First Semester, 2024–2025

THE UNIVERSITY OF HONG KONG

DEPARTMENT OF STATISTICS AND ACTUARIAL SCIENCE

STAT3904 CORPORATE FINANCE FOR ACTUARIAL SCIENCE

Tutorial 3: Chapter 5

1 Key Learning Points

In tests and examinations, candidates are expected to:

LP1 Explain the advantages and disadvantages of the following capital budgeting techniques:
(i) payback period; (ii) internal rate of return; (iii) net present value; (iv) profitability
index.

LP2 Given two mutually exclusive projects, select the superior one by (i) the NPV rule; (ii)
the IIRR rule; (iii) the PI rule.

LP3 Given a budget and several available projects, select the combination of projects that
yields the greatest NPV.

LP4 Given two machines with different lifetimes, modify the NPV method to select the superior
one.

2 Review of Key Concepts

2.1 Payback Period

( )
n
• Definition: Payback period := min n ∈ N :
P
CFj ⩾ initial investment .
j=1

• Payback rule: Accept a project if the payback period is less than a predetermined number.

• Variant - Discounted payback rule: Accept a project if the discounted payback period,
defined as min {n ∈ N : NPV in the first n years ⩾ 0}, is less than a predetermined num-
ber.

Exercise 1. A business venture requires initial investment of three payments, each of 0.8 million. STAT1802
The first is due at the start of the project. The second is due one year after the start of the 08-09
Exam
S&AS: STAT3904 Corporate Finance for Actuarial Science 2

Advantages Disadvantages
1. It tells one how quickly 1. It does not take the time value of money into
the investment can be recovered. account by ignoring the PV of cash flows.
2. It is easy to calculate and use. 2. It does not use all the cash flows; in particular,
those after the cutoff date are ignored.
3. Additional investments apart from the initial
one may be needed.

Table 1: Advantages and disadvantages of the payback rule.

project, and the third is due one year after the second payment. After 3 years, it is assumed
that a further outlay of 0.6 million will be required to continue the project. The project is
expected to provide no income before the end of the fourth year.
The first income payment of $200,000 will be collected at the end of the fourth year. The second
income payment collected one year later will increase to $300,000. Thereafter the income will
be received at the end of each year and is expected to grow at a rate of 5% per annum effective.
It is assumed that the income will cease at the end of the 40th year from the start of the project.
Calculate the discounted payback period for the project using an effective interest rate of 10.25%
per annum. [Total: 16 marks]

Solution. We consider three types of cashflows in the current setting. respectively as follows:

• The present value of the initial investments and the outlay at time 3 is
 
1 1 600000
800000 × 1 + + 2
+ = 2631514.801. (1)
1.1025 1.1025 1.10253

• The present value of the $200,000 income at time 4 is

200000
= 135367.8724. (2)
1.10254

• The present value of the growing annuity with payment by the end of the year k ∈
{5, 6, ..., 40}, is given by
1.05 t−4


1 1 − 1.1025
· 300000 · . (3)
1.10254 0.1025 − 0.05

It remains to solve the inequality (2) + (3) ⩾ (1), i.e.,

1.05 t−4


1 1 − 1.1025
135367.8724 + · 300000 · ⩾ 2631514.801,
1.10254 0.1025 − 0.05
which yields t ⩾ 25.2489. Therefore, the discounted payback period is 26 years.
S&AS: STAT3904 Corporate Finance for Actuarial Science 3

Advantages Disadvantages
1. It is intuitive. 1. It is difficult to intuitively explain the concept of internal rate of return.
2. It is not useful in evaluating complex projects, mutually exclusive
projects and dependent projects.
3. It is usually complicated to calculate the IRR.
4. One sometimes gets multiple rates of return in case of complex projects.
5. IRR cannot distinguish between borrowing and lending projects.

Table 2: Advantages and disadvantages of the IRR rule.

2.2 Internal Rate of Return (IRR)

• Definition: A discount rate that makes NPV zero.

• IRR Rule: Accept a project if its IRR is greater than the opportunity cost of capital.

2.3 Net Present Value (NPV)

• Decision rule:

– Without Budget: Accept all projects with a positive NPV;

– With Budget: Use Profitability Index to aid decision (See Section 2.4).

• Remarks concerning the NPV rule:

– Cashflows should be estimated on an incremental basis, i.e. additional cashflows

arising from project acceptance.
– Only cashflows are relevant; accounting incomes are not.
– Incidental effects should be included.
– Sunk costs should be ignored, i.e. past and irreversible costs.
– Inflation should be treated consistently.

Exercise 2. (Evaluating NPV in the Presence of Inflation) You are asked to evaluate a project STAT2807
with infinite life. Sales and costs are projected to be $1000 and $500 respectively. There is no 07-08
depreciation and the tax rate is 30%. The required real rate of return is 10%. The inflation 06-07
rate is 4% per year and is expected to be 4% forever. Sales and costs will increase at the rate Test
of inflation. If the initial cost of the project is $3,000, compute the net present value of the
project.

Solution. One can carry out calculations under either nominal figures or real figures, but in
either method, the numbers involved should be consistenly nominal or real.
S&AS: STAT3904 Corporate Finance for Actuarial Science 4

• Method 1 (Nominal figures)

Note that the nominal cashflow at time k is (1000 − 500) · 1.04k−1 · (1 − 0.3) = 350 · 1.04k−1 ,
and the nominal required rate of return is 1.1 × 1.04 − 1 = 0.144. Therefore, using the
C1
formula r−g for a growing perpetuity, where C1 = 350, r = 0.144 and g = 0.04, the NPV
350
of the project is 0.144−0.04 − 3000 = 365.3846.

• Method 2 (Real figures)

Since the real cashflow at time k is (1000−500)×(1−0.3)
1.04
= 336.5384615, we can use the formula
C
r
for a constant perpetuity (where C = 336.5384615 and r = 0.1) to calculate the NPV
336.5384615
of the project as 0.1
− 3000 = 365.3846.

• Choosing between Mutually Exclusive Projects

In tests and exams, there is a type of comparatively challenging questions, in which you
are given two mutually exclusive projects, say A (small) and B (big). Project A has a
higher IRR while Project B has a higher NPV, leading to a discrepancy between the
NPV rule (under which B will be chosen) and IRR rule (under which A will be chosen).
While using the NPV rule is simple since it suffices to choose the project with the higher
NPV, the question may insist in employing the IRR rule. In this case, the concept of
incremental IRR (IIRR) can be used as follows.

Step 1. Calculate the incremental cash flows ICFB−A

t for all t.
Step 2. With the ICFs determined in Step 1, calculate the incremental IRR (IIRR). Usually
the maximum value of t is at most 2, hence it suffices to solve an up-to-quadratic
equation in finding IIRR.
Step 3. If IIRR > cost of capital, then accept project B; otherwise, accept project A.

2.4 Profitability Index (PI)

• Scenario: A capital budget is imposed, so that not every project with a positive NPV
can be taken.
NPV
• Definition: PI := .
Investment
• Typical problem setting: You are given the information on several projects:

A B C D ···
Initial investment ···
NPV ···

Given a budget of $B, you are required to determine the project(s) giving the highest
NPV.
S&AS: STAT3904 Corporate Finance for Actuarial Science 5

Decision rule: For each possible combination of projects, compute its weighted average
profitability index, defined by
X Investmenti X
WAPI = PIi · subject to Investmenti ⩽ Budget.
i
Budget i

The pair which yields the maximum WAPI

P should be chosen; this is equivalent
Investmenti
P NPV P
to maximizing NPV, because WAPI = PIi · Budget = Budgeti ∝ NPVi .
i i i
As a shortcut, one may pick the projects with the highest PI until you run out
of capital, if the initial investment such a combination requires exactly equals
the budget.

• Choosing between Mutually Exclusive Projects: Apply a similar incremental analysis as

in the IRR case, and accept the bigger project if the incremental PI (or equivalently, the
incremental NPV) is positive.

2.5 Choosing Machines with Different Lifetimes

• The last important type of question in this chapter is to determine the machine yielding
lower costs among two mutually exclusive machines with different economic lives. In such
a question, the information about the specifics of the machines is usually given in the
following form, where TA < TB :

Machine Initial cost Maintenance cost Life

A cA mA TA
B cB mB TB

From the information on the costs, we can easily compute

NPVA = cA + mA a TA ,
NPVB = cB + mB a TB .

To make the problem interesting, usually NPVA < NPVB , i.e. the machine with a shorter
live costs less and is thus ostensibly better. Obviously the decision on which machine to
buy cannot be made directly by comparing the NPV of the costs of the two machines due
to different lifetimes of the machines. To be more specific, the machine with a smaller
lifetime will have to be replaced earlier, and the initial choice made today will affect future
investment decisions.

• Two commonly used methods:

– Method 1: Equivalent Annual Costs (EAC)

This method transforms the NPV of the costs into an equivalent level annuity of
cash flows continuing up to the lifetime of each machine. The amount paid by the
annuity each year is known as the equivalent annual cost, i.e., EACi = NPV
a
i
for
Ti
machine i, and the machine with a lower EAC should be chosen. The counterpart
of this method is the Equivalent Annual Benefit (EAB) method, where the one with
a higher EAB should be chosen.
S&AS: STAT3904 Corporate Finance for Actuarial Science 6

– Method 2: Matching Cycle

Set the time horizon T to be the least common multiple (LCM) of TA and TB . For
each machine, compute PV(costs) over T years assuming that it will be replaced
again and again until time T , and he machine with a lower PV(costs) should be
chosen. Textbook
Ch. 7
Exercise 3. Machines A and B are mutually exclusive and are expected to produce the following Ex. 8
real cash flows: (Adapted)

Cash Flows (in thousands)

Machine C0 C1 C2 C3
A −100 +110 +121
B −120 +110 +121 +133

The real opportunity cost of capital is 10%. Calculate the Net Present Value and Equivalent
Annual Benefit of each machine. Which machine should you buy?

Solution. By straightforward calculations, NPVA = −100 + 110 1.1

121
+ 1.12 = 100 and NPVB =

−120 + 110
1.1
+ 121
1.12
+ 133
1.13
= 179.92. Therefore, EABA = 100
a2
= 57.62 and EABB = 179.92
a3
= 72.35.
Since EABB > EABA , machine B should be chosen.

3 Questions

Attempt ALL FIVE questions. Marks for past paper questions are shown in square brackets.

1. Miscellaneous Short Questions

(a) State the payback rule, and list three of its disadvantages. [4 marks] STAT2807
09-10
Solution. See Section 2.1 and Table 1. Exam

(b) Explain the disadvantages of using the IRR method in evaluating an investment project. STAT2807
[4 marks] 10-11
09-10
Solution. See Table 2. Test
08-09
(c) Define the internal rate of return (IRR) and cost of capital. Comment on the validity Exam
of the statement “In case of a loan project, one should accept the project if the IRR is
higher than the cost of capital.” [4 marks] STAT2807
09-10
Solution. IRR is defined as a discount rate that makes NPV zero, and the cost of capital Exam
is the return offered by an equally risky investment. For the latter part, the statement
is wrong because the IRR of a loan project describes the return of its counterpart.
S&AS: STAT3904 Corporate Finance for Actuarial Science 7

(d) State five points that one has to watch out for when applying the net present rule. STAT2807
[6 marks] 09-10
Exam
(Adapted)
Solution. See Section 2.3.

(e) Explain the concept of value additivity. [5 marks] STAT2807

07-08
Solution. For example, the net present value (NPV) of the combined project (say A 06-07
and B) is equal to NPVA + NPVB , and this property holds well for the present values. Test
However, note that this property is not shared by IRR. The value additivity property
is very useful when making decisions about numerous projects.

2. An SOA Exam Question SOA

A firm with no debt has the following three short term investment projects to consider, each FETE
of which has an initial outlay of $90 with cash flows over two periods: Fall 2009
(Adapted)

Period Cash Flow

Project 1 Year 1 125
Year 2 −25
Project 2 Year 1 75
Year 2 30
Project 3 Year 1 30
Year 2 75

Assume that the cost of capital is 10%.

(a) Describe the strengths and weaknesses of the following capital budgeting techniques:
(i) Payback Method
(ii) Net Present Value
(iii) Internal Rate of Return
(b) Evaluate the preferred project, if any, under each of the capital budgeting techniques
assuming only one project can be selected.
(c) Recommend which project(s) to proceed with, assuming the firm has the capacity to
make all investments and desires to maximize shareholders’ wealth.

Solutions. (a) See Tables 1, 2 and Section 2.3.

(b) We omit the routine calculations here and list the results below:

Method Project 1 Project 2 Project 3 Decision

(i) 1 year 2 years 2 years Project 1
(ii) 2.9752 2.9752 −0.74 Project 1 or 2
(iii) 14.6% 12.8% 9.4% Project 1

(c) All projects with positive NPVs should be chosen, hence we should choose Projects 1
and 2
S&AS: STAT3904 Corporate Finance for Actuarial Science 8

3. IRR for Mutually Exclusive Projects STAT2807

Johnny To is considering the production of a new movie on either a small budget or a big 10-11
budget. The estimated cash flows are Test

Cash flow at date 0 Cash flow at date 1

Small budget −$10 million $40 million
Large budget −$25 million $60 million

Cost of capital is estimated at 25%.

(a) Find the NPV of both projects. Which one should Johnny choose according to the
NPV rule? [2 marks]
(b) Find the IRR of both projects. Which one should Johnny choose according to the IRR
rule? [2 marks]
(c) Suggest a method to reconcile the discrepancy in parts (a) and (b). [4 marks]

[Total: 8 marks]

Solutions. (a) The net present values associated with small and budgets (in millions) are
40
NPVSmall = −10 + = 22,
1.25
60
NPVLarge = −25 + = 23.
1.25
As NPVLarge > NPVSmall , Johnny should choose the large budget according to the NPV
rule.
(b) Solving
40 60
−10 + = 0 and − 25 + = 0,
1 + IRRSmall 1 + IRRLarge
we get IRRSmall = 3 and IRRLarge = 1.4. As IRRSmall > IRRLarge , Johnny should choose
the small budget according to the IRR rule.
(c) We suggest using the concept of incremental IRR to reconcile the discrepancy in parts
(a) and (b). Since the incremental cashflows at time 0 and 1 of the large one compared
to the small one are −15 and 20 respectively, by solving
20
−15 + = 0,
1 + IIRRLarge-Small
1
we get IIRRLarge-Small = 3
> 25%, hence Johnny should choose the large budget.

4. PI Rule for Mutually Exclusive Projects Textbook

Consider the following projects: Ch. 6
Ex. 14
Cashflow ($) (Adapted)
Project C0 C1
D −10, 000 +20, 000
E −20, 000 +35, 000
S&AS: STAT3904 Corporate Finance for Actuarial Science 9

Assume that the projects are mutually exclusive and that the opportunity cost of capital is
10%.

(a) Calculate the profitability index for each project.

(b) Use the profitability-index rule to select the superior project.

NPVD −10000 + 20000

1.1
Solution. (a) By definition, PID = = = 0.8182, and PIE =
InvestmentD 10000
NPVE −20000 + 35000
1.1
= = 0.5909.
InvestmentE 20000
(b) To choose between these projects, we perform the incremental analysis. Note that the
incremental cashflows are C0E−D = −10, 000 and C1E−D = 15, 000, hence the profitabil-
ity index of these incremental cashflows is

−10000 + 15000
1.1
PIE−D = = 0.3636 > 0.
10000
Therefore, Project E should be accepted.
Remark 1. Choosing Project E is in accordance with the NPV rule, even though Project E
actually has a lower profitability index.

5. PI Rule with a Capital Budget

The following table gives the available projects for a firm.

A B C D E F G
Initial investment (million) 5.0 4.0 5.0 1.0 2.0 7.0 8.0
NPV (million) 1.5 −0.5 1.0 0.5 0.5 1.0 1.0

If the firm has 20 million to invest, what is the maximum NPV the company can obtain?

Solution. The profitability index of each project is tabulated below:

A B C D E F G
Initial investment (million) 5.0 4.0 5.0 1.0 2.0 7.0 8.0
PI 0.3 −0.125 0.2 0.5 0.25 0.1429 0.125

Projects with the highest PIs should be chosen, until the budget is depleted. Hence Projects
D, A, E, C and F, which together require an initial investment of 20 million, should be
chosen. The maximum NPV the company can obtain is thus

1.5 + 1.0 + 0.5 + 0.5 + 1.0 = 4.5.

********** END OF TUTORIAL 3 **********