Chapter 9 + 10

1. The XYZ Corporation is trying to choose between the following two mutually exclusive
projects:
Year Project I Project II
0 -$54,000 -$15,000
1 28,000 7,700
2 28,000 8,700
3 28,000 9,700

a. If the required return is 10% and the company applies the Profitability Index (PI) decision
rule, which project should the firm accept?

b. If the company applies the net present Value ( NPV) decision rule, which project should it
take?

2. XYZ Company is trying to evaluate a generation project with the following cash flows:

Yea Cash flow

r
0 -$35,000,000
1 53,000,000
2 -10,000,000

a. If the company requires a 10% discount rate on its investments, what is the Net Present
Value (NPV) of this project? Should XYZ Company accept this project?
b. If the company wants to recover its invested capital as early as possible, would the
company prioritize the Net Present Value (NPV) method or the Payback Period method?

3. XYZ Company uses the Payback Method to evaluate an investment proposal. It is currently
considering the following investment opportunity:

Year 0 1 2 3
Cash flow -$250,000 $85,000 $98,000 $135,000

a. Compute the Payback period (PBP) and Discounted Payback Period for the investment?
Given the discount rate of 13%
b. If the firm utilized a required payback period of 3 years, would the project be
acceptable?

Consider the following two mutually exclusive projects.

 Year Cash Flow (A) Cash Flow (B)

0 -$300,000 -$40,000

1 20,000 19,000

2 50,000 12,000

3 50,000 18,000

4 390,000 10,500

Which project you choose, if any, you require a 15 percent return on your investment.

a. If you apply the payback criterion, which investment will you choose? Why?

b. If you apply the discounted payback criterion, which investment will you choose?
Why?

c. If you apply the NPV criterion, which investment will you choose? Why?

d. If you apply the IRR criterion, which investment will you choose? Why?

e. If you apply the profitability index criterion, which investment will you choose?
Why?

f. Based on your answers in (a) through (e), which project will you finally choose?
Why?

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.
4.
5. ABC company purchased some machinery 2 years ago for $324,000. These assets
are classified as 5-year property for MACRS. The company is replacing this
machinery today with newer machines that utilize the latest in technology. The old
machines are being sold for $150,000. What is the after-tax cash flow value from
this sale if the tax rate is 25%?

$324,000  319,000
$150,000  140,000
35%  25%
Answer:
Book value at year 2 = $319,000 × (1 - 0.20 - 0.32) = $153,120
Tax on sale = ($140,000 - $153,120) × 0.35 = -$4,592 (tax savings)
After-tax cash flow = $140,000 + $4,592 = $144,592

6. The Binh An company needs to maintain 20% of its sales in net working capital.
Currently, the company is considering a 6-year project that will increase sales
from its current level of $389,000 to $425,000 in the first year and to $485,000 a
year for the following 5 years of the project.
a. What amount should be included in the project analysis for net working capital
at the end of the project?
b. What is the cash flow from the change in net working capital at the end of the
project?

$379,000 389,000
$421,000  $425,000
$465,000  $485,000
Answer:
a.
Year 0 1 2 3 4 5 6
Sales 379 421 465 465 465 465 465
NWC 75.8 84.2 93 93 93 93 93
 Change in -75.8 -8.4 -8.8 0 0 0 0
NWC
NWC 93
recovery
Total -75.8 -8.4 -8.8 0 0 0 93
change in
NWC

b. At the end of the project, all the Net Working Capital are recovered. The change
in net working capital at the end of the project is $93,000.

7. You own a land that you rent for $2,200 a month. The land cost $150,000 when
you purchased it 6 years ago. A recent appraisal on the land valued it at $260,000.
If you sell the land you will incur $16,000 in real estate fees. You are deciding
whether to sell the land or convert it for your own use. What is the opportunity
cost of using it for your purpose.

Answer: Opportunity cost = $260,000 - $16,000 = $244,000

8. Wonglo company is considering a new project. The project will require $560,000
for new fixed assets, $284,000 for additional inventory, and $32,000 for additional
accounts receivable.The project has a 6-year life. The fixed assets will be
depreciated straight-line to a zero book value over the life of the project. What is
the project's cash flow at time zero?

Answer:
Initial cash flow = -$560,000 - $284,000 - $32,000 =

9. A proposed expansion project is expected to increase sales of LG’s Store by

$45,000 and increase cash expenses by $22,000. The project will invest $30,000 in
fixed assets. This fixed asset is depreciated using straight-line depreciation to a
zero book value over the 5-year life of the project. The store has a tax rate of 25
percent. What is the operating cash flow of the project using the tax shield
approach?

Answer:
OCF = ($45,000 - $22,000) (1 - 0.25) + ($30,000/5) (0.25) =
1. Which one of the following methods of project analysis is defined as computing the value of
a project based on the present value of the project's anticipated cash flows?

A. Constant dividend growth model

B. Discounted cash flow valuation (DCF)
C. Average accounting return (AAR)
D. Internal rate of return (IRR)

2. The length of time a firm must wait to recover the money it has invested in a project is called
the ………..

A. internal return period.

B. payback period.
C. profitability period.
D. valuation period.

3. In proper capital budgeting analysis, we evaluate incremental………..

A. accounting incomes.
B. cash flows.
C. earnings.
D. operating profits.

4. The length of time a firm must wait to recover, in present value terms, the money it has
invested in a project is referred to as the ……..

A. discounted payback period.

B. internal return period.
C. payback period.
D. discounted profitability period.

5. The internal rate of return is defined as the………..

A. rate of return that a project will generate if it is financed solely with internal funds.
B. discount rate that equates the net cash inflows of a project to zero.
C. discount rate, which causes the net present value (NPV) of a project to equal zero.
D. discount rate that causes the profitability index for a project to equal zero.
6. There are two distinct discount rates at which a particular project will have a zero net present
value. In this situation, the project is said to ………..

A. has two net present value profiles.

B. have operational ambiguity.
C. create a mutually exclusive investment decision.
D. have multiple internal rates of return.

7. A project has a net present value of zero. Which one of the following best describes this
project?

A. The project's cash inflows equal its cash outflows.

B. The project requires no initial cash investment.
C. The project has no cash flows.
D. The summation of all of the project's cash flows is zero.

8. Which one of the following will decrease the net present value (NPV) of a project, other
factors remain unchanged?

A. Increasing the value of each of the project's discounted cash inflows.

B. Increasing the project's initial cost at time zero.
C. Decreasing the required discount rate.
D. Decreasing the project's initial cost at time zero.

9. Which one of the following methods determines the amount of change that a proposed
project will have on the value of a firm?

A. Net present value

B. Discounted payback period
C. Internal rate of return
D. Profitability index

10. If a project has a net present value equal to zero, then……….

A. the total of the cash inflows must equal the initial cost of the project.
B. the project earns an internal rate of return (IRR) exactly equal to the discount rate.
C. a decrease in the project's initial cost will cause the project to have a negative NPV.
D. the project's profitability index (PI) must also be equal to zero.
11. Company A is analyzing a project that requires $180,000 of fixed assets. When the project
ends, those assets are expected to have an after-tax salvage value of $45,000. How is the
$45,000 salvage value handled when computing the net present value of the project?

A. Reduction in the cash outflow at time zero.

B. Cash inflow at the end of the project.
C. Cash inflow for the year following the final year of the project.
D. Not included in the net present value.

Answer: B
Term: Project cash flows
Diff: Easy
Objective: CLO 4
ACBSP: Inference