871 Ch06ARQ
871 Ch06ARQ
6.1 Explain and define the terms: net present value, internal rate of return, modified
internal rate of return, accounting rate of return, and payback period.
6.3 Assume that Anvil Inc. has estimated the following annual data for the
introduction of a new product, Ranch Hand:
(a) For Ranch Hand calculate NPV, IRR, MIRR, ARR, and payback period.
(b) Based on the calculations in part (a), make a recommendation to Anvil’s
management about the introduction of Ranch Hand.
6.4 With respect to investment decisions, explain the terms: mutual exclusivity,
replacement decisions, retirement decisions.
6.5 Discuss the difference in the usage of the terms ‘ asset replacement’ and ‘asset
replication’.
6.6 The formula to arrive at an NPV for asset replication in perpetuity is:
NPVn (1 +r ) n
NPV p = NPVr +
[(1 + r ) − 1]
n or NPV r n
( 1 + r ) − 1
Explain how this formula works, and show how it can be set up as a generic
calculation within an Excel spreadsheet.
6.7 Assume that White Knuckle Airlines Inc. operates a regional fifty-seat jet aircraft
fleet. White Knuckle expects that there will be a constant demand for this type of
flight service, and that the model of aircraft employed will remain in production
for the foreseeable future. White Knuckle has predicted the set of operational
cash flows shown in Table 6.11 for each aircraft.
If White Knuckle Inc. has a required rate of return of 12% per annum, determine the
optimum aircraft replacement cycle time, in perpetuity.
(a) Calculate the initial investment associated with the proposed replacement
decision.
(b) Calculate the incremental operating cash flows of the proposed replacement
decision.
(c) Calculate the terminal cash flows associated with the proposed replacement
decision.
(d) Compute the NPV of the replacement project assuming a discount rate of 6%
per annum.
(e) What is the proposed investment’s IRR?
(f) Use the computed IRR and NPV results and discuss the project accept / reject
decision.
ANSWERS
Answer to Q 6.1
Net present value: This is the net increase in the firm’s current wealth that will result
from undertaking an investment. For a simplified case where there is only one capital
outlay which occurs at the beginning of the first year of the project, the net present
value (NPV) is calculated by subtracting this capital outlay from the present value of
the annual net operating cash flows and the net terminal cash flow. See Chapter 1,
‘shareholder wealth maximization and net present value’ section for more details
including a simple calculation example. The present value is calculated by
discounting the future values. The discount rate represents the firm’s required rate of
return, which, under certainty, will equal the risk free rate. If a calculated NPV is
positive, the firm should accept the project. If the NPV is zero, the firm will be
indifferent towards the project, and if the NPV is negative, the project should be
rejected.
In many cases, the capital outlays can occur not only at the beginning of the first year
of the project but at other times later during the project’s progress as well. For
example, an upgrade to the plant and machinery may occur in a later year. In such
cases the present value of those capital outlays need to be calculated by discounting
the future capital outlays and then the present value of the total capital outlays need to
be subtracted from the present value of net operating and terminal cash flows. For a
calculation example, which contains a capital outlay at a later year of the project (in
addition to the initial capital investment at the beginning of the project), see Delta
project example in this chapter, (which has continued from Chapter 2).
Internal rate of return: This is the rate of discount which will equate all the future net
cash flows to the initial outlay. In other words, it is the discount rate at which the
NPV is equal to zero. Under Descarte’s rule of sign, there must be at least one change
of sign in the cash flows for a solution to be possible. This change of sign normally
occurs between the negative initial outlay, and the first, or subsequent net operating
cash flows. If the IRR is greater than or equal to the required rate of return, the firm
should accept the project. If the IRR is less than the required rate of return, the project
should be rejected.
The IRR is sometimes not suitable an investment decision criterion for the following
reasons: (1) it may have zero or multiple solutions, (2) it can cause conflict in ranking
mutually exclusive projects, (3) it does not relate directly to the firm’s goal of wealth
maximisation, (4) its calculation implicitly assumes that cash flows as received can be
re-invested at the required rate of return and this assumption may not be tenable.
Modified internal rate of return: This method re-calculates the IRR, where a specified
re-investment rate of return is applied to the received cash flows. This re-investment
rate is a rate predicted by management at which cash flows can be re-invested as they
come to hand. One of the underlying assumptions of the IRR method is that received
cash flows can be re-invested at the IRR. If management feels that this is not likely,
then the re-investment rate is applied and the MIRR calculated. The MIRR outcome is
compared against the required rate of return, and the decision is made in the same way
as that for the IRR. The MIRR has the same drawbacks as does the IRR, with the
added disadvantage of requiring an extra prediction for a future re-investment rate.
Accounting rate of return: This measure is a ratio of the average annual accounting
income to the dollar amount of the investment. The calculated ratio is compared with
the required rate in the same way as is the IRR.
The dollar amount of the investment can be calculated in several ways. Some of these
are: the amount of the initial investment, the average of the initial investment and the
closing book value, and the average of annual successive written down book values.
Other values are also possible.
The ARR is not a recommended project evaluation measure for the following reasons:
• It does not account for the time value of money.
• The rate of return calculated is not a time value of money rate of return; it is
an accounting ratio.
• The calculated accounting ratio does not relate to the firm’s goal of wealth
maximisation.
• There are several variants of the ARR measure; all of which are ‘correct’.
• The definition of accounting ‘income’ is situation specific; it is not an
objective measure as is annual cash flow.
Payback period: This is a measure of the time taken for the accumulated annual
operating cash flows to become equal to the initial outlay.
The Payback Period is not a recommended as a stand-alone project evaluation
decision support criterion for the following reasons:
• It does not account for the time value of money.
• The calculated payback period does not relate to the firm’s goal of wealth
maximisation.
• There is no objective measure of an acceptable payback period.
• Operating cash flows occurring after the payback period are ignored. Some of
these may have a negative impact on the project’s viability.
Answer to Q 6.2
Answer to Q 6.3
(a) Calculation of NPV, IRR, MIRR, ARR, PP:
These have been calculated on the Excel work sheet titled ‘Q 6.3 Excel Solution.xls’
The results are summarised below.
(b) Recommendations:
• The NPV is the primary decision parameter. Since this is positive at $3,166,
the new product Ranch Hand should be introduced.
• The IRR is not as reliable or definitive a measure as the NPV, but at 22.71% it
is above the required rate of 14%, thus supporting the NPV finding that Ranch
Hand should be introduced.
• The MIRR at 18.49% also supports the introduction of the new product.
• The ARR result of 33.56% appears to support the proposal. However, its value
and interpretation are open to question, so Anvil should not rely on this
measure as a decision parameter.
• The Payback Period of 4 years may support the proposal, but as the payback
measure is an unreliable parameter, Anvil should not rely on this figure for
project acceptance.
Answer to Q 6.4
Mutual exclusivity: this occurs where two or more assets compete for acceptance
within the constraint of limiting physical resources. For example, assume a firm owns
a parcel of land. The firm can build either a two storey, four storey or seven storey
building on this land. Each one of theses projects excludes the others. The projects are
mutually exclusive. The point of mutual exclusivity is that the NPV rule should
always be used in evaluating the competing investments. The IRR rule may give
misleading and conflicting results.
For example, a trucking company should review its truck fleet periodically. Whilst a
new truck may represent some improvement in performance and safety, it will
essentially provide the same services, albeit at a lesser cost. In this case, existing
forecasts of revenues and costs can be used.
However, if the firm replaced a current truck with one of markedly increased
capacity, then new forecasts of future cash flows would have to be made. In this case,
the investment decision is an ‘upgrade’ decision, and would have to be viewed as
new investment to replace the existing investment.
The relevant cash flows in the replacement decision will be the future changeable
flows. Past cash flows, current book values, and past cash spent on the asset will not
be relevant. The relevant cash flows will be concerned with the earning power of the
asset in place, against the earning power of a similar replacement asset.
Retirement decisions: These decisions are part of the asset review process. A firm
should evaluate assets to see whether the future benefits warrant the continuation of
the asset, or whether the cash released by the sale of the asset could be better
employed elsewhere. The relevant cash flows in this case are the current cash flows
from the asset in place, and the present value of the cash from sale.
Answer to Q 6.5
Asset replacement looks at comparing the asset in post with a similar asset that could
perform the same duties. The choice rests on the comparative NPVs. Asset
replacement becomes problematical when two or more assets compete to replace the
present asset. If the competing assets have different life spans, then the NPV
evaluation of each needs to be computed over a common time horizon.
This time horizon is usually the lowest common multiple number of years of the asset
lifetimes, but it can be alternatively cast out in perpetuity. If the life span is infinite,
the term used to describe the periodic asset replacement is ‘replication’. This term
implies that the asset will be replaced in exactly the same style and size over the same
cycle length in perpetuity. The word ‘replication’ is used to emphasise this infinite
replacement chain, rather than the more limited word ‘replacement’ which might
imply only a ‘once-off’ decision.
Answer to Q 6.6
The formula for the present value of an infinite replacement chain is:
NPVn
NPVp = NPVr +
[(1 + r ) − 1]
n
where, NPV p = The NPV at the present time of all the NPVs in the
[(1 + r ) n
]
− 1 = The periodic interest rate for each replication length. For
This formula is simply that for a perpetuity, having a cash flow of NPV n , being
discounted at the periodic rate k, plus the NPV of the first asset in the cycle. It can
therefore be viewed as the formula for a ‘perpetuity due’.
For example, an asset having an NPV of $418 , being replaced every 5 years, with an
annual rate of 7%, would have present NPV of $1,456,37 for the infinite chain; as
follows:
k = (1 + i ) 5 - 1
= (1 +.07 ) 5 - 1 = 1.402552 -1
= $1,456.37
This application can be made generic via the use of parameters in an Excel
spreadsheet. This is done on Excel file titled ‘Q 6.6 Excel Solutions.xls’.
Answer to Q 6.7
For each replacement cycle time, we compute the NPV from the expected yearly cash
inflows and the salvage value to be received at the end of the cycle. These individual
cycle length NPVs are then converted at their cycle lengths into the equivalent current
NPVs for infinite replication chains. For example:
These calculations are extended for all cycles up to the 5-year cycle on the Excel
spreadsheet titled ‘Q 6.7 Excel Solutions.xls’. The final results are given below.
This means that White Knuckle Airlines should replace its jet fleet at the end of every
year in perpetuity. (The solution is obvious in this particular case, since the one year
cycle is the only one with a positive NPV. However, the full solution is shown to give
a template for other investment projects.)
Answer to Q 6.8
For this solution ,we can use the same argument and layout as for Repco Corportaion
in Chapter 2. This layout is:
Initial Investment:
Taxes on sale of old machine = (Sale Proceeds – Book Value ) x tax rate
= (23,000 – 39,000) × .30 = - 4,800 (tax saving)
Book Value = cost – tax allowable accumulated depreciation
= 65,000 – (13,000 × 2) = 39,000
(b) Incremental Operating Cash Flows for Proposed Replacement Investment
New machine
1. Operating Income 143,000 143,000 143,000
2. Depreciation 70,000 70,000 0
3. Income before tax 73,000 73,000 143,000
4. Tax @ 30% 21,900 21,900 42,900
5. Income after tax 51,100 51, 100 100,100
6. Operating cash inflows ( 5 + 2) 121,100 121,100 100,100
Old machine
1. Operating income 120,000 120,000 120,000
2. Depreciation 13,000 13,000 13,000
3. Income before tax 107,000 107,000 107,000
4. Tax @ 30% 32,100 32,100 32,100
5. Income after tax 74,900 74,900 74,900
6. Operating cash inflows ( 5 + 2) 87,900 87,900 87,900
Incremental
1. New machine 121,100 121,100 100,100
2. Old machine 87,900 87,900 87,900
3. Proposal’s incremental cash inflows (1 – 2) 33,200 33,200 12,200
(c ) Kandy Coraption -Terminal cash flow for the proposed replacement investment
Taxes on sale of new machine = (Sale Proceeds – Book Value ) x tax rate
= (6,600 –6,000) x .3 = 180
Book Value = cost – tax allowable accumulated depreciation
= 146,000 – (70,000 x 2) = 6000
Taxes on sale of old machine = (Sale Proceeds – Book Value ) X tax rate
= (4,000 – 0) X .30 = 1,200
Book Value = cost – tax allowable accumulated depreciation
= 65,000 – (13,000 x 5) = 0
For replacement projects, we need to include proceeds from both the new asset and
the old asset. The rationale for the inclusion of cash inflow from the sale of new asset
is obvious. The reason why we subtract the proceeds from the sale of old machine in
arriving at the terminal cash flow of the proposed replacement investment is now
explained. If the replacement project commenced (at the beginning of year 2001), the
old asset would have been sold at that time. The proceeds from the sale of old
machine at that time was $23,000. This was treated as an inflow of capital in
calculating the initial investment of the proposed replacement investment project.
That is why the initial investment was reduced by that amount. Why then should we
include the $4,000 salvage value of the old machine at the end of year 2003 as a
terminal cash outflow of the proposed replacement investment? The answer lies in the
opportunity cost principle. The old machine’s sale proceeds of $4,000 (which would
have been a terminal cash inflow ‘without’ the proposed project), is now lost ‘with’
the proposed project. Therefore, that amount is attributed as a cash outflow for the
proposed replacement project.
Using a required rate of return of 6.00% for these cash flows, the Net Present Value
is:
= -$45,171.25
Using trial and error as a manual calculation for the IRR will be difficult here, as the
NPV is negative. This results means that the IRR will be less than 6.00% ( the
required rate), and the IRR may even be negative. It is easier to read the IRR result
from the spreadsheet solution. The resultant IRR is -16.04%.
Since the NPV is negative, and the IRR is less than the required rate of 6.00%, the
replacement project should NOT be undertaken.
All calculations are shown in the Excel file titled ‘Q 6.8 Excel Solution.xls’.