct measure of the
value of the project to shareholders.

e. The internal rate of return (IRR) is the discount rate that equates
the present value of the expected future cash inflows and outflows.
IRR measures the rate of return on a project, but it assumes that all
cash flows can be reinvested at the IRR rate.

f. The modified internal rate of return (MIRR) assumes that cash flows
from all projects are reinvested at the cost of capital as opposed to
the project's own IRR. This makes the modified internal rate of
return a better indicator of a project's true profitability. The
profitability index is found by dividing the project’s PV of future
cash flows by its initial cost. A profitability index greater than 1
is equivalent to a positive NPV project.
g. An NPV profile is the plot of a project's NPV versus its cost of
capital. The crossover rate is the cost of capital at which the NPV
profiles for two projects intersect.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 1
 h. Capital projects with nonnormal cash flows have a large cash outflow
either sometime during or at the end of their lives. A common
problem encountered when evaluating projects with nonnormal cash
flows is multiple IRRs. A project has normal cash flows if one or
more cash outflows (costs) are followed by a series of cash inflows.

i. The project cost of capital, or discount rate, is the rate used in

discounting future cash flows in the NPV method. It is, basically,
the cost to the firm of the capital that must be raised in order to
invest in the project. The cost of capital depends on the riskiness
of the project, the level of interest rates in the economy, and
several other factors.

j. The mathematics of the NPV method imply that project cash flows are
reinvested at the cost of capital while the IRR method assumes
reinvestment at the IRR. Since project cash flows can be replaced by
new external capital which costs k, the proper reinvestment rate
assumption is the cost of capital, and thus the best capital budget
decision rule is NPV.

k. The post-audit is the final aspect of the capital budgeting process.

The post-audit is a feedback process in which the actual results are
compared with those predicted in the original capital budgeting
analysis. The post-audit has several purposes, the most important
being to improve forecasts and improve operations.

11-2 Project classification schemes can be used to indicate how much analysis
is required to evaluate a given project, the level of the executive who
must approve the project, and the cost of capital that should be used to
calculate the project's NPV. Thus, classification schemes can increase
the efficiency of the capital budgeting process.

11-3 The NPV is obtained by discounting future cash flows, and the
discounting process actually compounds the interest rate over time.
Thus, an increase in the discount rate has a much greater impact on a
cash flow in Year 5 than on a cash flow in Year 1.

11-4 This question is related to Question 11-3 and the same rationale
applies. With regard to the second part of the question, the answer is
no; the IRR rankings are constant and independent of the firm's cost of
capital.

11-5 The NPV and IRR methods both involve compound interest, and the
mathematics of discounting requires an assumption about reinvestment
rates. The NPV method assumes reinvestment at the cost of capital,
while the IRR method assumes reinvestment at the IRR. MIRR is a
modified version of IRR which assumes reinvestment at the cost of
capital.

11-6 The statement is true. The NPV and IRR methods result in conflicts only
if mutually exclusive projects are being considered since the NPV is
positive if and only if the IRR is greater than the cost of capital. If
the assumptions were changed so that the firm had mutually exclusive
projects, then the IRR and NPV methods could lead to different

Answers and Solutions: 11 - 2 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 conclusions. A change in the cost of capital or in the cash flow
streams would not lead to conflicts if the projects were independent.
Therefore, the IRR method can be used in lieu of the NPV if the projects
being considered are independent.

11-7 Yes, if the cash position of the firm is poor and if it has limited
access to additional outside financing. But even here, the relationship
between present value and cost would be a better decision tool.

11-8 a. In general, the answer is no. The objective of management should be

to maximize value, and as we point out in subsequent chapters, stock
values are determined by both earnings and growth. The NPV
calculation automatically takes this into account, and if the NPV of
a long-term project exceeds that of a short-term project, the higher
future growth from the long-term project must be more than enough to
compensate for the lower earnings in early years.

b. If the same $100 million had been spent on a short-term project—one

with a faster payback—reported profits would have been higher for a
period of years. This is, of course, another reason why firms
sometimes use the payback method.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 3
 SOLUTIONS TO END-OF-CHAPTER PROBLEMS

11-1 $52,125/$12,000 = 4.3438, so the payback is about 4 years.

11-2 NPV = -$52,125 + $12,000(PVIFA12%,8)

= -$52,125 + $12,000(4.9676) = $7,486.20.

Financial calculator: Input the appropriate cash flows into the cash
flow register, input I = 12, and then solve for NPV = $7,486.68.

11-3 Let NPV = 0. Therefore,

0 = PMT(PVIFAi,n) - Investment outlay

PVIFAi,n = Investment outlay/PMT
PVIFAi,8 = $52,125/$12,000 = 4.3438.

This is a PVIFA for 8 years, so using Table A-2, we look across the 8
year row until we find 4.3438. In the 16% column we find the value
4.3436. Therefore, the IRR is approximately 16 percent.

Financial calculator: Input the appropriate cash flows into the cash
flow register and then solve for IRR = 16%.

11-4 Project K's discounted payback period is calculated as follows:

Annual Discounted @12%

Period Cash Flows Cash Flows Cumulative
0 ($52,125) ($52,125.00) ($52,125.00)
1 12,000 10,714.80 (41,410.20)
2 12,000 9,566.40 (31,843.80)
3 12,000 8,541.60 (23,302.20)
4 12,000 7,626.00 (15,676.20)
5 12,000 6,808.80 (8,867.40)
6 12,000 6,079.20 (2,788.20)
7 12,000 5,427.60 2,639.40
8 12,000 4,846.80 7,486.20

Install Equation Editor and double-

The discounted payback period is 6 + click here to view equation. years,
or 6.51 years.

Alternatively, since the annual cash flows are the same, one can divide
$12,000 by 1.12 (the discount rate = 12%) to arrive at CF1 and then
continue to divide by 1.12 seven more times to obtain the discounted

Answers and Solutions: 11 - 4 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 cash flows (Column 3 values). The remainder of the analysis would be
the same.

11-5 MIRR: PV Costs = $52,125.

FV Inflows:

PV FV
0 12% 1 2 3 4 5 6 7 8
├──────┼──────┼──────┼──────┼──────┼──────┼──────┼──────┤
12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000
│ │ │ │ │ │ └─ 13,440
│ │ │ │ │ └──────── 15,053
│ │ │ │ └─────────────── 16,859
│ │ │ └────────────────────── 18,882
│ │ └───────────────────────────── 21,148
│ └──────────────────────────────────── 23,686
└─────────────────────────────────────────── 26,528
52,125 ─────────────── MIRR = 13.89% ─────────────── 147,596

Financial calculator: Obtain the FVA by inputting N = 8, I = 12, PV =

0, PMT = 12000, and then solve for FV = $147,596. The MIRR can be
obtained by inputting N = 8, PV = -52125, PMT = 0, FV = 147596, and then
solving for I = 13.89%.

11-6 Project A:

Using a financial calculator, enter the following:

CF0 = -15000000
CF1 = 5000000
CF2 = 10000000
CF3 = 20000000

I = 10; NPV = $12,836,213.

Change I = 10 to I = 5; NPV = $16,108,952.

Change I = 5 to I = 15; NPV = $10,059,587.

Alternatively, you could use the PVIF factors in Table A-1 to calculate
the NPV.

Project B:

Using a financial calculator, enter the following:

CF0 = -15000000
CF1 = 20000000
CF2 = 10000000

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 5
 CF3 = 6000000
I = 10; NPV = $15,954,170.

Change I = 10 to I = 5; NPV = $18,300,939.

Change I = 5 to I = 15; NPV = $13,897,838.

Alternatively, you could use the PVIF factors in Table A-1 to calculate
the NPV.

11-7 Using a financial calculator, enter the following:

CF0 = -200
CF1 = 235
CF2 = -65
CF3 = 300

I = 11.5; NPV = $174.90.

11-8 Truck:

NPV = -$17,100 + $5,100(PVIFA14%,5)

= -$17,100 + $5,100(3.4331) = -$17,100 + $17,509
= $409. (Accept)

Financial calculator: Input the appropriate cash flows into the cash
flow register, input I = 14, and then solve for NPV = $409.

Let NPV = 0. Therefore,

$17,100 = $5,100(PVIFAi,5)
PVIFAi,5 = 3.3529
IRR  15%. (Accept)

Financial calculator: Input the appropriate cash flows into the cash
flow register and then solve for IRR = 14.99%  15%.

MIRR: PV Costs = $17,100.

FV Inflows:

PV FV
0 14% 1 2 3 4 5
├──────────┼──────────┼──────────┼─────────┼─────────┤
5,100 5,100 5,100 5,100 5,100
│ │ │ └───── 5,814
│ │ └─────────────── 6,628
│ └────────────────────────── 7,556
└───────────────────────────────────── 8,614
17,100 ────────────── MIRR = 14.54% (Accept) ────── 33,712

Answers and Solutions: 11 - 6 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 Financial calculator: Obtain the FVA by inputting N = 5, I = 14, PV =
0, PMT = 5100, and then solve for FV = $33,712. The MIRR can be
obtained by inputting N = 5, PV = -17100, PMT = 0, FV = 33712, and then
solving for I = 14.54%.

Pulley:

NPV = -$22,430 + $7,500(3.4331) = -$22,430 + $25,748

= $3,318. (Accept)

Financial calculator: Input the appropriate cash flows into the cash
flow register, input I = 14, and then solve for NPV = $3,318.

Let NPV = 0. Therefore,

$22,430 = $7,500(PVIFAi,5)
PVIFAi,5 = 2.9907
IRR = 20%. (Accept)

Financial calculator: Input the appropriate cash flows into the cash
flow register and then solve for IRR = 20%.

MIRR: PV Costs = $22,430.

FV Inflows:

PV FV
0 14% 1 2 3 4 5
├──────────┼──────────┼──────────┼─────────┼─────────┤
7,500 7,500 7,500 7,500 7,500
│ │ │ └───── 8,550
│ │ └─────────────── 9,747
│ └──────────────────────────11,112
└─────────────────────────────────────12,667
22,430 ────────────── MIRR = 17.19% (Accept) ────── 49,576

Financial calculator: Obtain the FVA by inputting N = 5, I = 14, PV =

0, PMT = 7500, and then solve for FV = $49,576. The MIRR can be
obtained by inputting N = 5, PV = -22430, PMT = 0, FV = 49576, and then
solving for I = 17.19%.

11-9 Electric-powered:

NPVE = -$22,000 + $6,290(PVIFA12%,6)

= -$22,000 + $6,290(4.1114) = -$22,000 + $25,861 = $3,861.

Financial calculator: Input the appropriate cash flows into the cash
flow register, input I = 12, and then solve for NPV = $3,861.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 7
 Let NPV = 0. Therefore,

$22,000 = $6,290(PVIFAi,6)
PVIFAi,6 = 3.4976
IRRE = 18%.

Financial calculator: Input the appropriate cash flows into the cash
flow register and then solve for IRR = 18%.

Gas-powered:

NPVG = -$17,500 + $5,000(PVIFA12%,6)

= -$17,500 + $5,000(4.1114) = -$17,500 + $20,557 = $3,057.

Financial calculator: Input the appropriate cash flows into the cash
flow register, input I = 12, and then solve for NPV = $3,057.

Let NPV = 0. Therefore,

$17,500 = $5,000(PVIFAi,6)
PVIFAi,6 = 3.5000.
IRRG  18%.

Financial calculator: Input the appropriate cash flows into the cash
flow register and then solve for IRR = 17.97%  18%.
The firm should purchase the electric-powered forklift because it has
a higher NPV than the gas-powered forklift. The company gets a high
rate of return (18% > k = 12%) on a larger investment.

11-10 Financial Calculator Solution, NPV:

Project S

Project L

Answers and Solutions: 11 - 8 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 Financial Calculator Solution, IRR:

Input CF0 = -10000, CF1 = 3000, Nj = 5, IRRS = ? IRRS = 15.24%.

Input CF0 = -25000, CF1 = 7400, Nj = 5, IRRL = ? IRRL = 14.67%.

Financial Calculator Solution, MIRR:

Project S

Project L

Install Equation Editor and double-

click here to view equation.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 9
 Install Equation Editor and double-
Thus, click here to view equation.
The scale difference between Projects S
and L result in the IRR, MIRR, and PI favoring S over L. However, NPV
favors Project L, and hence L should be chosen.

11-11 a. The IRRs of the two alternatives are undefined. To calculate an IRR,
the cash flow stream must include both cash inflows and outflows.

b. The PV of costs for the conveyor system is -$556,717, while the PV of

costs for the forklift system is -$493,407. Thus, the forklift
system is expected to be -$493,407 - (-$556,717) = $63,310 less
costly than the conveyor system, and hence the forklifts should be
used.
Install
Note:EquationIf
Editorthe
and double-
PVIFA interest factors are used, then
click here to view equation. and PVF = -$493,411.

11-12 Project X: 0 12% 1 2 3 4

├──────────┼──────────┼──────────┼──────────┤
-1,000 100 300 400 700.00
│ │ └───── 448.00
│ └──────────────── 376.32
└─────────────────────────── 140.49
1,664.81
1,000 ──────────── 13.59% = MIRRX ──────────────┘

$1,000 = $1,664.81/(1 + MIRRX)4.

Project Y: 0 12% 1 2 3 4
├──────────┼──────────┼──────────┼──────────┤
-1,000 1,000 100 50 50.00
│ │ └───── 56.00
│ └──────────────── 125.44
└─────────────────────────── 1,404.93
1,636.37
1,000 ──────────── 13.10% = MIRRY ──────────────┘

$1,000 = $1,636.37/(1 + MIRRY)4.

Thus, since MIRRX > MIRRY, Project X should be chosen.

Alternative step: You could calculate NPVs, see that Project X has the
higher NPV, and just calculate MIRRX.

NPVX = $58.02 and NPVY = $39.94.

11-13 Input the appropriate cash flows into the cash flow register, and then
calculate NPV at 10% and the IRR of each of the projects:

Project S: NPVS = $39.14; IRRS = 13.49%.

Answers and Solutions: 11 - 10 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 Project L: NPVL = $53.55; IRRL = 11.74%.

Since Project L has the higher NPV, it is the better project. Note the
PVIF tables could be used to solve for the NPVs; however, they could not
be used to solve for the IRRs.

11-14 Step 1: Determine the PMT:

12% 1 10
├─────────┼───────── ··· ─────────┤
1,000 PMT PMT

With a financial calculator, input N = 10, I = 12, PV = -1000,

and FV = 0 to obtain PMT = $176.98.

Step 2: Calculate the project's MIRR:

PMT 10% TV
176.98 ──────────── 2,820.61
│
MIRR = 10.93% │
────────────────────────┘

Install
FV of Equation
inflows:Editor and double-
With a financial calculator, input N = 10,
click here to view equation. , PV = 0, and PMT = 176.98 to obtain
FV = $2,820.61. Then Install input Equation EditorPV
N = 10, and=double-
-1000, PMT = 0, and FV
= 2820.61 to obtain click here to view equation. .

Using the tables:

Step 1: PV = PMT(PVIFA12%,10)
$1,000 = PMT(5.6502)
PMT = $176.98.

Step 2: FVA = PMT(FVIFA10%,10) = $176.98(15.9374) = $2,820.60.

-1,000 = $2,820.60(PVIFi,10)
0.3545 = PVIFi,10
therefore i is between 10% and 12%.

11-15 a. Purchase price $ 900,000

Installation 165,000
Initial outlay $1,065,000

CF0 = -1065000; CF1-5 = 350000; I = 14; NPV = ?

NPV = $136,578; IRR = 19.22%.

b. Ignoring environmental concerns, the project should be undertaken

because its NPV is positive and its IRR is greater than the firm's
cost of capital.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 11
 c. Environmental effects could be added by estimating penalties or any
other cash outflows that might be imposed on the firm to help return
the land to its previous state (if possible). These outflows could
be so large as to cause the project to have a negative NPV—in which
case the project should not be undertaken.

11-16 a. Year Sales Royalties Marketing Net

0 (20,000) (20,000)
1 75,000 (5,000) (10,000) 60,000
2 52,500 (3,500) (10,000) 39,000
3 22,500 (1,500) 21,000

Payback period = $20,000/$60,000 = 0.33 years.

NPV = $60,000/(1.11)1 + $39,000/(1.11)2 + $21,000/(1.11)3 - $20,000

= $81,062.35.

IRR = 261.90%.

b. Finance theory dictates that this investment should be accepted.

However, ask your students "Does this service encourage cheating?"
If yes, does a business person have a social responsibility not to
make this service available?

11-17 Facts: 5 years remaining on lease; rent = $2,000/month; 60 payments

left, payment at end of month.

New lease terms: $0/month for 9 months; $2,600/month for 51 months.

Cost of capital = 12% annual (1% per month).

a. 0 1% 1 2 59 60
├──────┼──────┼────── ··· ─────┼──────┤
2,000 2,000 2,000 2,000

PV cost of old lease: N = 60; I = 1; PMT = 2000; FV = 0; PV = ?

PV = -$89,910.08.

0 1% 1 9 10 59 60
├──────┼── ··· ──┼──────┼──── ··· ────┼──────┤
0 0 2,600 2,600 2,600
Install Equation Editor and double-
Install
PV costEquation
of Editor
new and double- CF = 0,
lease: click hereInstall
to viewEquation Editor and double-
equation. = 0;
0
click here to view equation. = 2,600; I = 1. click here to view equation.
.

Answers and Solutions: 11 - 12 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 Sharon should not accept the new lease because the present value of
its cost is $94,611.45 - $89,910.08 = $4,701.37 greater than the old
lease.

b. 0 1% 1 2 9 10 59 60
├──────┼──────┼─── ··· ───┼──────┼─── ··· ───┼──────┤
2,000 2,000 2,000 PMT PMT PMT
FV = ?

FV of first 9 months' rent under old lease:

N = 9; I = 1; PV = 0; PMT = 2000; FV = ? FV = $18,737.05.

The FV of the first 9 months' rent is equivalent to the PV of the 51-

period annuity whose payments represent the incremental rent during
months 10-60. To find this value:

N = 51; I = 1; PV = -18737.05; FV = 0; PMT = ? PMT = $470.80.

Thus, the new lease payment that will make her indifferent is $2,000
+ $470.80 = $2,470.80.

Check:

0 1% 1 9 10 59 60
├─────────┼─── ··· ───┼─────────┼──── ··· ────┼─────────┤
0 0 2,470.80 2,470.80 2,470.80
Install Equation Editor and double-
Install
PV costEquation
of Editor
new and double- CF = 0;
lease: click here to view equation. = 0;
0
Install Equation
click here Editor
to view and double-
equation. = 2470.80; I = 1.
click here to view equation.

Except for rounding; the PV cost of this lease equals the PV cost of
the old lease.

c. Period Old Lease New Lease Δ Lease

0 0 0 0
1-9 2,000 0 2,000
10-60 2,000 2,600 -600

CF0 = 0; CF1-9 = 2000; CF10-60 = -600; IRR = ? IRR = 1.9113%. This is

the periodic rate. To obtain the nominal cost of capital, multiply
by 12: 12(0.019113) = 22.94%.

Check: Old lease terms:

N = 60; I = 1.9113; PMT = 2000; FV = 0; PV = ? PV = -$71,039.17.

New lease terms:

CF0 = 0; CF1-9 = 0; CF10-60 = 2600; I = 1.9113; NPV = ? NPV = -

$71,038.98.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 13
 Except for rounding differences; the costs are the same.

11-18 a.

k NPVA NPVB
_____ ______ ______
0.0% $890 $399
10.0 283 179
12.0 200 146
18.1 0 62
20.0 (49) 41
24.0 (138) 0
30.0 (238) (51)

b. IRRA = 18.1%; IRRB = 24.0%.

c. At k = 12%, Project A has the greater NPV, specifically $200.41 as

compared to Project B's NPV of $145.93. Thus, Project A would be
selected. At k = 18%, Project B has an NPV of $63.68 which is higher
than Project A's NPV of $2.66. Thus, choose Project B if k = 18%.

d. Here is the MIRR for Project A when k = 12%:

PV costs = $300 + $387/(1.12)1 + $193/(1.12)2

+ $100/(1.12)3 + $180/(1.12)7 = $952.00.

TV inflows = $600(1.12)3 + $600(1.12)2 + $850(1.12)1 = $2,547.60.

Answers and Solutions: 11 - 14 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 Now, MIRR is that discount rate which forces the TV of $2,547.60 in 7
years to equal $952.00:

$952.00 = $2,547.60(PVIFi,7).
MIRRA = 15.10%.
Similarly, MIRRB = 17.03%.
At k = 18%,
MIRRA = 18.05%.
MIRRB = 20.49%.

e. To find the crossover rate, construct a Project Δ which is the

difference in the two projects' cash flows:

Project Δ =
Year CFA - CFB
____ ___________
0 $ 105
1 (521)
2 (327)
3 (234)
4 466
5 466
6 716
7 (180)

IRRΔ = Crossover rate = 14.53%.

Projects A and B are mutually exclusive, thus, only one of the

projects can be chosen. As long as the cost of capital is greater
than the crossover rate, both the NPV and IRR methods will lead to
the same project selection. However, if the cost of capital is less
than the crossover rate the two methods lead to different project
selections—a conflict exists. When a conflict exists the NPV method
must be used.
IRR/YR
STO Because of the sign changes and the size of the cash flows,
Project Δ has multiple IRRs. Thus, a calculator's IRR function will
not work. One could use the trial and error method of entering
different discount rates until NPV = $0. However, an HP can be
"tricked" into giving the roots. After you have keyed Project
Delta's cash flows into the g register of an HP-10B, you will see an
"Error-Soln" message. Now enter 10   and the 14.53% IRR is
found. Then enter 100   to obtain IRR = 456.22%. Similarly,
Excel or Lotus 1-2-3 can also be used.

11-19 a. Incremental Cash

Year Plan B Plan A Flow (B - A)
____ _____________ _____________ ________________
0 ($10,000,000) ($10,000,000) $ 0
1 1,750,000 12,000,000 (10,250,000)
2-20 1,750,000 0 1,750,000

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 15
 If the firm goes with Plan B, it will forgo $10,250,000 in Year 1,
but will receive $1,750,000 per year in Years 2-20.

b. If the firm could invest the incremental $10,250,000 at a return of

16.07%, it would receive cash flows of $1,750,000. If we set up an
amortization schedule, we would find that payments of $1,750,000 per
year for 19 years would amortize a loan of $10,250,000 at 16.0665%.
Financial Calculator Solution:

c. Yes, assuming (1) equal risk among projects, and (2) that the cost of
capital is a constant and does not vary with the amount of capital
raised.

d. See graph. If the cost of capital is less than 16.07%, then Plan B
should be accepted; if k > 16.07%, then Plan A is preferred.

11-20 a. Financial Calculator Solution:

Plan A

Answers and Solutions: 11 - 16 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 Plan B

Plan A

Plan B

b. If the company takes Plan A rather than B, its cash flows will be (in
millions of dollars):
Cash Flows Cash Flows Project Δ
Year from A from B Cash Flows
0 ($50) ($15.0) ($35.0)
1 8 3.4 4.6
2 8 3.4 4.6
. . . .
. . . .
. . . .
20 8 3.4 4.6

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 17
 So, Project Δ has a "cost" of $35,000,000 and "inflows" of
$4,600,000 per year for 20 years.

Answers and Solutions: 11 - 18 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 Since IRRΔ > k, and sincewe should accept Δ. This means accept the
NPVΔ > 0,
larger project (Project A). In addition, when dealing with mutually
exclusive projects, we use the NPV method for choosing the best
project.

c.

d. The NPV method implicitly assumes that the opportunity exists to

reinvest the cash flows generated by a project at the cost of
capital, while use of the IRR method implies the opportunity to
reinvest at the IRR. If the firm's cost of capital is constant at 10
percent, all projects with an NPV > 0 will be accepted by the firm.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 19
 As cash flows come in from these projects, the firm will either pay
them out to investors, or use them as a substitute for outside
capital which costs 10 percent. Thus, since these cash flows are
expected to save the firm 10 percent, this is their opportunity cost
reinvestment rate.

The IRR method assumes reinvestment at the internal rate of return

itself, which is an incorrect assumption, given a constant expected
future cost of capital, and ready access to capital markets.

11-21 a. The project's expected cash flows are as follows (in millions of
dollars):
Time Net Cash Flow
____ _____________
0 ($ 4.4)
1 27.7
2 (25.0)
We can construct the following NPV profile:

Discount Rate NPV

_____________ ____________
0% ($1,700,000)
9 (29,156)
10 120,661
50 2,955,556
100 3,200,000
200 2,055,556
300 962,500
400 140,000

Answers and Solutions: 11 - 20 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 410 70,204
420 2,367
430 (63,581)

The table above was constructed using a financial calculator with the
following inputs: CF0 = -4400000, CF1 = 27700000, CF2 = -25000000,
and I = discount rate to solve for the NPV.

b. If k = 8%, reject the project since NPV < 0. But if k = 14%, accept
the project because NPV > 0.

c. Other possible projects with multiple rates of return could be

nuclear power plants where disposal of radioactive wastes is required
at the end of the project's life, or leveraged leases where the
borrowed funds are repaid at the end of the lease life. (See Chapter
19 for more information on leases.)

d. Here is the MIRR for the project when k = 8%:

PV costs = $4,400,000 + $25,000,000/(1.08)2 = $25,833,470.51.

TV inflows = $27,700,000(1.08)1 = $29,916,000.00.

Now, MIRR is that discount rate which forces the PV of the TV of

$29,916,000 over 2 years to equal $25,833,470.51:

$25,833,470.51 = $29,916,000(PVIFk,2).

MIRR = 7.61%.

At k = 14%,

PV costs = $4,400,000 + $25,000,000/(1.14)2 = $23,636,688.21.

TV inflows = $27,700,000(1.14)1 = $31,578,000.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 21
 Now, MIRR is that discount rate which forces the PV of the TV of
$31,578,000 over 2 years to equal $23,636,688.21:

$23,636,688.21 = $31,578,000(PVIFk,2).

Yes. The MIRR method leads to the same conclusion as the NPV method.
Reject the project if k = 8%, which is greater than the corresponding
MIRR of 7.61%, and accept the project if k = 14%, which is less than
the corresponding MIRR of 15.58%.

11-22 Determine cash flows:

t=0: The firm must borrow the entire $2,000,000 in order to invest
in the casino project, since the casino will not generate any
funds until the end of the second year. However, the loan must
be repaid at the end of the first year, therefore, the firm
must use the extra $1 million to provide the funds needed to
repay the loan.

t=1: Repay $2 million loan, plus 10 percent interest ($200,000),

plus $700,000 fee: Net cash out flow = $2.9 million.

t=2: Receive $2 million from sale of casino.

Work out NPV profile:

Install Equation Editor and double-

click here to view equation.

Solve at different values of k:

k NPV
____ ________
0% $100,000
10 16,529
13 (78)  0
15 (9,452)
25 (40,000)
35 (50,754)
50 (44,444)
77 (32)  0
100 50,000
150 160,000

The table above was constructed using a financial calculator with the
following inputs: CF0 = 1000000, CF1 = -2900000, CF2 = 2000000, and I
= discount rate to solve for the NPV.

Answers and Solutions: 11 - 22 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 As the graph indicates, the NPV is positive at any k less than 13
percent or greater than 77 percent; within that range, the NPV is
negative.
The deal really amounts to a loan plus a construction project. If
the firm could borrow at low rates (less than 13 percent), then the
project would be profitable because the profit on the sale of the
casino ($1 million) would more than cover the interest and fee on the
loan. Or, if the firm had such good investment opportunities that
the firm could make over 76 percent on the $1 million made available
by the deal, it would be profitable. In between, it is not a good
project.

11-23 a. The IRRs of the two alternatives are undefined. To calculate an IRR,
the cash flow stream must include both cash inflows and outflows.

b. The PV of costs for the conveyor system is ($911,067), while the PV

of costs for the forklift system is ($838,834). Thus, the forklift
system is expected to be ($838,834) - ($911,067) = $72,233 less
costly than the conveyor system, and hence the forklift trucks should
be used.

Financial calculator solution:

Install Equation Editor and double-
Input: CF0 = -500000, click here to view equation. = -120000, Nj = 4,
CF2 = -20000, I = 8, NPVC = ? NPVC = -911,067.
Install Equation Editor and double-
Install
Input: Equation Editor and double-
CF0 = -200000, Install
click here to view Equation Editor and=double-
equation. -160000,
Install Equation
click here Editor
to view and double- = 5, I = 8, click here to view equation.
equation. = ?
click here to view equation. = -838,834.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 23
11-24 a. Payback A (cash flows in thousands):

Annual
Period Cash Flows Cumulative
0 ($25,000) ($25,000)
1 5,000 ( 20,000)
2 10,000 ( 10,000)
3 15,000 5,000
4 20,000 25,000

PaybackA = 2 + $10,000/$15,000 = 2.67 years.

Payback B (cash flows in thousands):

Annual
Period Cash Flows Cumulative
0 ($25,000) ($25,000)
1 20,000 ( 5,000)
2 10,000 5,000
3 8,000 13,000
4 6,000 19,000

PaybackB = 1 + $5,000/$10,000 = 1.50 years.

b. Discounted payback A (cash flows in thousands):

Annual Discounted @10%

Period Cash Flows Cash Flows Cumulative
0 ($25,000) ($25,000.00) ($25,000.00)
1 5,000 4,545.45 ( 20,454.55)
2 10,000 8,264.46 ( 12,190.09)
3 15,000 11,269.72 ( 920.37)
4 20,000 13,660.27 12,739.90

Discounted PaybackA = 3 + $920.37/$13,660.27 = 3.07 years.

Discounted payback B (cash flows in thousands):

Annual Discounted @10%

Period Cash Flows Cash Flows Cumulative
0 ($25,000) ($25,000.00) ($25,000.00)
1 20,000 18,181.82 ( 6,818.18)
2 10,000 8,264.46 1,446.28
3 8,000 6,010.52 7,456.80
4 6,000 4,098.08 11,554.88

Discounted PaybackB = 1 + $6,818.18/$8,264.46 = 1.825 years.

c. NPVA = $12,739,908; IRRA = 27.27%.

NPVB = $11,554,880; IRRB = 36.15%.

Answers and Solutions: 11 - 24 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 Both projects have positive NPVs, so both projects should be
undertaken.

d. At a discount rate of 5%, NPVA = $18,243,813.

At a discount rate of 5%, NPVB = $14,964,829.

At a discount rate of 5%, Project A has the higher NPV; consequently,

it should be accepted.

e. At a discount rate of 15%, NPVA = $8,207,071.

At a discount rate of 15%, NPVB = $8,643,390.

At a discount rate of 15%, Project B has the higher NPV;

consequently, it should be accepted.

f. Project Δ =
Year CFA - CFB
____ ___________
0 $ 0
1 (15)
2 0
3 7
4 14

IRRΔ = Crossover rate = 13.5254%  13.53%.

g. Use 3 steps to calculate MIRRA @ k = 10%:

Step 1: Calculate the NPV of the uneven cash flow stream, so its FV
can then be calculated. With a financial calculator, enter
the cash flow stream into the cash flow registers, then
enter I = 10, and solve for NPV = $37,739,908.

Step 2: Calculate the FV of the cash flow stream as follows:

Enter N = 4, I = 10, PV = -37739908, and PMT = 0 to solve
for FV = $55,255,000.

Step 3: Calculate MIRRA as follows:

Enter N = 4, PV = -25000000, PMT = 0, and FV = 55255000 to
solve for I = 21.93%.

Use 3 steps to calculate MIRRB @ k = 10%:

Step 1: Calculate the NPV of the uneven cash flow stream, so its FV
can then be calculated. With a financial calculator, enter
the cash flow stream into the cash flow registers, then
enter I = 10, and solve for NPV = $36,554,880.

Step 2: Calculate the FV of the cash flow stream as follows:

Enter N = 4, I = 10, PV = -36554880, and PMT = 0 to solve
for FV = $53,520,000.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Answers and Solutions: 11 - 25
 Step 3: Calculate MIRRB as follows:
Enter N = 4, PV = -25000000, PMT = 0, and FV = 53520000 to
solve for I = 20.96%.

According to the MIRR approach, if the 2 projects were mutually

exclusive, Project A would be chosen because it has the higher MIRR.
This is consistent with the NPV approach.

Answers and Solutions: 11 - 26 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 SOLUTION TO SPREADSHEET PROBLEM

11-25 a.

k NPVA NPVB
_____ ______ ______
0.0% $890 $399
10.0 283 179
18.1 0 62
20.0 (49) 41
24.0 (138) 0

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Solution to Spreadsheet Problem: 11 - 27
 30.0 (238) (51)

b. Input: CF0 = -300, CF1 = -387, CF2 = -193, CF3 = -100, CF4 = 600, Nj =
2, CF6 = 850, CF7 = -180, IRRA = ? IRRA = 18.1%.

Input: CF0 = -405, CF1 = 134, Nj = 6, CF7 = 0, IRRB = ? IRRB = 24.0%.

c. At k = 10%, Project A has the greater NPV, specifically $283.34 as

compared to Project B's NPV of $178.60. Thus, Project A would be
selected. At k = 17%, Project B has an NPV of $75.95 which is higher
than Project A's NPV of $31.05. Thus, choose Project B if k = 17%.

d. Here is the MIRR for Project A when k = 10%:

PV costs = $300 + $387/(1.10)1 + $193/(1.10)2 + $100/(1.10)3

+ $180/(1.10)7 = $978.82.

TV inflows = $600(1.10)3 + $600(1.10)2 + $850(1.10)1 = $2,459.60.

Now, MIRR is that discount rate which forces the PV of the TV of

$2,459.60 over 7 years to equal $978.82:

$978.82 = $2,459.60(PVIFk,7).

Financial Calculator Solution:

Here is the MIRR for Project B when k = 10%:

BEGIN MODE

Because the $134 payments occur in Years 1 through 6, but not Year 7,
it can be thought of as a 6-year annuity due.

FV inflowsL = $1,137.28.

Solution to Spreadsheet Problem: 11 - 28 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 PV costsB = $405.

END MODE

MIRR for Project A at k = 17%:

PV costs = $300 + $387/(1.17)1 + $193/(1.17)2 + $100/(1.17)3

+ $180/(1.17)7 = $894.17.

TV inflows = $600(1.17)3 + $600(1.17)2+ $850(1.17)1 = $2,776.81.

Now, MIRR is that discount rate which forces the PV of the TV of

$2,776.81 over 7 years to equal $894.17:

$894.17 = $2,776.81(PVIFk,7).

Financial Calculator Solution:

MIRR for Project B at k = 17%:

BEGIN MODE

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Solution to Spreadsheet Problem: 11 - 29
 Because the $134 payments occur in Years 1 through 6, but not Year 7,
it can be thought of as a 6-year annuity due.

FV inflowsL = $1,443.45.

PV costsB = $405.

END MODE

e. To find the crossover rate, construct a Project Δ which is the

difference in the two projects' cash flows:
Project Δ
Year CFA - CFB
____ _________
0 $ 105
1 (521)
2 (327)
3 (234)
4 466
5 466
6 716
7 (180)

Input: CF0 = 105, CF1 = -521, CF2 = -327, CF3 = -234, CF4 = 466, Nj =
2, CF6 = 716, CF7 = -180, IRRΔ = ? IRRΔ = 14.53% = Crossover rate.

This is the discount rate at which the NPV profiles of the two
projects cross and thus, at which the project’s NPVs are equal.

Because of the sign changes and the size of the cash flows, Project
Δ has multiple IRRs. Thus, a calculator's IRR function will not
work. One could use the trial and error method of entering different
discount rates until NPV = $0. However, an HP 10B can be "tricked"
into giving the roots. You must enter a guess for the IRR as
follows: after keying in Project Delta's cash flows into the CF j
register, estimate an IRR (for example, 10), press the gold key, the
STO key, the gold key again, and then IRR. The IRR of 14.53% is
found. Then guess 100, using the same key strokes as was done for
the guess of 10, to obtain IRR = 456.22%. Similarly, a spreadsheet
program can also be used.

Solution to Spreadsheet Problem: 11 - 30 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 f. Worst case scenario:

(k = 10%) *
Project A: NPV = $221.76 IRR = 16.67% MIRR = 13.08%
Project B: NPV = $101.63 IRR = 19.86% MIRR = 13.05%

(k = 17%) Project A: NPV = ($8.93) IRR = 16.67% MIRR = 16.84%

*
Project B: NPV = $25.97 IRR = 19.86% MIRR = 17.93%

Best case scenario:

(k = 10%) *
Project A: NPV = $339.79 IRR = 19.30% MIRR = 15.04%
Project B: NPV = $240.18 IRR = 26.54% MIRR = 17.57%

(k = 17%) Project A: NPV = $67.70 IRR = 19.30% MIRR = 18.28%

*
Project B: NPV = $115.93 IRR = 26.54% MIRR = 21.28%

*Project choice

g. k = 0%: NPVA = $890 NPVB = $399

k = 5%: NPVA = $540 NPVB = $275
k = 20%: NPVA = ($49) NPVB = $41
k = 400%: NPVA = ($385) NPVB = ($372)

MINI CASE

A. WHAT IS CAPITAL BUDGETING? ARE THERE ANY SIMILARITIES BETWEEN A

FIRM'S CAPITAL BUDGETING DECISIONS AND AN INDIVIDUAL'S INVESTMENT
DECISIONS?

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Solution to Spreadsheet Problem: 11 - 31
ANSWER: CAPITAL BUDGETING IS THE PROCESS OF ANALYZING ADDITIONS TO FIXED
ASSETS. CAPITAL BUDGETING IS IMPORTANT BECAUSE, MORE THAN ANYTHING
ELSE, FIXED ASSET INVESTMENT DECISIONS CHART A COMPANY'S COURSE FOR
THE FUTURE. CONCEPTUALLY, THE CAPITAL BUDGETING PROCESS IS IDENTICAL
TO THE DECISION PROCESS USED BY INDIVIDUALS MAKING INVESTMENT
DECISIONS. THESE STEPS ARE INVOLVED:

1. ESTIMATE THE CASH FLOWS--INTEREST AND MATURITY VALUE OR DIVIDENDS

IN THE CASE OF BONDS AND STOCKS, OPERATING CASH FLOWS IN THE CASE
OF CAPITAL PROJECTS.

2. ASSESS THE RISKINESS OF THE CASH FLOWS.

3. DETERMINE THE APPROPRIATE DISCOUNT RATE, BASED ON THE RISKINESS OF

THE CASH FLOWS AND THE GENERAL LEVEL OF INTEREST RATES. THIS IS
CALLED THE PROJECT COST OF CAPITAL IN CAPITAL BUDGETING.

4. FIND (A) THE PV OF THE EXPECTED CASH FLOWS AND/OR (B) THE ASSET'S
RATE OF RETURN.

5. IF THE PV OF THE INFLOWS IS GREATER THAN THE PV OF THE OUTFLOWS

(THE NPV IS POSITIVE), OR IF THE CALCULATED RATE OF RETURN (THE
IRR) IS HIGHER THAN THE PROJECT COST OF CAPITAL, ACCEPT THE
PROJECT.

B. WHAT IS THE DIFFERENCE BETWEEN INDEPENDENT AND MUTUALLY

EXCLUSIVE PROJECTS? BETWEEN PROJECTS WITH NORMAL AND NONNORMAL
CASH FLOWS?

ANSWER: PROJECTS ARE INDEPENDENT IF THE CASH FLOWS OF ONE ARE NOT AFFECTED BY
THE ACCEPTANCE OF THE OTHER. CONVERSELY, TWO PROJECTS ARE MUTUALLY
EXCLUSIVE IF ACCEPTANCE OF ONE IMPACTS ADVERSELY THE CASH FLOWS OF
THE OTHER; THAT IS, AT MOST ONE OF TWO OR MORE SUCH PROJECTS MAY BE
ACCEPTED. PUT ANOTHER WAY, WHEN PROJECTS ARE MUTUALLY EXCLUSIVE IT
MEANS THAT THEY DO THE SAME JOB. FOR EXAMPLE, A FORKLIFT TRUCK
VERSUS A CONVEYOR SYSTEM TO MOVE MATERIALS, OR A BRIDGE VERSUS A
FERRY BOAT.
PROJECTS WITH NORMAL CASH FLOWS HAVE OUTFLOWS, OR COSTS, IN THE
FIRST YEAR (OR YEARS) FOLLOWED BY A SERIES OF INFLOWS. PROJECTS WITH
NONNORMAL CASH FLOWS HAVE ONE OR MORE OUTFLOWS AFTER THE INFLOW
STREAM HAS BEGUN. HERE ARE SOME EXAMPLES:

Mini Case: 11 - 32 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 INFLOW (+) OR OUTFLOW (-) IN YEAR
0 1 2 3 4 5
NORMAL - + + + + +
- - + + + +
- - - + + +

NONNORMAL - + + + + -
- + + - + -
+ + + - - -

C. 1. WHAT IS THE PAYBACK PERIOD? FIND THE PAYBACKS FOR

PROJECTS L AND S.

ANSWER: THE PAYBACK PERIOD IS THE EXPECTED NUMBER OF YEARS REQUIRED TO

RECOVER A PROJECT'S COST. WE CALCULATE THE PAYBACK BY DEVELOPING THE
CUMULATIVE CASH FLOWS AS SHOWN BELOW FOR PROJECT L (IN THOUSANDS OF
DOLLARS):

EXPECTED NCF
YEAR ANNUAL CUMULATIVE
0 ($100) ($100)
1 10 (90)
2 60 (30) PAYBACK IS BETWEEN
3 80 50 ────── t = 2 AND t = 3

0 1 2 3
├──────────┼───────────┼───────────┤
-100 10 60 80
-90 -30 +50

PROJECT L'S $100 INVESTMENT HAS NOT BEEN RECOVERED AT THE END OF YEAR
2, BUT IT HAS BEEN MORE THAN RECOVERED BY THE END OF YEAR 3. THUS,
THE RECOVERY PERIOD IS BETWEEN 2 AND 3 YEARS. IF WE ASSUME THAT THE
CASH FLOWS OCCUR EVENLY OVER THE YEAR, THEN THE INVESTMENT IS
RECOVERED $30/$80 = 0.375  0.4 INTO YEAR 3. THEREFORE, PAYBACKL =
2.4 YEARS. SIMILARLY, PAYBACKS = 1.6 YEARS.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 11 - 33
 C. 2. WHAT IS THE RATIONALE FOR THE PAYBACK METHOD?
ACCORDING TO THE PAYBACK CRITERION, WHICH PROJECT OR PROJECTS
SHOULD BE ACCEPTED IF THE FIRM'S MAXIMUM ACCEPTABLE PAYBACK IS 2
YEARS, AND IF PROJECTS L AND S ARE INDEPENDENT? IF THEY ARE MUTUALLY
EXCLUSIVE?

Mini Case: 11 - 34 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
ANSWER: PAYBACK REPRESENTS A TYPE OF "BREAKEVEN" ANALYSIS: THE PAYBACK
PERIOD TELLS US WHEN THE PROJECT WILL BREAK EVEN IN A CASH FLOW
SENSE. WITH A REQUIRED PAYBACK OF 2 YEARS, PROJECT S IS ACCEPTABLE,
BUT PROJECT L IS NOT. WHETHER THE TWO PROJECTS ARE INDEPENDENT OR
MUTUALLY EXCLUSIVE MAKES NO DIFFERENCE IN THIS CASE.

C. 3. WHAT IS THE DIFFERENCE BETWEEN THE REGULAR AND DISCOUNTED

PAYBACK PERIODS?

ANSWER: DISCOUNTED PAYBACK IS SIMILAR TO PAYBACK EXCEPT THAT DISCOUNTED

RATHER THAN RAW CASH FLOWS ARE USED.
SETUP FOR PROJECT L'S DISCOUNTED PAYBACK, ASSUMING A 10% COST OF
CAPITAL:

EXPECTED NET CASH FLOWS

YEAR RAW DISCOUNTED CUMULATIVE
0 ($100) ($100.00) ($100.00)
1 10 9.09 (90.91)
2 60 49.59 (41.32)
3 80 60.11 18.79

DISCOUNTED PAYBACKL = 2 + ($41.32/$60.11) = 2.69 = 2.7 YEARS.

VERSUS 2.4 YEARS FOR THE REGULAR PAYBACK.

C. 4. WHAT IS THE MAIN DISADVANTAGE OF DISCOUNTED PAYBACK? IS

THE PAYBACK METHOD OF ANY REAL USEFULNESS IN CAPITAL BUDGETING DECISIONS?

ANSWER: REGULAR PAYBACK HAS TWO CRITICAL DEFICIENCIES: (1) IT IGNORES THE
TIME VALUE OF MONEY, AND (2) IT IGNORES THE CASH FLOWS THAT OCCUR
AFTER THE PAYBACK PERIOD. DISCOUNTED PAYBACK DOES CONSIDER THE TIME
VALUE OF MONEY, BUT IT STILL FAILS TO CONSIDER CASH FLOWS AFTER THE
PAYBACK PERIOD; HENCE IT HAS A BASIC FLAW. IN SPITE OF ITS
DEFICIENCY, MANY FIRMS TODAY STILL CALCULATE THE DISCOUNTED PAYBACK
AND GIVE SOME WEIGHT TO IT WHEN MAKING CAPITAL BUDGETING DECISIONS.
HOWEVER, PAYBACK IS NOT GENERALLY USED AS THE PRIMARY DECISION TOOL.
RATHER, IT IS USED AS A ROUGH MEASURE OF A PROJECT'S LIQUIDITY AND
RISKINESS.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 11 - 35
 D. 1. DEFINE THE TERM NET PRESENT VALUE (NPV). WHAT IS EACH PROJECT'S
NPV?

ANSWER: THE NET PRESENT VALUE (NPV) IS SIMPLY THE SUM OF THE PRESENT VALUES
OF A PROJECT'S CASH FLOWS:

Install Equation Editor and double-

click here to view equation.

PROJECT L'S NPV IS $18.79:

0 10% 1 2 3
├──────────────┼──────────────┼──────────────┤
(100.00) 10 60 80
9.09 ─────────┘ │ │
49.59 ────────────────────────┘ │
60.11 ───────────────────────────────────────┘
18.79 = NPVL

NPVs ARE EASY TO DETERMINE USING A CALCULATOR WITH AN NPV FUNCTION.

ENTER THE CASH FLOWS SEQUENTIALLY, WITH OUTFLOWS ENTERED AS
NEGATIVES; ENTER THE COST OF CAPITAL; AND THEN PRESS THE NPV BUTTON
TO OBTAIN THE PROJECT'S NPV, $18.78 (NOTE THE PENNY ROUNDING
DIFFERENCE). THE NPV OF PROJECT S IS NPVS = $19.98.

D. 2. WHAT IS THE RATIONALE BEHIND THE NPV METHOD? ACCORDING

TO NPV, WHICH PROJECT OR PROJECTS SHOULD BE ACCEPTED IF THEY ARE
INDEPENDENT? MUTUALLY EXCLUSIVE?

ANSWER: THE RATIONALE BEHIND THE NPV METHOD IS STRAIGHTFORWARD: IF A PROJECT

HAS NPV = $0, THEN THE PROJECT GENERATES EXACTLY ENOUGH CASH FLOWS
(1) TO RECOVER THE COST OF THE INVESTMENT AND (2) TO ENABLE INVESTORS
TO EARN THEIR REQUIRED RATES OF RETURN (THE OPPORTUNITY COST OF
CAPITAL). IF NPV = $0, THEN IN A FINANCIAL (BUT NOT AN ACCOUNTING)
SENSE, THE PROJECT BREAKS EVEN. IF THE NPV IS POSITIVE, THEN MORE
THAN ENOUGH CASH FLOW IS GENERATED, AND CONVERSELY IF NPV IS
NEGATIVE.
CONSIDER PROJECT L'S CASH INFLOWS, WHICH TOTAL $150. THEY ARE
SUFFICIENT (1) TO RETURN THE $100 INITIAL INVESTMENT, (2) TO PROVIDE
INVESTORS WITH THEIR 10 PERCENT AGGREGATE OPPORTUNITY COST OF
CAPITAL, AND (3) TO STILL HAVE $18.79 LEFT OVER ON A PRESENT VALUE
BASIS. THIS $18.79 EXCESS PV BELONGS TO THE SHAREHOLDERS--THE

Mini Case: 11 - 36 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 DEBTHOLDERS' CLAIMS ARE FIXED, SO THE SHAREHOLDERS' WEALTH WILL BE
INCREASED BY $18.79 IF PROJECT L IS ACCEPTED. SIMILARLY, AXIS'S
SHAREHOLDERS GAIN $19.98 IN VALUE IF PROJECT S IS ACCEPTED.
IF PROJECTS L AND S ARE INDEPENDENT, THEN BOTH SHOULD BE ACCEPTED,
BECAUSE THEY BOTH ADD TO SHAREHOLDERS' WEALTH, HENCE TO THE STOCK
PRICE. IF THE PROJECTS ARE MUTUALLY EXCLUSIVE, THEN PROJECT S SHOULD
BE CHOSEN OVER L, BECAUSE S ADDS MORE TO THE VALUE OF THE FIRM.

D. 3. WOULD THE NPVs CHANGE IF THE COST OF CAPITAL CHANGED?

ANSWER: THE NPV OF A PROJECT IS DEPENDENT ON THE COST OF CAPITAL USED. THUS,
IF THE COST OF CAPITAL CHANGED, THE NPV OF EACH PROJECT WOULD CHANGE.
NPV DECLINES AS k INCREASES, AND NPV RISES AS k FALLS.

E. 1. DEFINE THE TERM INTERNAL RATE OF RETURN (IRR). WHAT IS

EACH PROJECT'S IRR?

ANSWER: THE INTERNAL RATE OF RETURN (IRR) IS THAT DISCOUNT RATE WHICH FORCES
THE NPV OF A PROJECT TO EQUAL ZERO:

0 IRR 1 2 3
├──────────────┼──────────────┼──────────────┤
CF0 CF1 CF2 CF3
PVCF1 ─────────┘ │ │
PVCF2 ────────────────────────┘ │
PVCF3 ───────────────────────────────────────┘
_____
0 = SUM OF PVs = NPV.

EXPRESSED AS AN EQUATION, WE HAVE:

Install Equation Editor and double-

click here to view equation.

NOTE THAT THE IRR EQUATION IS THE SAME AS THE NPV EQUATION, EXCEPT
THAT TO FIND THE IRR THE EQUATION IS SOLVED FOR THE PARTICULAR
DISCOUNT RATE, IRR, WHICH FORCES THE PROJECT'S NPV TO EQUAL ZERO (THE
IRR) RATHER THAN USING THE COST OF CAPITAL (k) IN THE DENOMINATOR AND
FINDING NPV. THUS, THE TWO APPROACHES DIFFER IN ONLY ONE RESPECT:
IN THE NPV METHOD, A DISCOUNT RATE IS SPECIFIED (THE PROJECT'S COST

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 11 - 37
 OF CAPITAL) AND THE EQUATION IS SOLVED FOR NPV, WHILE IN THE IRR
METHOD, THE NPV IS SPECIFIED TO EQUAL ZERO AND THE DISCOUNT RATE
(IRR) WHICH FORCES THIS EQUALITY IS FOUND.
PROJECT L'S IRR IS 18.1 PERCENT:

0 18.1% 1 2 3
├──────────────┼──────────────┼──────────────┤
-100.00 10 60 80
8.47 ────────┘ │ │
43.02 ───────────────────────┘ │
48.57 ──────────────────────────────────────┘
$ 0.06  $0 IF IRRL = 18.1% IS USED AS THE DISCOUNT RATE.

THEREFORE, IRRL  18.1%.

A FINANCIAL CALCULATOR IS EXTREMELY HELPFUL WHEN CALCULATING IRRs.

THE CASH FLOWS ARE ENTERED SEQUENTIALLY, AND THEN THE IRR BUTTON IS
PRESSED. FOR PROJECT S, IRRS  23.6%. NOTE THAT WITH MANY
CALCULATORS, YOU CAN ENTER THE CASH FLOWS INTO THE CASH FLOW
REGISTER, ALSO ENTER k = I, AND THEN CALCULATE BOTH NPV AND IRR BY
PRESSING THE APPROPRIATE BUTTONS.

E. 2. HOW IS THE IRR ON A PROJECT RELATED TO THE YTM ON A BOND?

ANSWER: THE IRR IS TO A CAPITAL PROJECT WHAT THE YTM IS TO A BOND—IT IS THE
EXPECTED RATE OF RETURN ON THE PROJECT, JUST AS THE YTM IS THE
PROMISED RATE OF RETURN ON A BOND.

E. 3. WHAT IS THE LOGIC BEHIND THE IRR METHOD? ACCORDING TO

IRR, WHICH PROJECTS SHOULD BE ACCEPTED IF THEY ARE INDEPENDENT? MUTUALLY
EXCLUSIVE?

ANSWER: IRR MEASURES A PROJECT'S PROFITABILITY IN THE RATE OF RETURN SENSE:

IF A PROJECT'S IRR EQUALS ITS COST OF CAPITAL, THEN ITS CASH FLOWS
ARE JUST SUFFICIENT TO PROVIDE INVESTORS WITH THEIR REQUIRED RATES OF
RETURN. AN IRR GREATER THAN k IMPLIES AN ECONOMIC PROFIT, WHICH
ACCRUES TO THE FIRM'S SHAREHOLDERS, WHILE AN IRR LESS THAN k
INDICATES AN ECONOMIC LOSS, OR A PROJECT THAT WILL NOT EARN ENOUGH TO
COVER ITS COST OF CAPITAL.

Mini Case: 11 - 38 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 PROJECTS' IRRs ARE COMPARED TO THEIR COSTS OF CAPITAL, OR HURDLE
RATES. SINCE PROJECTS L AND S BOTH HAVE A HURDLE RATE OF 10 PERCENT,
AND SINCE BOTH HAVE IRRs GREATER THAN THAT HURDLE RATE, BOTH SHOULD
BE ACCEPTED IF THEY ARE INDEPENDENT. HOWEVER, IF THEY ARE MUTUALLY
EXCLUSIVE, PROJECT S WOULD BE SELECTED, BECAUSE IT HAS THE HIGHER
IRR.

E. 4. WOULD THE PROJECTS' IRRs CHANGE IF THE COST OF CAPITAL

CHANGED?

ANSWER: IRRs ARE INDEPENDENT OF THE COST OF CAPITAL. THEREFORE, NEITHER IRR S
NOR IRRL WOULD CHANGE IF k CHANGED. HOWEVER, THE ACCEPTABILITY OF
THE PROJECTS COULD CHANGE—L WOULD BE REJECTED IF k WERE ABOVE 18.1%,
AND S WOULD ALSO BE REJECTED IF k WERE ABOVE 23.6%.

F. 1. DRAW NPV PROFILES FOR PROJECTS L AND S. AT WHAT DISCOUNT

RATE DO THE PROFILES CROSS?

ANSWER: THE NPV PROFILES ARE PLOTTED IN THE FIGURE BELOW.

NOTE THE FOLLOWING POINTS:

1. THE Y-INTERCEPT IS THE PROJECT'S NPV WHEN k = 0%. THIS IS $50 FOR
L AND $40 FOR S.

2. THE X-INTERCEPT IS THE PROJECT'S IRR. THIS IS 18.1 PERCENT FOR L

AND 23.6 PERCENT FOR S.

3. NPV PROFILES ARE CURVES RATHER THAN STRAIGHT LINES. TO SEE THIS,
NOTE THAT THESE PROFILES APPROACH COST = -$100 AS k APPROACHES
INFINITY.

4. FROM THE FIGURE BELOW, IT APPEARS THAT THE CROSSOVER POINT IS

BETWEEN 8 AND 9 PERCENT. THE PRECISE VALUE IS APPROXIMATELY 8.7
PERCENT. ONE CAN CALCULATE THE CROSSOVER RATE BY (1) GOING BACK
TO THE DATA ON THE PROBLEM, FINDING THE CASH FLOW DIFFERENCES FOR
EACH YEAR, (2) ENTERING THOSE DIFFERENCES INTO THE CASH FLOW
REGISTER, AND (3) PRESSING THE IRR BUTTON TO GET THE CROSSOVER
RATE, 8.68%  8.7%.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 11 - 39
 k NPVL NPVS
___ _____ _____
0% $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5

F. 2. LOOK AT YOUR NPV PROFILE GRAPH WITHOUT REFERRING TO THE

ACTUAL NPVs AND IRRs. WHICH PROJECT OR PROJECTS SHOULD BE ACCEPTED IF THEY
ARE INDEPENDENT? MUTUALLY EXCLUSIVE? EXPLAIN. ARE YOUR ANSWERS CORRECT
AT ANY COST OF CAPITAL LESS THAN 23.6 PERCENT?

ANSWER: THE NPV PROFILES SHOW THAT THE IRR AND NPV CRITERIA LEAD TO THE SAME
ACCEPT/REJECT DECISION FOR ANY INDEPENDENT PROJECT. CONSIDER PROJECT
L. IT INTERSECTS THE X-AXIS AT ITS IRR, 18.1 PERCENT. ACCORDING TO
THE IRR RULE, L IS ACCEPTABLE IF k IS LESS THAN 18.1 PERCENT. ALSO,
AT ANY k LESS THAN 18.1 PERCENT, L'S NPV PROFILE WILL BE ABOVE THE X
AXIS, SO ITS NPV WILL BE GREATER THAN $0. THUS, FOR ANY INDEPENDENT
PROJECT, NPV AND IRR LEAD TO THE SAME ACCEPT/REJECT DECISION.
IRRL. NOW ASSUME THAT L AND S ARE MUTUALLY EXCLUSIVE. IN THIS CASE, A
CONFLICT MIGHT ARISE. FIRST, NOTE THAT IRRS = 23.6% > 18.1% =
THEREFORE, REGARDLESS OF THE SIZE OF k, PROJECT S WOULD BE RANKED
HIGHER BY THE IRR CRITERION. HOWEVER, THE NPV PROFILES SHOW THAT

Mini Case: 11 - 40 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 NPVL > NPVS IF k IS LESS THAN 8.7 PERCENT. THEREFORE, FOR ANY k
BELOW THE 8.7% CROSSOVER RATE, SAY k = 7 PERCENT, THE NPV RULE SAYS
CHOOSE L, BUT THE IRR RULE SAYS CHOOSE S. THUS, IF k IS LESS THAN
THE CROSSOVER RATE, A RANKING CONFLICT OCCURS.

G. 1. WHAT IS THE UNDERLYING CAUSE OF RANKING CONFLICTS BETWEEN

NPV AND IRR?

ANSWER: FOR NORMAL PROJECTS' NPV PROFILES TO CROSS, ONE PROJECT MUST HAVE
BOTH A HIGHER VERTICAL AXIS INTERCEPT AND A STEEPER SLOPE THAN THE
OTHER. A PROJECT'S VERTICAL AXIS INTERCEPT TYPICALLY DEPENDS ON (1)
THE SIZE OF THE PROJECT AND (2) THE SIZE AND TIMING PATTERN OF THE
CASH FLOWS—LARGE PROJECTS, AND ONES WITH LARGE DISTANT CASH FLOWS,
WOULD GENERALLY BE EXPECTED TO HAVE RELATIVELY HIGH VERTICAL AXIS
INTERCEPTS. THE SLOPE OF THE NPV PROFILE DEPENDS ENTIRELY ON THE
TIMING PATTERN OF THE CASH FLOWS—LONG-TERM PROJECTS HAVE STEEPER NPV
PROFILES THAN SHORT-TERM ONES. THUS, WE CONCLUDE THAT NPV PROFILES
CAN CROSS IN TWO SITUATIONS: (1) WHEN MUTUALLY EXCLUSIVE PROJECTS
DIFFER IN SCALE (OR SIZE) AND (2) WHEN THE PROJECTS' CASH FLOWS
DIFFER IN TERMS OF THE TIMING PATTERN OF THEIR CASH FLOWS (AS FOR
PROJECTS L AND S).

G. 2. WHAT IS THE "REINVESTMENT RATE ASSUMPTION," AND HOW DOES

IT AFFECT THE NPV VERSUS IRR CONFLICT?

ANSWER: THE UNDERLYING CAUSE OF RANKING CONFLICTS IS THE REINVESTMENT RATE

ASSUMPTION. ALL DCF METHODS IMPLICITLY ASSUME THAT CASH FLOWS CAN BE
REINVESTED AT SOME RATE, REGARDLESS OF WHAT IS ACTUALLY DONE WITH THE
CASH FLOWS. DISCOUNTING IS THE REVERSE OF COMPOUNDING. SINCE
COMPOUNDING ASSUMES REINVESTMENT, SO DOES DISCOUNTING. NPV AND IRR
ARE BOTH FOUND BY DISCOUNTING, SO THEY BOTH IMPLICITLY ASSUME SOME
DISCOUNT RATE. INHERENT IN THE NPV CALCULATION IS THE ASSUMPTION
THAT CASH FLOWS CAN BE REINVESTED AT THE PROJECT'S COST OF CAPITAL,
WHILE THE IRR CALCULATION ASSUMES REINVESTMENT AT THE IRR RATE.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 11 - 41
 G. 3. WHICH METHOD IS THE BEST? WHY?

ANSWER: WHETHER NPV OR IRR GIVES BETTER RANKINGS DEPENDS ON WHICH HAS THE
BETTER REINVESTMENT RATE ASSUMPTION. NORMALLY, THE NPV'S ASSUMPTION
IS BETTER. THE REASON IS AS FOLLOWS: A PROJECT'S CASH INFLOWS ARE
GENERALLY USED AS SUBSTITUTES FOR OUTSIDE CAPITAL, THAT IS, PROJECTS'
CASH FLOWS REPLACE OUTSIDE CAPITAL AND, HENCE, SAVE THE FIRM THE COST
OF OUTSIDE CAPITAL. THEREFORE, IN AN OPPORTUNITY COST SENSE, A
PROJECT'S CASH FLOWS ARE REINVESTED AT THE COST OF CAPITAL. TO SEE
THIS GRAPHICALLY, THINK OF THE FOLLOWING SITUATION: ASSUME THE
FIRM'S COST OF CAPITAL IS A CONSTANT 10% WITHIN THE RELEVANT RANGE OF
FINANCING CONSIDERED, AND IT HAS PROJECTS AVAILABLE AS SHOWN IN THE
GRAPH BELOW:

WHAT PROJECTS WILL BE ACCEPTED, BY EITHER NPV OR IRR? PROJECTS A,

B, C, AND D.
IF THE SAME SITUATION EXISTS YEAR AFTER YEAR, AT WHAT RATE OF
RETURN WILL CASH FLOWS FROM EARLIER YEARS' INVESTMENTS BE REINVESTED?
CAPITAL BUDGETING DECISIONS ARE MADE IN THIS SEQUENCE: (1) THE
COMPANY WOULD SAY, "WE CAN TAKE ON A, B, C, AND D AND FINANCE THEM
WITH 10% MONEY, SO LET'S DO IT." (2) THEN IT WOULD GET CASH FLOWS
FROM EARLIER YEARS' PROJECTS. WHAT WOULD IT DO WITH THOSE CASH
FLOWS? IT WOULD USE THEM IN LIEU OF RAISING MONEY THAT COSTS 10%, SO
IT WOULD SAVE 10%. THEREFORE, 10% IS THE OPPORTUNITY COST OF THE
CASH FLOWS. IN EFFECT, CASH FLOWS ARE REINVESTED AT THE 10% COST OF
CAPITAL.

Mini Case: 11 - 42 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 NOTE, HOWEVER, THAT NPV AND IRR ALWAYS GIVE THE SAME ACCEPT/REJECT
DECISIONS FOR INDEPENDENT PROJECTS, SO IRR CAN BE USED JUST AS WELL
AS NPV WHEN INDEPENDENT PROJECTS ARE BEING EVALUATED. THE NPV VERSUS
IRR CONFLICT ARISES ONLY IF MUTUALLY EXCLUSIVE PROJECTS ARE INVOLVED.

H. 1. DEFINE THE TERM MODIFIED IRR (MIRR). FIND THE MIRRs FOR
PROJECTS L AND S.

ANSWER: MIRR IS THAT DISCOUNT RATE WHICH EQUATES THE PRESENT VALUE OF THE
TERMINAL VALUE OF THE INFLOWS, COMPOUNDED AT THE COST OF CAPITAL, TO
THE PRESENT VALUE OF THE COSTS. HERE IS THE SETUP FOR CALCULATING
PROJECT L'S MODIFIED IRR:

0 k = 10% 1 2 3
├──────────────┼──────────────┼──────────────┤
PV OF COSTS = (100.00) 10 60 80.00
│ └────────── 66.00
└───────────────────────── 12.10
TV OF INFLOWS = 158.10
MIRR = ? │
PV OF TV = 100.00 ────────────────────────────────────────────┘
Install Equation Editor and double-
= $100 = click here to view equation. .

Install Equation Editor and double-

click here to view equation.

MIRRS AFTER YOU CALCULATE THE TV, ENTER N = 3, PV = -100, PMT = 0, FV =

158.1, AND THEN PRESS I TO GET THE ANSWER, MIRR L = 16.5%. WE COULD
CALCULATE MIRRS SIMILARLY: = 16.9%. THUS, PROJECT S IS RANKED HIGHER
THAN L. THIS RESULT IS CONSISTENT WITH THE NPV DECISION.

H. 2. WHAT ARE THE MIRR'S ADVANTAGES AND DISADVANTAGES VIS-A-

VIS THE REGULAR IRR? WHAT ARE THE MIRR'S ADVANTAGES AND DISADVANTAGES VIS-
A-VIS THE NPV?

ANSWER: MIRR IS A BETTER RATE OF RETURN MEASURE THAN IRR FOR TWO REASONS:
(1) IT CORRECTLY ASSUMES REINVESTMENT AT THE PROJECT'S COST OF
CAPITAL RATHER THAN AT ITS IRR. (2) MIRR AVOIDS THE PROBLEM OF
MULTIPLE IRRs—THERE CAN BE ONLY ONE MIRR FOR A GIVEN PROJECT.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 11 - 43
 MIRR DOES NOT ALWAYS LEAD TO THE SAME DECISION AS NPV WHEN
MUTUALLY EXCLUSIVE PROJECTS ARE BEING CONSIDERED. IN PARTICULAR,
SMALL PROJECTS OFTEN HAVE A HIGHER MIRR, BUT A LOWER NPV, THAN LARGER
PROJECTS. THUS, MIRR IS NOT A PERFECT SUBSTITUTE FOR NPV, AND NPV
REMAINS THE SINGLE BEST DECISION RULE. HOWEVER, MIRR IS SUPERIOR TO
THE REGULAR IRR, AND IF A RATE OF RETURN MEASURE IS NEEDED, MIRR
SHOULD BE USED.
BUSINESS EXECUTIVES AGREE. AS NOTED IN THE TEXT, BUSINESS
EXECUTIVES PREFER TO COMPARE PROJECTS' RATES OF RETURN TO COMPARING
THEIR NPVs. THIS IS AN EMPIRICAL FACT. AS A RESULT, FINANCIAL
MANAGERS ARE SUBSTITUTING MIRR FOR IRR IN THEIR DISCUSSIONS WITH
OTHER CORPORATE EXECUTIVES. THIS FACT WAS BROUGHT OUT IN THE OCTOBER
1989 FMA MEETINGS, WHERE EXECUTIVES FROM DU PONT, HERSHEY, AND
AMERITECH, AMONG OTHERS, ALL REPORTED A SWITCH FROM IRR TO MIRR.

I. AS A SEPARATE PROJECT (PROJECT P), THE FIRM IS CONSIDERING

SPONSORING A PAVILION
YEAR NET ATCASH
THE FLOWS
UPCOMING WORLD'S FAIR. THE PAVILION
WOULD COST $800,000,
0 ($0.8)
AND IT IS EXPECTED TO RESULT IN $5 MILLION OF
INCREMENTAL CASH 1 INFLOWS
5.0 DURING ITS 1 YEAR OF OPERATION. HOWEVER,
IT WOULD THEN 2TAKE (5.0) ANOTHER YEAR, AND $5 MILLION OF COSTS, TO
DEMOLISH THE SITE AND RETURN IT TO ITS ORIGINAL CONDITION. THUS,
PROJECTTHE
P'SPROJECT
EXPECTED
IS ESTIMATED
NET CASH FLOWS
TO BE OF
LOOK
AVERAGE
LIKE THIS
RISK,(IN
SOMILLIONS
ITS COSTOF
OF
DOLLARS):
CAPITAL IS 10 PERCENT.

1. WHAT IS PROJECT P's NPV? WHAT IS ITS IRR? ITS MIRR?

ANSWER: HERE IS THE TIME LINE FOR THE CASH FLOWS, AND THE NPV:

0 10% 1 2
├──────────────┼──────────────┤
-800,000 5,000,000 -5,000,000

NPVP = -$386,776.86.
WE CAN FIND THE NPV BY ENTERING THE CASH FLOWS INTO THE CASH FLOW
REGISTER, ENTERING I = 10, AND THEN PRESSING THE NPV BUTTON.
HOWEVER, CALCULATING THE IRR PRESENTS A PROBLEM. WITH THE CASH FLOWS
IN THE REGISTER, PRESS THE IRR BUTTON. AN HP-10B FINANCIAL
CALCULATOR WILL GIVE THE MESSAGE "ERROR-SOLN." THIS MEANS THAT
PROJECT P HAS MULTIPLE IRRs. AN HP-17B WILL ASK FOR A GUESS. IF YOU
GUESS 10%, THE CALCULATOR WILL PRODUCE IRR = 25%. IF YOU GUESS A

Mini Case: 11 - 44 The Dryden Press items and derived items copyright © 1999 by The Dryden Press
 HIGH NUMBER, SUCH AS 200%, IT WILL
Install Equation PRODUCE
Editor THE SECOND IRR, 400% 1.
and double-
THE MIRR OF PROJECT click here to view equation. , AND IS FOUND BY
COMPUTING THE DISCOUNT RATE THAT EQUATES THE TERMINAL VALUE ($5.5
MILLION) TO THE PRESENT VALUE OF COST ($4.93 MILLION).

I. 2. DRAW PROJECT P'S NPV PROFILE. DOES PROJECT P HAVE NORMAL

OR NON-NORMAL CASH FLOWS? SHOULD THIS PROJECT BE ACCEPTED?

ANSWER: YOU COULD PUT THE CASH FLOWS IN YOUR CALCULATOR AND THEN ENTER A
SERIES OF I VALUES, GET AN NPV FOR EACH, AND THEN PLOT THE POINTS TO
CONSTRUCT THE NPV PROFILE. WE USED A SPREADSHEET PROGRAM TO AUTOMATE
THE PROCESS AND THEN TO DRAW THE PROFILE. NOTE THAT THE PROFILE
CROSSES THE X-AXIS TWICE, AT 25% AND AT 400%, SIGNIFYING TWO IRRs.
WHICH IRR IS CORRECT? IN ONE SENSE, THEY BOTH ARE—BOTH CAUSE THE
PROJECT'S NPV TO EQUAL ZERO. HOWEVER, IN ANOTHER SENSE, BOTH ARE
WRONG—NEITHER HAS ANY ECONOMIC OR FINANCIAL SIGNIFICANCE.
PROJECT P HAS NONNORMAL CASH FLOWS; THAT IS, IT HAS MORE THAN ONE
CHANGE OF SIGNS IN THE CASH FLOWS. WITHOUT THIS NONNORMAL CASH FLOW
PATTERN, WE WOULD NOT HAVE THE MULTIPLE IRRs.
SINCE PROJECT P'S NPV IS NEGATIVE, THE PROJECT SHOULD BE REJECTED,
EVEN THOUGH BOTH IRRs (25% AND 400%) ARE GREATER THAN THE PROJECT'S
10 PERCENT COST OF CAPITAL. THE MIRR OF 5.6% ALSO SUPPORTS THE
DECISION THAT THE PROJECT SHOULD BE REJECTED.

1 Looking at the figure below, if you guess an IRR to the left of the peak NPV rate, the lower IRR will appear.
If you guess IRR > peak NPV rate, the higher IRR will appear.

The Dryden Press items and derived items copyright © 1999 by The Dryden Press Mini Case: 11 - 45
Mini Case: 11 - 46 The Dryden Press items and derived items copyright © 1999 by The Dryden Press