Scribd
Upload
76 views

Chapter 9 Practice Problem Solutions

1. The document presents cash flow information for two projects, Projects A and B, over 4 years and calculates their payback periods and discounted payback periods. Project B has a shorter payback period and discounted payback period. 2. It then calculates the net present value (NPV) of each project using a discount rate and finds that Project A has a higher NPV. 3. The internal rate of return (IRR) is also calculated, and Project B has a higher IRR. Therefore, based on the IRR, Project B should be accepted.

Uploaded by

Hi Hey
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
76 views

Chapter 9 Practice Problem Solutions

1. The document presents cash flow information for two projects, Projects A and B, over 4 years and calculates their payback periods and discounted payback periods. Project B has a shorter payback period and discounted payback period. 2. It then calculates the net present value (NPV) of each project using a discount rate and finds that Project A has a higher NPV. 3. The internal rate of return (IRR) is also calculated, and Project B has a higher IRR. Therefore, based on the IRR, Project B should be accepted.

Uploaded by

Hi Hey
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 5

Chapter 9

17. a.

  Project A Project A
Cumulati Cumulati
Year Cash flow ve Cash flow ve
0 -364000   -52000  
1 46000 -318000 25000 -27000
2 68000 -250000 22000 -5000
3 68000 -182000 21500 16500
4 458000 276000 17500 34000

The payback period for each project is:


A: 3 + ($182,000/$458,000) = 3.40 years
B: 2 + ($5,000/$21,500) = 2.23 years
The payback criterion implies accepting Project B, because it pays back sooner than Project A.

b.

  Project A Project A
Year Cash flow DCF Cumulative DCF Cash flow DCF Cumulative DCF
0 -364,000 -364,000 -52,000 -52,000
1 46,000 41,441 -322,559 25,000 22,523 -29,477
2 68,000 55,190 -267,368 22,000 17,856 -11,622
3 68,000 49,721 -217,647 21,500 15,721 4,099
4 458,000 301,699 84,052 17,500 11,528 15,627

The discounted payback for each project is:


A:
Discounted payback = 3 + ($217647)/$301,699 =3.72 (assuming cash flows occur evenly
throughout the year))
= 4 years (assuming all cash flow is at the end of the year)

B: Discounted payback = 2 + ($11622)/$15,721 (assuming cash flows occur evenly throughout


the year)) = 2.74 years.
Discounted payback = 3 years (assuming all cash flow is at the end of the year)
The discounted payback criterion implies accepting Project B because it pays back sooner than A.

c. The NPV for each project is:


A: NPV = add all discounted CF
NPV = $84,051.57
B: NPV = $15,626.62
NPV criterion implies we accept Project A because Project A has a higher NPV than Project B.
d. The IRR for each project is:
A: IRR = 18.14%
B: IRR = 25.29%
IRR decision rule implies we accept Project B because IRR for B is greater than IRR for A.
19. The MIRRs for the project with all three approaches is:
Discounting approach:
In the discounting approach, we find the value of all negative cash outflows at Time 0, while any
positive cash inflows remain at the time at which they occur. So, discounting the cash outflows to
Time 0, we find:
Time 0 cash flow = –$47,000 – $9,500/1.105
Time 0 cash flow = –$52,898.75
So, the MIRR using the discounting approach is:
0 = –$52,898.75 + $16,900/(1 + MIRR) + $20,300/(1 + MIRR)2 + $25,800/(1 + MIRR)3
+ $19,600/(1 + MIRR)4
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find:
MIRR = 19.68%

Reinvestment approach:
In the reinvestment approach, we find the future value of all cash except the initial cash flow at the
end of the project. So, reinvesting the cash flows to Time 5, we find:
Time 5 cash flow = $16,900(1.104) + $20,300(1.103) + $25,800(1.102) + $19,600(1.10) – $9,500
Time 5 cash flow = $95,040.59
So, the MIRR using the reinvestment approach is:

0 = –$47,000 + $95,040.59/(1 + MIRR)5


$95,040.59/$47,000 = (1 + MIRR)5
MIRR = ($95,040.59/$47,000)1/5 – 1
MIRR = .1512, or 15.12%

Combination approach:
In the combination approach, we find the value of all cash outflows at Time 0, and the value of all
cash inflows at the end of the project. So, the value of the cash flows is:
Time 0 cash flow = –$47,000 – $9,500/1.105
Time 0 cash flow = –$52,898.75
Time 5 cash flow = $16,900(1.104) + $20,300(1.103) + $25,800(1.102) + $19,600(1.10)
Time 5 cash flow = $104,540.59

So, the MIRR using the combination approach is:

0 = –$52,898.75 + $104,540.59/(1 + MIRR)5


$104,540.59/$52,898.75 = (1 + MIRR)5
MIRR = ($104,540.59/$52,898.75)1/5 – 1
MIRR = .1460, or 14.60%

23. Given the seven-year payback, the worst case is that the payback occurs at the end of the seventh
year. Thus, the worst-case:

NPV = –$685,000 + $685,000/1.117


NPV = –$355,063.99
Since payback rule does not take into account cash flows occurring after 7 years, we can assume that
the project will continue to have cash flows in perpetuity. Thus, the best case NPV is infinite.
25. a. Here the cash inflows of the project go on forever and grow at a constant rate forever, which is
a growing perpetuity. If you remember back to the chapter on stock valuation, we presented a
formula for a growing perpetuity, so we can use it here. The PV of the future cash flows from
the project is:
PV of cash inflows = C1/(R – g)
PV of cash inflows = $145,000/(.11 – .04)
PV of cash inflows = $2,071,428.57

NPV is the PV of the inflows minus the PV of the outflows, so the NPV is:

NPV = –$1,900,000 + 2,071,428.57


NPV = $171,428.57
The NPV is positive, so we would accept the project.
b. Here we want to know the minimum growth rate in cash flows necessary to accept the project.
The minimum growth rate is the growth rate at which we would have a zero NPV. The equation
for a zero NPV, using the equation for the PV of a growing perpetuity, is:
0 = –$1,900,000 + $145,000/(.11 – g)
Solving for g, we get: g = .0337, or 3.37%

26. The IRR of the project is:


$59,000 = $34,000/(1 + IRR) + $39,000/(1 + IRR)2
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find
that:
IRR = 15.07%
At an interest rate of 12 percent, the NPV is:
NPV = $59,000 – $34,000/1.12 – $39,000/1.122
NPV = –$2,447.70
At an interest rate of zero percent, we can add cash flows, so the NPV is:
NPV = $59,000 – $34,000 – $39,000
NPV = –$14,000
And at an interest rate of 24 percent, the NPV is:
NPV = $59,000 – $34,000/1.24 – $39,000/1.242
NPV = $6,216.44

The cash flows for the project are unconventional. Since the initial cash flow is positive and the
remaining cash flows are negative, the decision rule for IRR is invalid in this case. The NPV
profile is upward sloping, indicating that the project is more valuable when the interest rate increases
– this is absurd as value of a project should decline as discount rate or riskiness increases.

You might also like