Chapter

 9  Solutions  

1. To calculate the payback period, we need to find the time that the project has recovered its initial
investment. After three years, the project has created:

$1,600 + 1,900 + 2,300 = $5,800

in cash flows. The project still needs to create another:

$6,400 – 5,800 = $600

in cash flows. During the fourth year, the cash flows from the project will be $1,400. So, the payback
period will be 3 years, plus what we still need to make divided by what we will make during the
fourth year. The payback period is:

Payback = 3 + ($600 / $1,400) = 3.43 years

2. To calculate the payback period, we need to find the time that the project has recovered its initial
investment. The cash flows in this problem are an annuity, so the calculation is simpler. If the initial
cost is $2,400, the payback period is:

Payback = 3 + ($105 / $765) = 3.14 years

There is a shortcut to calculate the future cash flows are an annuity. Just divide the initial cost by the
annual cash flow. For the $2,400 cost, the payback period is:

Payback = $2,400 / $765 = 3.14 years

For an initial cost of $3,600, the payback period is:

Payback = $3,600 / $765 = 4.71 years

The payback period for an initial cost of $6,500 is a little trickier. Notice that the total cash inflows
after eight years will be:

Total cash inflows = 8($765) = $6,120

If the initial cost is $6,500, the project never pays back. Notice that if you use the shortcut for annuity
cash flows, you get:

Payback = $6,500 / $765 = 8.50 years

This answer does not make sense since the cash flows stop after eight years, so again, we must
conclude the payback period is never.

3. Project A has cash flows of $19,000 in Year 1, so the cash flows are short by $21,000 of recapturing
the initial investment, so the payback for Project A is:

Payback = 1 + ($21,000 / $25,000) = 1.84 years

Project B has cash flows of:

Cash flows = $14,000 + 17,000 + 24,000 = $55,000

 during this first three years. The cash flows are still short by $5,000 of recapturing the initial
investment, so the payback for Project B is:

B: Payback = 3 + ($5,000 / $270,000) = 3.019 years

Using the payback criterion and a cutoff of 3 years, accept project A and reject project B.

4. When we use discounted payback, we need to find the value of all cash flows today. The value today
of the project cash flows for the first four years is:

Value today of Year 1 cash flow = $4,200/1.14 = $3,684.21

Value today of Year 2 cash flow = $5,300/1.142 = $4,078.18
Value today of Year 3 cash flow = $6,100/1.143 = $4,117.33
Value today of Year 4 cash flow = $7,400/1.144 = $4,381.39

To find the discounted payback, we use these values to find the payback period. The discounted first
year cash flow is $3,684.21, so the discounted payback for a $7,000 initial cost is:

Discounted payback = 1 + ($7,000 – 3,684.21)/$4,078.18 = 1.81 years

For an initial cost of $10,000, the discounted payback is:

Discounted payback = 2 + ($10,000 – 3,684.21 – 4,078.18)/$4,117.33 = 2.54 years

Notice the calculation of discounted payback. We know the payback period is between two and three
years, so we subtract the discounted values of the Year 1 and Year 2 cash flows from the initial cost.
This is the numerator, which is the discounted amount we still need to make to recover our initial
investment. We divide this amount by the discounted amount we will earn in Year 3 to get the
fractional portion of the discounted payback.

If the initial cost is $13,000, the discounted payback is:

Discounted payback = 3 + ($13,000 – 3,684.21 – 4,078.18 – 4,117.33) / $4,381.39 = 3.26 years

5. R = 0%: 3 + ($2,100 / $4,300) = 3.49 years

discounted payback = regular payback = 3.49 years

R = 5%: $4,300/1.05 + $4,300/1.052 + $4,300/1.053 = $11,709.97

$4,300/1.054 = $3,537.62
discounted payback = 3 + ($15,000 – 11,709.97) / $3,537.62 = 3.93 years

R = 19%: $4,300(PVIFA19%,6) = $14,662.04

The project never pays back.

7. The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that defines
the IRR for this project is:

0 = – $34,000 + $16,000/(1+IRR) + $18,000/(1+IRR)2 + $15,000/(1+IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 20.97%

Since the IRR is greater than the required return we would accept the project.
8. The NPV of a project is the PV of the outflows minus the PV of the inflows. The equation for the
NPV of this project at an 11 percent required return is:

NPV = – $34,000 + $16,000/1.11 + $18,000/1.112 + $15,000/1.113 = $5,991.49

At an 11 percent required return, the NPV is positive, so we would accept the project.

The equation for the NPV of the project at a 30 percent required return is:

NPV = – $34,000 + $16,000/1.30 + $18,000/1.302 + $15,000/1.303 = –$4,213.93

At a 30 percent required return, the NPV is negative, so we would reject the project.

9. The NPV of a project is the PV of the outflows minus the PV of the inflows. Since the cash inflows
are an annuity, the equation for the NPV of this project at an 8 percent required return is:

NPV = –$138,000 + $28,500(PVIFA8%, 9) = $40,036.31

At an 8 percent required return, the NPV is positive, so we would accept the project.

The equation for the NPV of the project at a 20 percent required return is:

NPV = –$138,000 + $28,500(PVIFA20%, 9) = –$23,117.45

At a 20 percent required return, the NPV is negative, so we would reject the project.

We would be indifferent to the project if the required return was equal to the IRR of the project, since
at that required return the NPV is zero. The IRR of the project is:

0 = –$138,000 + $28,500(PVIFAIRR, 9)

IRR = 14.59%

10. The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that defines
the IRR for this project is:

0 = –$19,500 + $9,800/(1+IRR) + $10,300/(1+IRR)2 + $8,600/(1+IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 22.64%

11. The NPV of a project is the PV of the outflows minus the PV of the inflows. At a zero discount rate
(and only at a zero discount rate), the cash flows can be added together across time. So, the NPV of
the project at a zero percent required return is:

NPV = –$19,500 + 9,800 + 10,300 + 8,600 = $9,200

The NPV at a 10 percent required return is:

NPV = –$19,500 + $9,800/1.1 + $10,300/1.12 + $8,600/1.13 = $4,382.79

 The NPV at a 20 percent required return is:

NPV = –$19,500 + $9,800/1.2 + $10,300/1.22 + $8,600/1.23 = $796.30

And the NPV at a 30 percent required return is:

NPV = –$19,500 + $9,800/1.3 + $10,300/1.32 + $8,600/1.33 = –$1,952.44

Notice that as the required return increases, the NPV of the project decreases. This will always be
true for projects with conventional cash flows. Conventional cash flows are negative at the beginning
of the project and positive throughout the rest of the project.

12. a. The IRR is the interest rate that makes the NPV of the project equal to zero. The equation for the IRR
of Project A is:

0 = –$43,000 + $23,000/(1+IRR) + $17,900/(1+IRR)2 + $12,400/(1+IRR)3 + $9,400/(1+IRR)4

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find
that:

IRR = 20.44%

The equation for the IRR of Project B is:

0 = –$43,000 + $7,000/(1+IRR) + $13,800/(1+IRR)2 + $24,000/(1+IRR)3 + $26,000/(1+IRR)4

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find
that:

IRR = 18.84%

Examining the IRRs of the projects, we see that the IRRA is greater than the IRRB, so IRR
decision rule implies accepting project A. This may not be a correct decision; however, because
the IRR criterion has a ranking problem for mutually exclusive projects. To see if the IRR
decision rule is correct or not, we need to evaluate the project NPVs.

b. The NPV of Project A is:

NPVA = –$43,000 + $23,000/1.11+ $17,900/1.112 + $12,400/1.113 + $9,400/1.114

NPVA = $7,507.61

And the NPV of Project B is:

NPVB = –$43,000 + $7,000/1.11 + $13,800/1.112 + $24,000/1.113 + $26,000/1.114

NPVB = $9,182.29

The NPVB is greater than the NPVA, so we should accept Project B.

c. To find the crossover rate, we subtract the cash flows from one project from the cash flows of
the other project. Here, we will subtract the cash flows for Project B from the cash flows of
Project A. Once we find these differential cash flows, we find the IRR. The equation for the
crossover rate is:

Crossover rate: 0 = $16,000/(1+R) + $4,100/(1+R)2 – $11,600/(1+R)3 – $16,600/(1+R)4

 Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find
that:

R = 15.30%

At discount rates above 15.30% choose project A; for discount rates below 15.30% choose
project B; indifferent between A and B at a discount rate of 15.30%.

13. The IRR is the interest rate that makes the NPV of the project equal to zero. The equation to calculate
the IRR of Project X is:

0 = –$15,000 + $8,150/(1+IRR) + $5,050/(1+IRR)2 + $6,800/(1+IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 16.57%

For Project Y, the equation to find the IRR is:

0 = –$15,000 + $7,700/(1+IRR) + $5,150/(1+IRR)2 + $7,250/(1+IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 16.45%

To find the crossover rate, we subtract the cash flows from one project from the cash flows of the
other project, and find the IRR of the differential cash flows. We will subtract the cash flows from
Project Y from the cash flows from Project X. It is irrelevant which cash flows we subtract from the
other. Subtracting the cash flows, the equation to calculate the IRR for these differential cash flows
is:

Crossover rate: 0 = $450/(1+R) – $100/(1+R)2 – $450/(1+R)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

R = 11.73%

The table below shows the NPV of each project for different required returns. Notice that Project Y
always has a higher NPV for discount rates below 11.73 percent, and always has a lower NPV for
discount rates above 11.73 percent.

R $NPVX $NPVY
0% $5,000.00 $5,100.00
5% $3,216.50 $3,267.36
10% $1,691.59 $1,703.23
15% $376.59 $356.78
20% –$766.20 –$811.34
25% –$1,766.40 –$1,832.00

14. a. The equation for the NPV of the project is:

NPV = –$45,000,000 + $78,000,000/1.1 – $14,000,000/1.12 = $13,482,142.86

 The NPV is greater than 0, so we would accept the project.

b. The equation for the IRR of the project is:

0 = –$45,000,000 + $78,000,000/(1+IRR) – $14,000,000/(1+IRR)2

From Descartes rule of signs, we know there are potentially two IRRs since the cash flows change
signs twice. From trial and error, the two IRRs are:

IRR = 53.00%, –79.67%

When there are multiple IRRs, the IRR decision rule is ambiguous. Both IRRs are correct, that
is, both interest rates make the NPV of the project equal to zero. If we are evaluating whether or
not to accept this project, we would not want to use the IRR to make our decision.

15. The profitability index is defined as the PV of the cash inflows divided by the PV of the cash
outflows. The equation for the profitability index at a required return of 10 percent is:

PI = [$7,300/1.1 + $6,900/1.12 + $5,700/1.13] / $14,000 = 1.187

The equation for the profitability index at a required return of 15 percent is:

PI = [$7,300/1.15 + $6,900/1.152 + $5,700/1.153] / $14,000 = 1.094

The equation for the profitability index at a required return of 22 percent is:

PI = [$7,300/1.22 + $6,900/1.222 + $5,700/1.223] / $14,000 = 0.983

We would accept the project if the required return were 10 percent or 15 percent since the PI is
greater than one. We would reject the project if the required return were 22 percent since the PI is
less than one.

16. a. The profitability index is the PV of the future cash flows divided by the initial investment. The
cash flows for both projects are an annuity, so:

PII = $27,000(PVIFA10%,3 ) / $53,000 = 1.267

PIII = $9,100(PVIFA10%,3) / $16,000 = 1.414

The profitability index decision rule implies that we accept project II, since PIII is greater than
the PII.

b. The NPV of each project is:

NPVI = –$53,000 + $27,000(PVIFA10%,3) = $14,145.00

NPVII = –$16,000 + $9,100(PVIFA10%,3) = $6,630.35

The NPV decision rule implies accepting Project I, since the NPVI is greater than the NPVII.

c. Using the profitability index to compare mutually exclusive projects can be ambiguous when
the magnitude of the cash flows for the two projects are of different scale. In this problem,
project I is roughly 3 times as large as project II and produces a larger NPV, yet the profitability
index criterion implies that project II is more acceptable.
17. a. The payback period for each project is:

A: 3 + ($180,000/$390,000) = 3.46 years

B: 2 + ($9,000/$18,000) = 2.50 years

The payback criterion implies accepting project B, because it pays back sooner than project A.

b. The discounted payback for each project is:

A: $20,000/1.15 + $50,000/1.152 + $50,000/1.153 = $88,074.30

$390,000/1.154 = $222,983.77

Discounted payback = 3 + ($390,000 – 88,074.30)/$222,983.77 = 3.95 years

B: $19,000/1.15 + $12,000/1.152 + $18,000/1.153 = $37,430.76

$10,500/1.154 = $6,003.41

Discounted payback = 3 + ($40,000 – 37,430.76)/$6,003.41 = 3.43 years

The discounted payback criterion implies accepting project B because it pays back sooner than A.

c. The NPV for each project is:

A: NPV = –$300,000 + $20,000/1.15 + $50,000/1.152 + $50,000/1.153 + $390,000/1.154

NPV = $11,058.07

B: NPV = –$40,000 + $19,000/1.15 + $12,000/1.152 + $18,000/1.153 + $10,500/1.154

NPV = $3,434.16

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: $300,000 = $20,000/(1+IRR) + $50,000/(1+IRR)2 + $50,000/(1+IRR)3 + $390,000/(1+IRR)4

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we
find that:

IRR = 16.20%

B: $40,000 = $19,000/(1+IRR) + $12,000/(1+IRR)2 + $18,000/(1+IRR)3 + $10,500/(1+IRR)4

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we
find that:

IRR = 19.50%

IRR decision rule implies we accept project B because IRR for B is greater than IRR for A.

e. The profitability index for each project is:

A: PI = ($20,000/1.15 + $50,000/1.152 + $50,000/1.153 + $390,000/1.154) / $300,000 = 1.037

B: PI = ($19,000/1.15 + $12,000/1.152 + $18,000/1.153 + $10,500/1.154) / $40,000 = 1.086

 Profitability index criterion implies accept project B because its PI is greater than project A’s.

f. In this instance, the NPV criteria implies that you should accept project A, while profitability
index, payback period, discounted payback, and IRR imply that you should accept project B. The
final decision should be based on the NPV since it does not have the ranking problem associated
with the other capital budgeting techniques. Therefore, you should accept project A.

18. At a zero discount rate (and only at a zero discount rate), the cash flows can be added together across
time. So, the NPV of the project at a zero percent required return is:

NPV = –$684,680 + 263,279 + 294,060 + 227,604 + 174,356 = $274,619

If the required return is infinite, future cash flows have no value. Even if the cash flow in one year is
$1 trillion, at an infinite rate of interest, the value of this cash flow today is zero. So, if the future cash
flows have no value today, the NPV of the project is simply the cash flow today, so at an infinite
interest rate:

NPV = –$684,680

The interest rate that makes the NPV of a project equal to zero is the IRR. The equation for the IRR
of this project is:

0 = –$684,680 + $263,279/(1+IRR) + $294,060/(1+IRR)2 + $227,604/(1+IRR)3 + 174,356/(1+IRR)4

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 16.23%

25. a. Here the cash inflows of the project go on forever, which is a perpetuity. Unlike ordinary
perpetuity cash flows, the cash flows here 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
valuing a stock with constant growth in dividends. This formula is actually the 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 = $85,000/(.13 – .06) = $1,214,285.71

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

NPV of the project = –$1,400,000 + 1,214,285.71 = –$185,714.29

The NPV is negative, so we would reject 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 = –$1,400,000 + $85,000/(.13 – g)

Solving for g, we get:

g = .0693 or 6.93%

26. The IRR of the project is:

 $58,000 = $34,000/(1+IRR) + $45,000/(1+IRR)2

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 22.14%

At an interest rate of 12 percent, the NPV is:

NPV = $58,000 – $34,000/1.12 – $45,000/1.122

NPV = –$8,230.87

At an interest rate of zero percent, we can add cash flows, so the NPV is:

NPV = $58,000 – $34,000 – $45,000

NPV = –$21,000.00

And at an interest rate of 24 percent, the NPV is:

NPV = $58,000 – $34,000/1.24 – $45,000/1.242

NPV = +$1,314.26

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 in invalid in this case. The NPV profile
is upward sloping, indicating that the project is more valuable when the interest rate increases.

27. The IRR is the interest rate that makes the NPV of the project equal to zero. So, the IRR of the
project is:

0 = $20,000 – $26,000 / (1 + IRR) + $13,000 / (1 + IRR)2

Even though it appears there are two IRRs, a spreadsheet, financial calculator, or trial and error will
not give an answer. The reason is that there is no real IRR for this set of cash flows. If you examine
the IRR equation, what we are really doing is solving for the roots of the equation. Going back to
high school algebra, in this problem we are solving a quadratic equation. In case you don’t
remember, the quadratic equation is:

− b ± b 2 − 4ac
x=
2a

In this case, the equation is:

− (−26,000) ± (−26,000) 2 − 4(20,000)(13,000)

x=
2(26,000)

The square root term works out to be:

676,000,000 – 1,040,000,000 = –364,000,000

The square root of a negative number is a complex number, so there is no real number solution,
meaning the project has no real IRR.
 

 
Chapter  10  Solutions  

1. The $6 million acquisition cost of the land six years ago is a sunk cost. The $6.4 million current
aftertax value of the land is an opportunity cost if the land is used rather than sold off. The $14.2
million cash outlay and $890,000 grading expenses are the initial fixed asset investments needed to
get the project going. Therefore, the proper year zero cash flow to use in evaluating this project is

$6,400,000 + 14,200,000 + 890,000 = $21,490,000

2. Sales due solely to the new product line are:

19,000($13,000) = $247,000,000

Increased sales of the motor home line occur because of the new product line introduction; thus:

4,500($53,000) = $238,500,000

in new sales is relevant. Erosion of luxury motor coach sales is also due to the new mid-size campers;
thus:

900($91,000) = $81,900,000 loss in sales

is relevant. The net sales figure to use in evaluating the new line is thus:

$247,000,000 + 238,500,000 – 81,900,000 = $403,600,000

3. We need to construct a basic income statement. The income statement is:

Sales $ 830,000
Variable costs 498,000
Fixed costs 181,000
Depreciation 77,000
EBT $ 74,000
Taxes@35% 25,900
Net income $ 48,100

9. Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final
answer will be the same no matter which of the four methods you use.), we get:

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF = ($2,650,000 – 840,000)(1 – 0.35) + 0.35($3,900,000/3)
OCF = $1,631,500

10. Since we have the OCF, we can find the NPV as the initial cash outlay plus the PV of the OCFs,
which are an annuity, so the NPV is:

NPV = –$3,900,000 + $1,631,500(PVIFA12%,3)

NPV = $18,587.71
 

11. The cash outflow at the beginning of the project will increase because of the spending on NWC. At
the end of the project, the company will recover the NWC, so it will be a cash inflow. The sale of the
 equipment will result in a cash inflow, but we also must account for the taxes which will be paid on
this sale. So, the cash flows for each year of the project will be:

Year Cash Flow

0 –$4,200,000 = –$3,900,000 – 300,000
1 1,631,500
2 1,631,500
3 2,068,000 = $1,631,500 + 300,000 + 210,000 + (0 – 210,000)(.35)

And the NPV of the project is:

NPV = –$4,200,000 + $1,631,500(PVIFA12%,2) + ($2,068,000 / 1.123)

NPV = $29,279.79