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The Basics of Capital Budgeting: Evaluating Cash Flows: Solutions To End-Of-Chapter Problems
The Basics of Capital Budgeting: Evaluating Cash Flows: Solutions To End-Of-Chapter Problems
Financial calculator: Input the appropriate cash flows into the cash flow register, input
I = 12, and then solve for NPV = $7,486.68.
10-2 Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 16%.
FV Inflows:
PV FV
0 12% 1 2 3 4 5 6 7 8
| | | | | | | | |
12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000
13,440
15,053
16,859
18,882
21,148
23,686
26,528
52,125 MIRR = 13.89% 147,596
Mini Case: 10 - 1
10-4 PV = $12,000[(1/I)-(1/(I*(1+I)N)]
= $12,000[(1/0.12)-(1/(0.12*(1+0.12)8)]
= $59,611.68.
10-5
Year CF Cumulative CF
0 -52,125 -52,125
1 12,000 -40,125
2 12,000 -28,125
3 12,000 -16,125
4 12,000 -4,125
5 12,000 7,875
6 12,000 19,875
7 12,000 31,875
8 12,000 43,875
The cumulative cash flows turns positive in Year 5, so the payback will be 4 plus the part
of Year 5 that is required to return the investment:
Payback = 4 + ($4,125/$12,000) = 4.34 years.
Because the future cash flows are identical, we can also find the payback period by
dividing the cost by the cash flow: $52,125/$12,000 = 4.34 years.
Mini Case: 10 - 2
10-6 The project’s discounted payback period is calculated as follows:
$ 2,788.20
The discounted payback period is 6 + $5,427.60 years, or 6.51 years.
10-7 Project A:
CF0 = -15000000
CF1 = 5000000
CF2 = 10000000
CF3 = 20000000
Mini Case: 10 - 3
Project B:
CF0 = -15000000
CF1 = 20000000
CF2 = 10000000
CF3 = 6000000
10-8 Truck:
Financial calculator: Input the appropriate cash flows into the cash flow register, input
I = 14, and then solve for NPV = $409.
Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 14.99% ≈ 15%.
FV Inflows:
PV FV
0 14% 1 2 3 4 5
| | | | | |
5,100 5,100 5,100 5,100 5,100
5,814
6,628
7,556
8,614
17,100 MIRR = 14.54% (Accept) 33,712
Mini Case: 10 - 4
Pulley:
Financial calculator: Input the appropriate cash flows into the cash flow register, input
I = 14, and then solve for NPV = $3,318.
Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 20%.
FV Inflows:
PV FV
0 1 2 3 4 5
| | | | | |
7,500 7,500 7,500 7,500 7,500
14%
8,550
9,747
11,112
12,667
22,430 MIRR = 17.19% (Accept) 49,576
Mini Case: 10 - 5
10-9 Electric-powered:
Financial calculator: Input the appropriate cash flows into the cash flow register, input
I = 12, and then solve for NPV = $3,861.
Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 18%.
Gas-powered:
Financial calculator: Input the appropriate cash flows into the cash flow register, input
I = 12, and then solve for NPV = $3,057.
Financial calculator: Input the appropriate cash flows into the cash flow register and then
solve for IRR = 17.97% ≈ 18%.
The firm should purchase the electric-powered forklift because it has a higher NPV
than the gas-powered forklift. The company gets a high rate of return (18% > r = 12%)
on a larger investment.
Mini Case: 10 - 6
10-10 Financial calculator solution, NPV:
Project S
Inputs 5 12 3000 0
N I PV PMT FV
Output = -10,814.33
Project L
Inputs 5 12 7400 0
N I PV PMT FV
Output = -26,675.34
Inputs 5 12 0 3000
N I PV PMT FV
Output = -19,058.54
PV costsS = $10,000.
FV inflowsS = $19,058.54.
Output = 13.77
MIRRS = 13.77%.
Mini Case: 10 - 7
Project L
Inputs 5 12 0 7400
N I PV PMT FV
Output = -47,011.07
PV costsL = $25,000.
FV inflowsL = $47,011.07.
Output = 13.46
MIRRL = 13.46%.
$10,814.33 $26,675.34
PIS = $10,000 = 1.081. PIL = $25,000 = 1.067.
Thus, NPVL > NPVS; IRRS > IRRL; MIRRS > MIRRL; and PIS > PIL. The scale difference
between Projects S and L result in the IRR, MIRR, and PI favoring S over L. However,
NPV favors Project L, and hence L should be chosen.
Mini Case: 10 - 8
10-11 Project X: 0 1 2 3 4
| 12% | | | |
-1,000 100 300 400 700.00
448.00
376.32
140.49
1,664.81
1,000 13.59% = MIRRX`
Project Y: 0 12% 1 2 3 4
| | | | |
-1,000 1,000 100 50 50.00
56.00
125.44
1,404.93
1,636.37
1,000 13.10% = MIRRY
Alternative step: You could calculate NPVs, see that Project X has the higher NPV, and
just calculate MIRRX.
b. Ignoring environmental concerns, the project should be undertaken because its NPV
is positive and its IRR is greater than the firm's cost of capital.
Mini Case: 10 - 9
10-13 a.
NPV
($)
1,000
900
800
700
600
500
Project A
400
300
200 Project B
100 Cost of
Capital (%)
-100 5 10 15 20 25 30
-200
-300
r NPVA NPVB
0.0% $890 $399
10.0 283 179
12.0 200 146
18.1 0 62
20.0 (49) 41
24.0 (138) 0
30.0 (238) (51)
Mini Case: 10 - 10
b. At r = 10%, Project A has the greater NPV, specifically $283.34 as compared to
Project B's NPV of $178.60. Thus, Project A would be selected. At r = 17%, Project
B has an NPV of $75.95 which is higher than Project A's NPV of $31.05. Thus,
choose Project B if r = 17%.
Now, MIRR is that discount rate which forces the TV of $2,459.60 in 7 years to equal
$978.82:
$978.82 = $2,459.60/(1+MIRR)7.
MIRRA = 14.07%.
Similarly, MIRRB = 15.89%.
At r = 17%,
MIRRA = 17.57%.
MIRRB = 19.91%.
d. To find the crossover rate, construct a Project ∆ which is the difference in the two
projects' cash flows:
Project ∆ =
Year CFA - CFB
0 $105
1 (521)
2 (327)
3 (234)
4 466
5 466
6 716
7 (180)
Projects A and B are mutually exclusive, thus, only one of the projects can be chosen.
As long as the cost of capital is greater than the crossover rate, both the NPV and IRR
methods will lead to the same project selection. However, if the cost of capital is less
than the crossover rate the two methods lead to different project selections--a conflict
exists. When a conflict exists the NPV method must be used.
Mini Case: 10 - 11
10-14 a. Incremental Cash
Year Plan B Plan A Flow (B - A)
0 ($10,000,000) ($10,000,000) $ 0
1 1,750,000 12,000,000 (10,250,000)
2-20 1,750,000 0 1,750,000
If the firm goes with Plan B, it will forgo $10,250,000 in Year 1, but will receive
$1,750,000 per year in Years 2-20.
b. If the firm could invest the incremental $10,250,000 at a return of 16.07%, it would
receive cash flows of $1,750,000. If we set up an amortization schedule, we would
find that payments of $1,750,000 per year for 19 years would amortize a loan of
$10,250,000 at 16.0665%.
Output = 16.0665
c. Yes, assuming (1) equal risk among projects, and (2) that the cost of capital is a
constant and does not vary with the amount of capital raised.
d. See graph. If the cost of capital is less than 16.07%, then Plan B should be accepted;
if r > 16.07%, then Plan A is preferred.
NPV (Millions of Dollars)
25
B
20
15
A
IRRB = 16.7%
5
IRRA = 20%
Cost of
Capital (%)
5 10 15 20 25
Mini Case: 10 - 12
10-15 a. Financial calculator solution:
Plan A
Inputs 20 10 8000000 0
N I PV PMT FV
Output = -68,108,510
Inputs 20 10 3400000 0
N I PV PMT FV
Output = -28,946,117
Plan A
Output = 15.03
IRRA = 15.03%.
Plan B
Output = 22.26
IRRB = 22.26%.
Mini Case: 10 - 13
b. If the company takes Plan A rather than B, its cash flows will be (in millions of
dollars):
Cash Flows Cash Flows Project ∆
Year from A from B Cash Flows
0 ($50) ($15.0) ($35.0)
1 8 3.4 4.6
2 8 3.4 4.6
. . . .
. . . .
. . . .
20 8 3.4 4.6
So, Project ∆ has a "cost" of $35,000,000 and "inflows" of $4,600,000 per year for 20
years.
Inputs 20 10 4600000 0
N I PV PMT FV
Output = -39,162,393
Output = 11.71
IRR = 11.71%.
Since IRR∆ > r, we should accept ∆. This means accept the larger project (Project A).
In addition, when dealing with mutually exclusive projects, we use the NPV method
for choosing the best project.
Mini Case: 10 - 14
c.
NPV (Millions of Dollars)
125
A
100 Crossover Rate = 11.7%
75 B
50 IRRA = 15.03%
IRRB = 22.26%
25
5 10 15 20 25 30
d. The NPV method implicitly assumes that the opportunity exists to reinvest the cash
flows generated by a project at the cost of capital, while use of the IRR method
implies the opportunity to reinvest at the IRR. If the firm's cost of capital is constant
at 10 percent, all projects with an NPV > 0 will be accepted by the firm. As cash
flows come in from these projects, the firm will either pay them out to investors, or
use them as a substitute for outside capital which costs 10 percent. Thus, since these
cash flows are expected to save the firm 10 percent, this is their opportunity cost
reinvestment rate.
The IRR method assumes reinvestment at the internal rate of return itself, which
is an incorrect assumption, given a constant expected future cost of capital, and ready
access to capital markets.
Mini Case: 10 - 15
10-16 The EAA of plane A is found by first finding the PV: N = 5, I/YR = 12, PMT = 30,
FV = 0; solve for PV = −108.143. The NPV is $108.143 − $100 = $8.143 million. We
convert this to an equivalent annual annuity by inputting: N = 5, I/YR = 12,
PV = −8.143, FV = 0, and solve for PMT = EAA = 2.259 ≈ $2.26 million.
For plane B, the NPV = 9.256. We convert this to an equivalent annual annuity by
inputting: N = 10, I/YR = 12, PV = −9.256, FV = 0, and solve for PMT = EAA =
1.638 ≈ $1.64 million.
10-17 The EAA of machine A is found by first finding the PV: N = 4, I/YR = 10, PMT = 4,
FV = 0; solve for PV = −12.679. The NPV is $12.679 − $10 = $2.679 million. We
convert this to an equivalent annual annuity by inputting: N = 4, I/YR = 10,
PV = −2.679, FV = 0, and solve for PMT = EAA = 0.845 ≈ $0.85 million.
For machine B, the NPV = 3.672. We convert this to an equivalent annual annuity by
inputting: N = 8, I/YR = 10, PV = −3.672, FV = 0, and solve for PMT = EAA = 0.688
≈ $0.69 million. Accept machine A.
10-18 The EAA of machine 190-3 is found by converting its NPV to an equivalent annual
annuity by inputting: N = 3, I/YR = 14, PV = −11,981.99, FV = 0, and solve for
PMT = EAA = 5,161.019 ≈ $5,161.02.
The EAA of machine 360-6 is found by converting its NPV to an equivalent annual
annuity by inputting: N = 6, I/YR = 14, PV = −22,256.02, FV = 0, and solve for
PMT = EAA = 5,723.302 ≈ $5,723.30.
Both new machines have positive NPVs, hence the old machine should be replaced.
Choose Model 360-6.
Mini Case: 10 - 16
10-19 a. The project's expected cash flows are as follows (in millions of dollars):
Time Net Cash Flow
0 ($ 4.4)
1 27.7
2 (25.0)
Discount
Rate (%)
10 20 80.5 420
-1
IRR1 = 9.2% IRR2 = 420%
-2
-3
NPV approaches -$4.0 as
the cost of capital
-4 approaches
-4.4
The table above was constructed using a financial calculator with the following
inputs: CF0 = -4400000, CF1 = 27700000, CF2 = -25000000, and I = discount rate to
solve for the NPV.
Mini Case: 10 - 17
b. If r = 8%, reject the project since NPV < 0. But if r = 14%, accept the project because
NPV > 0.
c. Other possible projects with multiple rates of return could be nuclear power plants
where disposal of radioactive wastes is required at the end of the project's life, or
leveraged leases where the borrowed funds are repaid at the end of the lease life.
Now, MIRR is that discount rate which forces the PV of the TV of $29,916,000 over
2 years to equal $25,833,470.51:
$25,833,470.51 = $29,916,000(PVIFr,2).
Output = 7.61
MIRR = 7.61%.
At r = 14%,
Output = 15.58
MIRR = 15.58%.
Now, MIRR is that discount rate which forces the PV of the TV of $31,578,000 over
2 years to equal $23,636,688.21:
$23,636,688.21 = $31,578,000(PVIFr,2).
Mini Case: 10 - 18
Yes. The MIRR method leads to the same conclusion as the NPV method. Reject the
project if r = 8%, which is greater than the corresponding MIRR of 7.61%, and accept
the project if r = 14%, which is less than the corresponding MIRR of 15.58%.
10-20 The PV of costs for the conveyor system is ($911,067), while the PV of costs for the
forklift system is ($838,834). Thus, the forklift system is expected to be ($838,834) -
($911,067) = $72,233 less costly than the conveyor system, and hence the forklift
trucks should be used.
Annual
Period Cash Flows Cumulative
0 ($25,000) ($25,000)
1 5,000 (20,000)
2 10,000 (10,000)
3 15,000 5,000
4 20,000 25,000
Mini Case: 10 - 19
b. Discounted payback A (cash flows in thousands):
At a discount rate of 5%, Project A has the higher NPV; consequently, it should be
accepted.
At a discount rate of 15%, Project B has the higher NPV; consequently, it should be
accepted.
Mini Case: 10 - 20
f. Project ∆ =
Year CFA - CFB
0 $ 0
1 (15)
2 0
3 7
4 14
Step 1: Calculate the NPV of the uneven cash flow stream, so its FV can then be
calculated. With a financial calculator, enter the cash flow stream into the
cash flow registers, then enter I = 10, and solve for NPV = $37,739,908.
Step 1: Calculate the NPV of the uneven cash flow stream, so its FV can then be
calculated. With a financial calculator, enter the cash flow stream into the
cash flow registers, then enter I = 10, and solve for NPV = $36,554,880.
According to the MIRR approach, if the 2 projects were mutually exclusive, Project
A would be chosen because it has the higher MIRR. This is consistent with the NPV
approach.
Mini Case: 10 - 21
10-22 a. NPV of termination after Year t:
Using a financial calculator, input the following: CF0 = -22500, CF1 = 23750, and
I = 10 to solve for NPV1 = -$909.09 ≈ -$909.
Using a financial calculator, input the following: CF0 = -22500, CF1 = 6250,
CF2 = 20250, and I = 10 to solve for NPV2 = -$82.64 ≈ -$83.
The firm should operate the truck for 3 years, NPV3 = $1,307.
b. No. Proceeds from selling the asset could only raise NPV and IRR. The value of the
firm is maximized by terminating the project after Year 3.
Mini Case: 10 - 22