CHAPTER 3

INVESTMENT APPRAISAL
Concept Questions and Analysis:
Concept Questions:
1. Incremental Cash Flows Which of the following should be treated as an incremental cash flow
when computing the NPV of an investment?
a. A reduction in the sales of a company’s other products caused by the investment.
b. An expenditure on plant and equipment that has not yet been made and will be made only if the
project is accepted.
c. Costs of research and development undertaken in connection with the product during the past three
years.
d. Annual depreciation expense from the investment.
e. Dividend payments by the firm.
f. The resale value of plant and equipment at the end of the project’s life.
g. Salary and medical costs for production personnel who will be employed only if the project
is accepted.
2. Incremental Cash Flows Your company currently produces and sells steel shaft golf clubs. The
board of directors wants you to consider the introduction of a new line of titanium bubble
woods with graphite shafts. Which of the following costs are not relevant?
a. Land you already own that will be used for the project, but otherwise will be sold for $700,000, its
market value.
b. A $300,000 drop in your sales of steel shaft clubs if the titanium woods with graphite shafts are
introduced.
c. $200,000 spent on research and development last year on graphite shafts.
3. Comparing Investment Criteria Define each of the following investment rules and
discuss any potential shortcomings of each. In your definition, state the criterion for
accepting or rejecting independent projects under each rule.
a. Payback period.
b. Internal rate of return.
c. Profitability index.
d. Net present value.
4. Net Present Value You are evaluating Project A and Project B. Project A has a short period of
future cash flows, while Project B has relatively long future cash flows. Which project will be more
sensitive to changes in the required return? Why?
5. Payback and Internal Rate of Return A project has perpetual cash flows of C per period, a cost
of I, and a required return of R. What is the relationship between the project’s payback and its
IRR? What implications does your answer have for long-lived projects with relatively constant cash
flows?
6. Net Present Value The investment in Project A is $1 million, and the investment in Project B is $2
million. Both projects have a unique internal rate of return of 20 percent. Is the following statement
true or false? For any discount rate from 0 percent to 20 percent, Project B has an NPV twice as great
as that of Project A.
Exercises
1. Calculating Discounted Payback An investment project has annual cash inflows of $5,000,
$5,500, $6,000, and $7,000, and a discount rate of 12 percent. What is the discounted payback
period for these cash flows if the initial cost is $8,000? What if the initial cost is $12,000? What
if it is $16,000?
1,8 years if cost 8k
2,7379 years if cost 12k
3,6475 years if cost 16k
2. NPV versus IRR Consider the following cash flows on two mutually exclusive projects for
the Bahamas Recreation Corporation (BRC). Both projects require an annual return of 14 percent.

b
As a financial analyst for BRC, you are asked the following questions:
a. If your decision rule is to accept the project with the greater IRR, which project should you
choose?
IRR fishing = 18,58%
IRR submarine = 17,8%
-> choose fishing
b. Because you are fully aware of the IRR rule’s scale problem, you calculate the incremental IRR
for the cash flows. Based on your computation, which project should you choose?
Incremental IRR = 16,842% > r = 14%
 Choose larger project ( submarine)
c. To be prudent, you compute the NPV for both projects. Which project should you
choose? Is it consistent with the incremental IRR rule?
NPV fishing = 69,09
NPV submarine = 103,3573
-> choose submarine -> always consistent with incremental IRR rule
3. Comparing Investment Criteria Wii Brothers, a game manufacturer, has a new idea for an
adventure game. It can market the game either as a traditional board game or as an interactive
DVD, but not both. Consider the following cash flows of the two mutually exclusive projects for
the company. Assume the discount rate for both projects is 10 percent.

a. Based on the payback period rule, which project should be chosen?

Discounted Payback period board game = 1,69 years
Discounted Payback period DVD = 1,59 years

Payback period board game = 1,45 years

Payback period dvd = 1,57 years
-> choose board game
b. Based on the NPV, which project should be chosen?
NPV board game = 238,58
 NPV dvd = 469,5
-> choose dvd
c. Based on the IRR, which project should be chosen?
IRR board game = 27,5%
IRR dvd = 25,09%
-> choose board game
d. Based on the incremental IRR, which project should be chosen?
Incremental IRR = 23,2% > r = 10%
-> choose dvd
4. Profitability Index versus NPV Hanmi Group, a consumer electronics conglomerate, is
reviewing its annual budget in wireless technology. It is considering investments in three different
technologies to develop wireless communication devices. Consider the following cash flows of the
three independent projects available to the company. Assume the discount rate for all projects is 10
percent. Further, the company has only $40 million to invest in new projects this year.

a. Based on the profitability index decision rule, rank these investments.

b. Based on the NPV, rank these investments.
c. Based on your findings in (a) and (b), what would you recommend to the CEO of the company
and why?
5. Payback and NPV An investment under consideration has a payback of six years and a cost of
$573,000. If the required return is 12 percent, what is the worst-case NPV? The best-case NPV?
Explain. Assume the cash flows are conventional.
6. Calculating IRR Consider two streams of cash flows, A and B. Stream A’s first cash flow is
$11,600 and is received three years from today. Future cash flows in Stream A grow by 4 percent in
perpetuity. Stream B’s first cash flow is -$13,000, is received two years from today, and will
continue in perpetuity. Assume that the appropriate discount rate is 12 percent.
a. What is the present value of each stream?
b. Suppose that the two streams are combined into one project, called C. What is the IRR
of Project C?
c. What is the correct IRR rule for Project C?
7. Calculating Project NPV The Best Manufacturing Company is considering a new
investment. Financial projections for the investment are tabulated here. The corporate tax rate is 34
percent. Assume all sales revenue is received in cash, all operating costs and income taxes are paid
in cash, and all cash flows occur at the end of the year. All net working capital is recovered at the
end of the project.
a. Compute the incremental net income of the investment for each year.
b. Compute the incremental cash flows of the investment for each year.
c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the project?
8. Project Evaluation Dog Up! Franks is looking at a new sausage system with an installed
cost of $345,000. This cost will be depreciated straight-line to zero over the project’s five-year
life, at the end of which the sausage system can be scrapped for $25,000. The sausage
system will save the firm $85,000 per year in pretax operating costs, and the system requires an
initial investment in net working capital of $20,000. If the tax rate is 34 percent and the discount
rate is 10 percent, what is the NPV of this project?
9. Calculating NPV Howell Petroleum is considering a new project that complements its existing
business. The machine required for the project costs $3.9 million. The marketing department
predicts that sales related to the project will be $2.35 million per year for the next four years, after
which the market will cease to exist. The machine will be depreciated down to zero over its four-
year economic life using the straight-line method. Cost of goods sold and operating expenses
related to the project are predicted to be 25 percent of sales. Howell also needs to add net
working capital of $150,000 immediately. The additional net working capital will be recovered in
full at the end of the project’s life. The corporate tax rate is 35 percent. The required rate of return
for Howell is 13 percent. Should Howell proceed with the project?
10. Calculating EAC You are evaluating two different silicon wafer milling machines. The
Techron I costs $245,000, has a three-year life, and has pretax operating costs of $39,000 per year.
The Techron II costs $315,000, has a five-year life, and has pretax operating costs of $48,000 per
year. For both milling machines, use straight-line depreciation to zero over the project’s life and
assume a salvage value of $20,000. If your tax rate is 35 percent and your discount rate is 9 percent,
compute the EAC for both machines. Which do you prefer? Why?
11. NPV, IRR, PI
GoodMan Enterprise is planning to implement an investment project, the total initial investment
capital is $10,510, of which: fixed assets investment is $9,000 and working capital is $1,510. The
operation period of the project is 4 years, the annual profit after tax generated by the project is
$2,900. By the end of the project, the fixed assets can be sold at $800. The cost of capital of the
project is 10%/year and the corporate income tax rate is 20%.
Calculate the NPV, IRR, PI (profitability index) of the investment project and state whether the
company should make this investment? Knowing that the enterprise uses straight line depreciation.
Depreciation = 9000/4 = 2250
OCF each year = 2900 + 2250 = 5150
NPV = 6251,93
IRR = 34,8% > 10%
PI = 1,59
12. NPV
A company specializing in the production of sports equipment is working on setting up a
production line with an expected life span of 5 years. The estimated figures are as follows:
- Investment in procurement of 100 specialized machines: The purchase price (without VAT) is
$80,00/machine. Sum = $8.000
- The installation of the machine is carried out on an existing land of the company. If not used for
the project, the land can be leased with an estimated net income of $130,00/year = initial investment
(opportunity cost)
- Initial working capital investment is $190,00.
- Annual revenue is estimated at $410,00.
- Operating expenses (excluding depreciation) are $280,23/year.
- The corporate income tax rate is 20%.
- The company applies the straight-line depreciation method.
- The average capital cost of the project is 10%/year
Based on the NPV, should the company make this investment?
OCF = 423,816
NPV = -6958,2
13. NPV, PI
Phoenix company is working on an investment of a new product line. It is estimated that the
production of this new product requires the company to procure a machine for $7,500 with 5-year
life span. By the end of the project, the machine can be sold at $700. At the same time, the company
must also invest $1,000 in working capital. Annual revenue from new products is estimated to be
$2,200. However, if this new product is put into production, it could help stimulating the
consumption of other current products, thus increasing the revenue of these products by $500
annually. Annual operating expenses (excluding depreciation) is $970.
The company applies the straight-line depreciation method. The average cost of capital is 10% per
year and the CIT rate is 20%.
Requirement: Determine the NPV and PI of the project and advise the company whether to invest in
this new product or not?
14. NPV, IRR
Company X is currently considering whether to buy a new machine or continue using the old one:
- The old machine has the original price of $200,000, has been depreciated by 40%. Its current
market price is $90,000. If continued to use, this machine can generate $70,000 in profit before tax
per year. After 4 more years, it will have to be liquidated, the estimated liquidation value is
$10,000.
- If buying the new machine, the estimated investment capital is $300,000. The company also needs
to invest another $50,000 in working capital. The total estimated life span of the machine is 6 years.
Each year, estimated annual profit before tax is $95,000. It is estimated that after 4 years of use, it
can be sold for $30,000.
The company applies the straight-line depreciation method and the CIT rate is 20%. The cost of
capital is 10%/year. The company needs to use either of the machine for only 4 years.
Requirement: Please advise the company whether to buy the new machine or not using the NPV
and IRR?
 If sell old machine = 90000 – (90000 – 200000 x (1 – 40%)) x tc = 96000
Depre new machine = 300000 /6 = 50000
OCF = 50000 + 95000 x tc = 126000
NWC recovered =
Sell new machine = 30000 – (30000 – 50000 x 2) x tc =

0 1 2 3 4
old machine ocf
gain/loss from old
machine
liquidation
 Opportunity
cost

New machine
Capital spending
Nwc
Gain/loss from old
machine ocf
Gain/loss from new
machine
Solutions:
Concept Questions:
1. Incremental Cash Flows Which of the following should be treated as an incremental cash flow
when computing the NPV of an investment?
a. A reduction in the sales of a company’s other products caused by the investment.
b. An expenditure on plant and equipment that has not yet been made and will be made only if the
project is accepted.
c. Costs of research and development undertaken in connection with the product during the past three
years.
d. Annual depreciation expense from the investment.
e. Dividend payments by the firm.
f. The resale value of plant and equipment at the end of the project’s life.
g. Salary and medical costs for production personnel who will be employed only if the project
is accepted.
a. Yes, the reduction in the sales of the company’s other products, referred to as erosion, should be
treated as an incremental cash flow. These lost sales are included because they are a cost (a revenue
reduction) that the firm must bear if it chooses to produce the new product.
b. Yes, expenditures on plant and equipment should be treated as incremental cash flows. These are
costs of the new product line. However, if these expenditures have already occurred (and cannot be
recaptured through a sale of the plant and equipment), they are sunk costs and are not included as
incremental cash flows.
c. No, the research and development costs should not be treated as incremental cash flows. The costs
of research and development undertaken on the product during the past three years are sunk costs and
should not be included in the evaluation of the project. Decisions made and costs incurred in the past
cannot be changed. They should not affect the decision to accept or reject the project.
d. Yes, the annual depreciation expense must be taken into account when calculating the cash flows
related to a given project. While depreciation is not a cash expense that directly affects cash flow, it
decreases a firm’s net income and hencelowers its tax bill for the year. Because of this depreciation tax
shield, the firm has more cash on hand at the end of the year than it would have had without expensing
depreciation.
e. No, dividend payments should not be treated as incremental cash flows. A firm’s decision to pay or
not pay dividends is independent of the decision to accept or reject any given investment project. For
this reason, dividends are not an incremental cash flow to a given project. Dividend policy is discussed
in more detail in later chapters.
f. Yes, the resale value of plant and equipment at the end of a project’s life should be treated as an
incremental cash flow. The price at which the firm sells the equipment is a cash inflow, and any
difference between the book value of the equipment and its sale price will create accounting gains or
losses that result in either a tax credit or liability.
g. Yes, salary and medical costs for production employees hired for a project should be treated as
incremental cash flows. The salaries of all personnel connected to the project must be included as costs
of that project.
2. Incremental Cash Flows Your company currently produces and sells steel shaft golf clubs. The
board of directors wants you to consider the introduction of a new line of titanium bubble
woods with graphite shafts. Which of the following costs are not relevant?
a. Land you already own that will be used for the project, but otherwise will be sold for $700,000, its
market value.
b. A $300,000 drop in your sales of steel shaft clubs if the titanium woods with graphite shafts are
introduced.
c. $200,000 spent on research and development last year on graphite shafts.
Item (a) is a relevant cost because the opportunity to sell the land is lost if the new golf club is
produced. Item (b) is also relevant because the firm must take into account the erosion of sales of
existing products when a new product is introduced. If the firm produces the new club, the earnings
from the existing clubs will decrease, effectively creating a cost that must be included in the decision.
Item (c) is not relevant because the costs of research and development are sunk costs. Decisions made
in the past cannot be changed. They are not relevant to the production of the new club.
3. Comparing Investment Criteria Define each of the following investment rules and
discuss any potential shortcomings of each. In your definition, state the criterion for
accepting or rejecting independent projects under each rule.
a. Payback period.
b. Internal rate of return.
c. Profitability index.
d. Net present value.
4. Net Present Value You are evaluating Project A and Project B. Project A has a short period of
future cash flows, while Project B has relatively long future cash flows. Which project will be more
sensitive to changes in the required return? Why?
Project B’s NPV would be more sensitive to changes in the discount rate. The reason is the time value
of money. Cash flows that occur further out in the future are always more sensitive to changes in the
interest rate. This sensitivity is similar to the interest rate risk of a bond.
5. Payback and Internal Rate of Return A project has perpetual cash flows of C per period, a cost
of I, and a required return of R. What is the relationship between the project’s payback and its
IRR? What implications does your answer have for long-lived projects with relatively constant cash
flows?
For a project with future cash flows that are an annuity:
Payback = I / C
And the IRR is: 0 = – I + C / IRR
Solving the IRR equation for IRR, we get: IRR = C / I
Notice this is just the reciprocal of the payback. So: IRR = 1 / PB
For long-lived projects with relatively constant cash flows, the sooner the project pays back, the
greater is the IRR, and the IRR is approximately equal to the reciprocal of the payback period.
6. Net Present Value The investment in Project A is $1 million, and the investment in Project B is $2
million. Both projects have a unique internal rate of return of 20 percent. Is the following statement
true or false? For any discount rate from 0 percent to 20 percent, Project B has an NPV twice as great
as that of Project A.
The statement is false. If the cash flows of Project B occur early and the cash flows of Project A occur
late, then for a low discount rate the NPV of A can exceed the NPV of B. Observe the following
example.
C0 C1 C2 IRR NPV @ 0%
Project A –$1,000,000 $0 $1,440,000 20% $440,000
Project B –$2,000,000 $2,400,000 $0 20% 400,000
However, in one particular case, the statement is true for equally risky projects. If the lives of the two
projects are equal and the cash flows of Project B are twice the cash flows of Project A in every time
period, the NPV of Project B will be twice the NPV of Project A.
Exercises
1. Calculating Discounted Payback An investment project has annual cash inflows of $5,000,
$5,500, $6,000, and $7,000, and a discount rate of 12 percent. What is the discounted payback
period for these cash flows if the initial cost is $8,000? What if the initial cost is $12,000? What if it
is $16,000?
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 = $5,000 / 1.12 = $4,464.29
Value today of Year 2 cash flow = $5,500 / 1.122 = $4,384.57
Value today of Year 3 cash flow = $6,000 / 1.123 = $4,270.68
Value today of Year 4 cash flow = $7,000 / 1.124 = $4,448.63
 To find the discounted payback, we use these values to find the payback period. The
discounted first year cash flow is $4,464.29, so the discounted payback for an initial cost of $8,000
is:
Discounted payback = 1 + ($8,000 – 4,464.29) / $4,384.57 = 1.81 years
For an initial cost of $12,000, the discounted payback is:
Discounted payback = 2 + ($12,000 – 4,464.29 – 4,384.57) / $4,270.68 = 2.74 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 $16,000, the discounted payback is:
Discounted payback = 3 + ($16,000 – 4,464.29 – 4,384.57 – 4,270.68) / $4,448.63 = 3.65 years
2. NPV versus IRR Consider the following cash flows on two mutually exclusive projects for
the Bahamas Recreation Corporation (BRC). Both projects require an annual return of 14 percent.

b
As a financial analyst for BRC, you are asked the following questions:
a. If your decision rule is to accept the project with the greater IRR, which project should you
choose?
b. Because you are fully aware of the IRR rule’s scale problem, you calculate the incremental IRR
for the cash flows. Based on your computation, which project should you choose?
c. To be prudent, you compute the NPV for both projects. Which project should you choose? Is it
consistent with the incremental IRR rule?
a. The IRR is the interest rate that makes the NPV of the project equal to zero. So, the IRR for each project is:
Deepwater Fishing IRR:
0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3
0 = –$850,000 + $320,000 / (1 + IRR) + $470,000 / (1 + IRR)2 + $410,000 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 18.58%
Submarine Ride IRR:
0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3
0 = –$1,650,000 + $810,000 / (1 + IRR) + $750,000 / (1 + IRR)2 + $690,000 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 17.81%
 Based on the IRR rule, the deepwater fishing project should be chosen because it has the higher IRR.
b. To calculate the incremental IRR, we subtract the smaller project’s cash flows from the larger project’s
cash flows. In this case, we subtract the deepwater fishing cash flows from the submarine ride cash
flows. The incremental IRR is the IRR of these incremental cash flows. So, the incremental cash flows of
the submarine ride are:

Year 0 Year 1 Year 2 Year 3

Submarine Ride –$1,650,000 $810,000 $750,000 $690,000
Deepwater Fishing –850,000 320,000 470,000 410,000
Submarine – Fishing –$800,000 $490,000 $280,000 $280,000

Setting the present value of these incremental cash flows equal to zero, we find the incremental IRR is:
0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3
0 = –$800,000 + $490,000 / (1 + IRR) + $280,000 / (1 + IRR)2 + $280,000 / (1 + IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
Incremental IRR = 16.84%
For investing-type projects, accept the larger project when the incremental IRR is greater than the
discount rate. Since the incremental IRR, 16.84 percent, is greater than the required rate of return of 14
percent, choose the submarine ride project. Note that this is not the choice when evaluating only the IRR
of each project. The IRR decision rule is flawed because there is a scale problem. That is, the submarine
ride has a greater initial investment than does the deepwater fishing project. This problem is corrected by
calculating the IRR of the incremental cash flows, or by evaluating the NPV of each project.
c. The NPV is the sum of the present value of the cash flows from the project, so the NPV of each project
will be:
Deepwater Fishing:
NPV = –$850,000 + $320,000 / 1.14 + $470,000 / 1.142 + $410,000 / 1.143
NPV = $69,089.81
Submarine Ride:
NPV = –$1,650,000 + $810,000 / 1.14 + $750,000 / 1.142 + $690,000 / 1.143
NPV = $103,357.31
Since the NPV of the submarine ride project is greater than the NPV of the deepwater fishing project,
choose the submarine ride project. The incremental IRR rule is always consistent with the NPV rule.
3. Comparing Investment Criteria Wii Brothers, a game manufacturer, has a new idea for an
adventure game. It can market the game either as a traditional board game or as an interactive
DVD, but not both. Consider the following cash flows of the two mutually exclusive projects for
the company. Assume the discount rate for both projects is 10 percent.

a. Based on the payback period rule, which project should be chosen?

b. Based on the NPV, which project should be chosen?
c. Based on the IRR, which project should be chosen?
d. Based on the incremental IRR, which project should be chosen?
a. The payback period is the time that it takes for the cumulative undiscounted cash inflows to equal the initial
investment.
 Board game:
Cumulative cash flows Year 1 = $700 = $700
Cumulative cash flows Year 2 = $700 + 550 = $1,250
Payback period = 1 + ($950 – 700)/ $550 = 1.45years

DVD:
Cumulative cash flows Year 1 = $1,500 = $1,500
Cumulative cash flows Year 2 = $1,500 + 1,050 = $2,550

Payback period = 1 + ($2,100 – 1,500) / $1,050

Payback period = 1.57 years

Since the board game has a shorter payback period than the DVD project, the company should choose
the board game.
b. The NPV is the sum of the present value of the cash flows from the project, so the NPV of each project
will be:
Board game:
NPV = –$950 + $700 / 1.10 + $550 / 1.102 + $130 / 1.103
NPV = $238.58
DVD:
NPV = –$2,100 + $1,500 / 1.10 + $1,050 / 1.102 + $450/ 1.103
NPV = $469.50
Since the NPV of the DVD is greater than the NPV of the board game, choose the DVD.

c. The IRR is the interest rate that makes the NPV of a project equal to zero. So, the IRR of each project is:
Board game:
0 = –$950 + $700 / (1 + IRR) + $550 / (1 + IRR)2 + $130 / (1 + IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 27.51%
DVD:
0 = –$2,100 + $1,500 / (1 + IRR) + $1,050 / (1 + IRR)2 + $450/ (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
IRR = 25.09%

Since the IRR of the board game is greater than the IRR of the DVD, IRR implies we choose the board
game. Note that this is the choice when evaluating only the IRR of each project. The IRR decision rule is
flawed because there is a scale problem. That is, the DVD has a greater initial investment than does the
board game. This problem is corrected by calculating the IRR of the incremental cash flows, or by
evaluating the NPV of each project.
d. To calculate the incremental IRR, we subtract the smaller project’s cash flows from the larger project’s
cash flows. In this case, we subtract the board game cash flows from the DVD cash flows. The
incremental IRR is the IRR of these incremental cash flows. So, the incremental cash flows of the DVD
are:

Year 0 Year 1 Year 2 Year 3

DVD –$2,100 $1,500 $1,050 $450
Board game –950 700 550 130
DVD – Board game –$1,150 $800 $500 $320

Setting the present value of these incremental cash flows equal to zero, we find the incremental IRR is:
0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3
0 = –$1,150 + $800 / (1 + IRR) + $500 / (1 + IRR)2 + $320/ (1 + IRR)3
Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
Incremental IRR = 23.19%
For investing-type projects, accept the larger project when the incremental IRR is greater than the
discount rate. Since the incremental IRR, 23.19 percent, is greater than the required rate of return of 10
percent, choose the DVD project.
 4. Profitability Index versus NPV Hanmi Group, a consumer electronics conglomerate, is
reviewing its annual budget in wireless technology. It is considering investments in three different
technologies to develop wireless communication devices. Consider the following cash flows of the
three independent projects available to the company. Assume the discount rate for all projects is 10
percent. Further, the company has only $40 million to invest in new projects this year.

a. Based on the profitability index decision rule, rank these investments.

b. Based on the NPV, rank these investments.
c. Based on your findings in (a) and (b), what would you recommend to the CEO of the company
and why?
a. The profitability index is the PV of the future cash flows divided by the initial investment . The profitability
index for each project is:
PICDMA = [$22,000,000 / 1.10 + $15,000,000 / 1.102 + $5,000,000 / 1.103] / $16,000,000 = 2.26
PIG4 = [$20,000,000 / 1.10 + $50,000,000 / 1.102 + $40,000,000 / 1.103] / $24,000,000 = 3.73
PIWi-Fi = [$36,000,000 / 1.10 + $64,000,000 / 1.102 + $40,000,000 / 1.103] / $40,000,000 = 2.89
The profitability index implies we accept the G4 project. Remember this is not necessarily correct because
the profitability index does not necessarily rank projects with different initial investments correctly.
 b. The NPV of each project is:
NPVCDMA = –$16,000,000 + $22,000,000 / 1.10 + $15,000,000 / 1.102 + $5,000,000 / 1.103
NPVCDMA = $20,153,268.22
NPVG4 = –$24,000,000 + $20,000,000 / 1.10 + $50,000,000 / 1.102 + $40,000,000 / 1.103
NPVG4 = $65,556,724.27
NPVWi-Fi = –$40,000,000 + $36,000,000 / 1.10 + $64,000,000 / 1.102 + $40,000,000 / 1.103
NPVWi-Fi = $75,672,426.75
NPV implies we accept the Wi-Fi project since it has the highest NPV. This is the correct decision if the
projects are mutually exclusive.
c. We would like to invest in all three projects since each has a positive NPV. If the budget is limited to $40
million, we can only accept the CDMA project and the G4 project, or the Wi-Fi project. NPV is additive
across projects and the company. The total NPV of the CDMA project and the G4 project is:
NPVCDMA and G4 = $20,153,268.22 + 65,556,724.27
NPVCDMA and G4 = $85,709,992.49
This is greater than the Wi-Fi project, so we should accept the CDMA project and the G4 project.
5. Payback and NPV An investment under consideration has a payback of six years and a cost of
$573,000. If the required return is 12 percent, what is the worst-case NPV? The best-case NPV?
Explain. Assume the cash flows are conventional.
Given the six-year payback, the worst case is that the payback occurs at the end of the sixth year. Thus, the worst
case:
NPV = –$573,000 + $573,000/1.126
NPV = –$282,700.37
The best case has infinite cash flows beyond the payback point. Thus, the best-case NPV is infinite.
6. Calculating IRR Consider two streams of cash flows, A and B. Stream A’s first cash flow is
$11,600 and is received three years from today. Future cash flows in Stream A grow by 4 percent in
perpetuity. Stream B’s first cash flow is -$13,000, is received two years from today, and will
continue in perpetuity. Assume that the appropriate discount rate is 12 percent.
a. What is the present value of each stream?
b. Suppose that the two streams are combined into one project, called C. What is the IRR
of Project C?
c. What is the correct IRR rule for Project C?
a. We can apply the growing perpetuity formula to find the PV of Stream A. The perpetuity formula values the
stream as of one year before the first payment.Therefore, the growing perpetuity formula values the
stream of cash flows as of Year 2. Next, discount the PV as of the end of Year 2 back two years to find
the PV as of today, Year 0. Doing so, we find:
PV(A) = [C3 / (r – g)] / (1 + r)2
PV(A) = [$11,600 / (.12 – .04)] / (1.12)2
PV(A) = $115,593.11
We can apply the perpetuity formula to find the PV of Stream B. The perpetuity formula discounts the
stream back to Year 1, one period prior to the first cash flow. Discount the PV as of the end of Year 1
back one year to find the PV as of today, Year 0.Doing so, we find:

PV(B) = [C2 / r] / (1 + r)
PV(B) = [–$13,000 / .12] / (1.12)
PV(B) = –$96,726.19

b. If we combine the cash flow streams to form Project C, we get:

Project A = [C3 / (r – g)] / (1 + r)2
Project B = [C2 / r] / (1 + r)
Project C = Project A + Project B
Project C = [C3 / (r – g)] / (1 + r)2 + [C2 / r] / (1 + r)
0 = [$11,600 / (IRR – .04)] / (1 + IRR)2 + [–$13,000 / IRR] / (1 + IRR)

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:
 IRR = 16.90%
c. The correct decision rule for an investing-type project is to accept the project if the discount rate is below
the IRR. Since there is one IRR, a decision can be made.At a point in the future, the cash flows from
Project A will be greater than those from ProjectB. Therefore, although there are many cash flows, there
will be only one change in sign. When the sign of the cash flows change more than once over the life of
the project, there may be multiple internal rates of return. In such cases, there is no correct decision rule
for accepting and rejecting projects using the internal rate of return.
7. Calculating Project NPV The Best Manufacturing Company is considering a new
investment. Financial projections for the investment are tabulated here. The corporate tax rate is 34
percent. Assume all sales revenue is received in cash, all operating costs and income taxes are paid
in cash, and all cash flows occur at the end of the year. All net working capital is recovered at the
end of the project.

a. Compute the incremental net income of the investment for each year.
b. Compute the incremental cash flows of the investment for each year.
c. Suppose the appropriate discount rate is 12 percent. What is the NPV of the
project?
We will use the bottom-up approach to calculate the operating cash flow for each year. We also must be sure
to include the net working capital cash flows each year. So, the net income and total cash flow each year will
be:
Year 1 Year 2 Year 3 Year 4
Sales $12,900 $14,000 $15,200 $11,200
Costs 2,700 2,800 2,900 2,100
Depreciation 6,850 6,850 6,850 6,850
EBT $3,350 $4,350 $5,450 $2,250
Tax 1,139 1,479 1,853 765
Net income $2,211 $2,871 $3,597 $1,485

OCF $9,061 $9,721 $10,447 $8,335

Capital spending –$27,400 0 0 0 0
NWC –300 –200 –225 –150 875
Incremental cash flow –$27,700 $8,861 $9,496 $10,297 $9,210

The NPV for the project is:

NPV = –$27,700 + $8,861 / 1.12 + $9,496 / 1.122 + $10,297 / 1.123 + $9,210 / 1.124 = $964.08
8. Project Evaluation Dog Up! Franks is looking at a new sausage system with an installed
cost of $345,000. This cost will be depreciated straight-line to zero over the project’s five-year
life, at the end of which the sausage system can be scrapped for $25,000. The sausage
system will save the firm $85,000 per year in pretax operating costs, and the system requires an
initial investment in net working capital of $20,000. If the tax rate is 34 percent and the discount
rate is 10 percent, what is the NPV of this project?
First, we will calculate the annual depreciation of the new equipment. It will be:
Annual depreciation = $345,000/5 = $69,000
Now, we calculate the aftertax salvage value. The aftertax salvage value is the market price minus
(or plus) the taxes on the sale of the equipment, so:
Aftertax salvage value = MV + (BV – MV)tc
Very often, the book value of the equipment is zero as it is in this case. If the book value is zero, the
equation for the aftertax salvage value becomes:
Aftertax salvage value = MV + (0 – MV)tc
Aftertax salvage value = MV(1 – tc)
We will use this equation to find the aftertax salvage value since we know the book value is zero.
So, the aftertax salvage value is
Aftertax salvage value = $25,000(1 – .34) = $16,500
Using the tax shield approach, we find the OCF for the project is:
OCF = $85,000(1 – .34) + .34($69,000) = $79,560
Now we can find the project NPV. Notice that we include the NWC in the initial cash outlay. The
recovery of the NWC occurs in Year 5, along with the aftertax salvage value.
NPV = –$345,000 – 20,000 + $79,560(PVIFA10%,5) + [($16,500 + 20,000) / 1.105] = –$40,741.38
9. Calculating NPV Howell Petroleum is considering a new project that complements its existing
business. The machine required for the project costs $3.9 million. The marketing department
predicts that sales related to the project will be $2.35 million per year for the next four years, after
which the market will cease to exist. The machine will be depreciated down to zero over its four-
year economic life using the straight-line method. Cost of goods sold and operating expenses
related to the project are predicted to be 25 percent of sales. Howell also needs to add net
working capital of $150,000 immediately. The additional net working capital will be recovered in
full at the end of the project’s life. The corporate tax rate is 35 percent. The required rate of return
for Howell is 13 percent. Should Howell proceed with the project?
We will begin by calculating the initial cash outlay, that is, the cash flow at Time 0. To undertake the
project, we will have to purchase the equipment and increase net working capital. So, the cash outlay today
for the project will be:
Equipment –$3,900,000
NWC –150,000
Total –$4,050,000
 Using the bottom-up approach to calculating the operating cash flow, we find the operating cash flow each
year will be:
Sales $2,350,000
Costs 587,500
Depreciation 975,000
EBT $787,500
Tax 275,625
Net income $511,875

The operating cash flow is:

OCF = Net income + Depreciation = $511,875 + 975,000 = $1,486,875
To find the NPV of the project, we add the present value of the project cash flows. We must be sure to add
back the net working capital at the end of the project life, since we are assuming the net working capital will
be recovered. So, the project NPV is:
NPV = –$4,050,000 + $1,486,875(PVIFA13%,4) + $150,000 / 1.134 = $464,664.86
10. Calculating EAC You are evaluating two different silicon wafer milling machines. The
Techron I costs $245,000, has a three-year life, and has pretax operating costs of $39,000 per year.
The Techron II costs $315,000, has a five-year life, and has pretax operating costs of $48,000 per
year. For both milling machines, use straight-line depreciation to zero over the project’s life and
assume a salvage value of $20,000. If your tax rate is 35 percent and your discount rate is 9 percent,
compute the EAC for both machines. Which do you prefer? Why?
We will need the aftertax salvage value of the equipment to compute the EAC. Even though the
equipment for each product has a different initial cost, both have the same salvage value. The
aftertax salvage value for both is:
Both cases: aftertax salvage value = $20,000(1 – .35) = $13,000
To calculate the EAC, we first need the OCF and NPV of each option. The OCF and NPV for
Techron I is:
OCF = –$39,000(1 – .35) + .35($245,000 / 3) = $3,233.33
NPV = –$245,000 + $3,233.33(PVIFA9%,3) + ($13,000 / 1.093) = –$226,777.10
EAC = –$226,777.10 / (PVIFA12%,3) = –$89,589.37
And the OCF and NPV for Techron II is:
OCF = – $48,000(1 – .35) + .35($315,000 / 5) = –$9,150
NPV = –$315,000 – $9,150(PVIFA9%,5) + ($13,000 / 1.095) = –$342,141.20
EAC = –$342,141.20 / (PVIFA12%,5) = –$87,961.62
The two milling machines have unequal lives, so they can only be compared by expressing both on
an equivalent annual basis, which is what the EAC method does. Thus, you prefer the Techron II
because it has the lower (less negative) annual cost.
11. NPV, IRR, PI
GoodMan Enterprise is planning to implement an investment project, the total initial investment
capital is $10,510, of which: fixed assets investment is $9,000 and working capital is $1,510. The
operation period of the project is 4 years, the annual profit after tax generated by the project is
$2,900. By the end of the project, the fixed assets can be sold at $800. The cost of capital of the
project is 10%/year and the corporate income tax rate is 20%.
Calculate the NPV, IRR, PI of the investment project and state whether the company should make
this investment? Knowing that the enterprise uses straight line depreciation.
12. NPV
A company specializing in the production of sports equipment is working on setting up a
production line with an expected life span of 5 years. The estimated figures are as follows:
- Investment in procurement of 100 specialized machines: The purchase price (without VAT) is
$80,000/machine.
- The installation of the machine is carried out on an existing land of the company. If not used for
the project, the land can be leased with an estimated net income of $130,000/year
- Initial working capital investment is $190,000.
- Annual revenue is estimated at $410,00.
- Operating expenses (excluding depreciation) are $280,230/year.
- The corporate income tax rate is 20%.
- The company applies the straight-line depreciation method.
- The average capital cost of the project is 10%/year
Based on the NPV, should the company make this investment?
13. NPV, PI
Phoenix company is working on an investment of a new product line. It is estimated that the
production of this new product requires the company to procure a machine for $7,500 with 5-year
life span. By the end of the project, the machine can be sold at $700. At the same time, the company
must also invest $1,000 in working capital. Annual revenue from new products is estimated to be
$2,200. However, if this new product is put into production, it could help stimulating the
consumption of other current products, thus increasing the revenue of these products by $500
annually. Annual operating expenses (excluding depreciation) is $970.
The company applies the straight-line depreciation method. The average cost of capital is 10% per
year and the CIT rate is 20%.
Requirement: Determine the NPV and PI of the project and advise the company whether to invest in
this new product or not?
14. NPV, IRR
Company X is currently considering whether to buy a new machine or continue using the old one:
- The old machine has the original price of $200,000, has been depreciated by 40%. Its current
market price is $90,000. If continued to use, this machine can generate $70,000 in profit before tax
per year. After 4 more years, it will have to be liquidated, the estimated liquidation value is
$10,000.
- If buying the new machine, the estimated investment capital is $300,000. The company also needs
to invest another $50,000 in working capital. The total estimated life span of the machine is 6 years.
Each year, estimated annual profit before tax is $95,000. It is estimated that after 4 years of use, it
can be sold for $30,000.
The company applies the straight-line depreciation method and the CIT rate is 20%. The cost of
capital is 10%/year. The company needs to use either of the machine for only 4 years.
Requirement: Please advise the company whether to buy the new machine or not using the NPV
and IRR?