Professional Documents
Culture Documents
Chapter 9
1. Payback Period Given the cash flows of the four projects, A, B, C, and D, and using
the Payback Period decision model, which projects do you accept and which projects do
you reject with a three year cut-off period for recapturing the initial cash outflow?
Assume that the cash flows are equally distributed over the year for Payback Period
calculations.
Projects
Cost
Cash Flow Year One
Cash Flow Year Two
Cash Flow Year Three
Cash Flow Year Four
Cash Flow year Five
Cash Flow Year Six
A
$10,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
B
$25,000
$2,000
$8,000
$14,000
$20,000
$26,000
$32,000
C
$45,000
$10,000
$15,000
$20,000
$20,000
$15,000
$10,000
D
$100,000
$40,000
$30,000
$20,000
$10,000
$0
$0
Solution
Project A:
Project B:
Project C:
Project D:
2. Payback Period What are the Payback Periods of Projects E, F, G and H? Assume
all cash flows are evenly spread throughout the year. If the cut-off period is three years,
which projects do you accept?
Projects
Cost
Cash Flow Year One
Cash Flow Year Two
Cash Flow Year Three
Cash Flow Year Four
Cash Flow year Five
Cash Flow Year Six
E
$40,000
$10,000
$10,000
$10,000
$10,000
$10,000
$10,000
F
$250,000
$40,000
$120,000
$200,000
$200,000
$200,000
$200,000
G
$75,000
$20,000
$35,000
$40,000
$40,000
$35,000
$20,000
H
$100,000
$30,000
$30,000
$30,000
$20,000
$10,000
$0
Solution
Project E:
Project G:
Project H:
20% discount rate. What do you notice about the payback period as the discount rate
rises? Explain this relationship.
Projects
Cost
Cash Flow Year One
Cash Flow Year Two
Cash Flow Year Three
Cash Flow Year Four
Cash Flow year Five
Cash Flow Year Six
A
$10,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
B
$25,000
$2,000
$8,000
$14,000
$20,000
$26,000
$32,000
C
$45,000
$10,000
$15,000
$20,000
$20,000
$15,000
$10,000
D
$100,000
$40,000
$30,000
$20,000
$10,000
$10,000
$0
Cash Flows
Initial Cost
Cash flow year one
Cash flow year two
Cash flow year three
Cash flow year four
Project R
$24,000
$6,000
$8,000
$10,000
$12,000
Solution at 8%
Project R:
Project S
$18,000
$9,000
$6,000
$6,000
$3,000
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Because Graham Incorporated is using a four year cut-off period, only the first four years
of cash flow matter. If the first four years of anticipated cash flows are insufficient to
cover the initial outlay of cash, the project is rejected regardless of the cash flows in years
five and forward.
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Project One
$10,000
$4,000
$4,000
$4,000
Project Two
$15,000
$7,000
$5,500
$4,000
Project
Three
$8,000
$3,000
$3,500
$4,000
Project Four
$18,000
$10,000
$11,000
$0
Solution
Calculate the Discounted Payback Periods of each project at 10% discount rate:
Project One
Present Value of cash flow year one = $4,000 / 1.10 = $3,636.36
Present Value of cash flow year two = $4,000 / 1.102 = $3,305.78
Present Value of cash flow year three = $4,000 / 1.103 = $3,005.26
Discounted Payback Period = -$10,000 + $3,636.36 + $3,305.78 +
$3,005.26 = -$52.60 so the discount payback period is over 3 years and the project is
a no-go!
Project Two
Present Value of cash flow year one = $7,000 / 1.10 = $6,930.69
Present Value of cash flow year two = $5,500 / 1.102 = $5,391.63
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7. Net Present Value Swanson Industries has a project with the following projected
cash flows:
Initial Cost, Year 0: $240,000
Cash flow year one: $25,000
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8. Net Present Value Campbell Industries has a project with the following projected
cash flows:
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9. Net Present Value Swanson Industries has four potential projects all with an initial
cost of $2,000,000. The capital budget for the year will only allow Swanson industries to
accept one of the four projects. Given the discount rates and the future cash flows of each
project, which project should they accept?
Cash Flows
Year one
Year two
Year three
Year four
Year five
Discount Rate
Project M
$500,000
$500,000
$500,000
$500,000
$500,000
6%
Project N
$600,000
$600,000
$600,000
$600,000
$600,000
9%
Project O
$1,000,000
$800,000
$600,000
$400,000
$200,000
15%
Project P
$300,000
$500,000
$700,000
$900,000
$1,100,000
22%
Solution, find the NPV of each project and compare the NPVs.
Project Ms NPV = -$2,000,000 + $500,000/1.05 + $500,000/1.052 +
$500,000/1.053 + $500,000/1.054 + $500,000/1.055
Project Ms NPV = -$2,000,000 + $476,190.48 + $453,514.74 + $431,918.80
+ $411,351.24 + $391,763.08
Project Ns NPV = $164,738.34
Project Ns NPV = -$2,000,000 + $600,000/1.09 + $600,000/1.092 +
$600,000/1.093 + $600,000/1.094 + $600,000/1.095
Project Ns NPV = -$2,000,000 + $550,458.72 + $505,008.00 + $463,331.09
+ $425,055.13 + $389,958.83
Project Ns NPV = $333,790.77
Project Os NPV = -$2,000,000 + $1,000,000/1.15 + $800,000/1.152 +
$600,000/1.153 + $400,000/1.154 + $200,000/1.155
Project Os NPV = -$2,000,000 + $869,565.22 + $604,914.93 + $394,509.74
+ $228,701.30 + $99,435.34
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Project Q
$350,000
$350,000
$350,000
$350,000
$350,000
4%
Project R
$400,000
$400,000
$400,000
$400,000
$400,000
8%
Project S
$700,000
$600,000
$500,000
$400,000
$300,000
13%
Project T
$200,000
$400,000
$600,000
$800,000
$1,000,000
18%
Solution, find the NPV of each project and compare the NPVs.
Project Qs NPV = -$1,500,000 + $350,000/1.04 + $350,000/1.042 +
$350,000/1.043 + $350,000/1.044 + $350,000/1.045
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Project M
-$2,000,000
$500,000, 1
$500,000, 1
$500,000, 1
$500,000, 1
$500,000, 1
7.93%
Project N
-$2,000,000
$600,000, 1
$600,000, 1
$600,000, 1
$600,000, 1
$600,000, 1
15.24%
Project O
-$2,000,000
$1,000,000, 1
$800,000, 1
$600,000, 1
$400,000, 1
$200,000, 1
20.27%
Project P
-$2,000,000
$300,000, 1
$500,000, 1
$700,000, 1
$900,000, 1
$1,100,000, 1
17.72%
12. Internal Rate of Return -- Internal Rate of Return What are the IRRs of the four
projects for Campbell Industries in problem #10?
Solution, this is an iterative process but can be solved quickly on a calculator or
spreadsheet.
Enter the keys noted for each project in the CF of a Texas BA II Plus calculator
Cash Flows
CFO
CO1, F1
CO2, F2
Year three
Year four
Year five
CPT IRR
Project Q
-$1,500,000
$350,000, 1
$350,000, 1
$350,000, 1
$350,000, 1
$350,000, 1
5.37%
Project R
-$1,500,000
$400,000, 1
$400,000, 1
$400,000, 1
$400,000, 1
$400,000, 1
10.42%
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Project S
-$1,500,000
$700,000, 1
$600,000, 1
$500,000,1
$400,000, 1
$300,000, 1
23.57%
Project T
-$1,500,000
$200,000, 1
$400,000, 1
$600,000, 1
$800,000, 1
$1,000,000, 1
21.86%
13. Comparing NPV and IRR Chandler and Joey were having a discussion about which
financial model to use for their new business. Chandler supports NPV and Joey supports
IRR. The discussion starts to get heated when Ross steps in and states, gentlemen, it
doesnt matter which method we choose, they give the same answer on all projects. Is
Ross right? Under what conditions will IRR and NPV be consistent when accepting or
rejecting projects?
Solution: Ross is partially right as NPV and IRR both reject or both accept the
same projects under the following conditions:
The hurdle rate for IRR is the same as the discount rate for NPV
14. Comparing NPR and IRR Monica and Rachel are having a discussion about IRR
and NPV as a decision model for Monicas new restaurant. Monica wants to use IRR
because it gives a very simple and intuitive answer. Rachel states that there can be errors
made with IRR that are not made with NPV. Is Rachel right? Show one type of error can
be made with IRR and not with NPV?
Solution: The most typical example here is with two mutually exclusive
projects where the IRR of one project is higher than the IRR of the other
project but the NPV of the second project is higher than the NPV of the first
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project. When comparing two projects using only IRR this method fails to
account for the level of risk of the project cash flows. When the discount rate
is below the cross-over rate one project is better under NPV while the other
project is better if the discount rate is above the cross-over rate and still below
the IRR.
15. Profitability Index -- Given the discount rates and the future cash flows of each
project, which projects should they accept using profitability index?
Cash Flows
Year zero
Year one
Year two
Year three
Year four
Year five
Discount Rate
Project U
-$2,000,000
$500,000
$500,000
$500,000
$500,000
$500,000
6%
Project V
-$2,500,000
$600,000
$600,000
$600,000
$600,000
$600,000
9%
Project W
-$2,400,000
$1,000,000
$800,000
$600,000
$400,000
$200,000
15%
Project X
-$1,750,000
$300,000
$500,000
$700,000
$900,000
$1,100,000
22%
Solution, find the present value of benefits and divide by the present value of the
costs for each project.
Project Us PV Benefits = $500,000/1.05 + $500,000/1.052 + $500,000/1.053
+ $500,000/1.054 + $500,000/1.055
Project Us PV Benefits = $476,190.48 + $453,514.74 + $431,918.80 +
$411,351.24 + $391,763.08 = $2,164,738.34
Project Us PV Costs = $2,000,000
Project Us PI = $2,164,738.34 / $2,000,000 = $1.0824 accept project.
Project Vs PV Benefits = $600,000/1.09 + $600,000/1.092 + $600,000/1.093
+ $600,000/1.094 + $600,000/1.095
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16. Profitability Index -- Given the discount rates and the future cash flows of each
project, which projects should they accept using profitability index?
Cash Flows
Year zero
Year one
Year two
Year three
Year four
Year five
Discount Rate
Project A
-$1,500,000
$350,000
$350,000
$350,000
$350,000
$350,000
4%
Project B
-$1,500,000
$400,000
$400,000
$400,000
$400,000
$400,000
8%
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Project C
-$2,000,000
$700,000
$600,000
$500,000
$400,000
$300,000
13%
Project D
-$2,000,000
$200,000
$400,000
$600,000
$800,000
$1,000,000
18%
Solution, find the present value of benefits and divide by the present value of the
costs for each project.
Project As PV Benefits = $350,000/1.04 + $350,000/1.042 + $350,000/1.043
+ $350,000/1.044 + $350,000/1.045
Project As PV Benefits = $336,538.46 + $323,594.67 + $311,148.73 +
$299,181.47 + $287,674.49 = $1,558,137.84
Project As PV Costs = $1,500,000
Project As PI = $1,558,137.84 / $1,500,000 = 1.0388 and accept project.
Project Bs PV Benefits = $400,000/1.08 + $400,000/1.082 + $400,000/1.083
+ $400,000/1.084 + $400,000/1.085
Project Bs NPV = -$2,000,000 + $370,370.37 + $342,935.53 + $317,532.90
+ $294,011.94 + $272,233.28 = $1,597,084.02
Project Bs PV Costs = $1,500,000
Project Bs PI = $1,597,084.02 / $1,500,000 = 1.0647 and accept project.
Project Cs PV Benefits = $700,000/1.13 + $600,000/1.132 + $500,000/1.133
+ $400,000/1.134 + $300,000/1.135
Project Cs PV Benefits = $619,469.03 + $469,888.01 + $346,525.08 +
$245,327.49 + $162,827.98 = $1,844,037.59
Project Cs PV Costs = $2,000,000
Project Cs PI = $1,844,037.59 / $2,000,000 = 0.9220 and reject project.
Project Ds PV Benefits = $200,000/1.18 + $400,000/1.182 + $600,000/1.183
+ $800,000/1.184 + $1,000,000/1.185
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17. Comparing All Methods -- Given the following After Tax Cash Flows for Tylers
Tinkering Toys on a new toy find the Payback Period, NPV, and Profitability Index of
this project. The appropriate discount rate for the project is 12%. If the cut-off period is
six years for major projects, determine if the project is accepted or rejected under the four
different decision models.
Year 0 cash outflow: $10,400,000
Years 1 to 4 cash inflow: $2,600,000 each year
Year 5 cash outflow: $1,200,000
Years 6 8 cash inflow: $750,000 each year
Solution:
Payback Period: -$10,400,000 + $2,600,000 + $2,600,000 + $2,600,000 +
$2,600,000 = $0 (Four years but year five is also an outflow so we need to
continue) -$1,200,000 + $7,500,000 + $7,500,000 = $300,000 so we only need
part of year seven, $4,500,000 / $7,500,000 = 0.6 so total Payback is 7.6 years
and project is rejected with six year cut-off.
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Risky Business wants to know the Payback Period, NPV, and Profitability Index
of this project. The appropriate discount rate for the project is 14%. If the cut-off
period is six years for major projects, determine if the project is accepted or
rejected under the four different decision models.
Solution:
Payback Period = -$3,600,000 + $500,000 + $625,000 + $625,000 + $625,000 +
$625,000 + $625,000 = $ 25,000 and we only need part of year 6 so,
$600,000 / $625,000 = 0.96 and Payback Period is 5.96 years and project is
accepted.
NPV = -$3,600,000 + $500,000 / 1.14 + $625,000/1.142 + $625,000/1.143 +
$625,000/1.144 + $625,000/1.145 + $625,000/1.146 + $530,000/1.147
+ $530,000 /1.148 + $530,000/1.149 + $385,000/1.1410
NPV = -$3,600,000 + $438,596.49 + $480,917.21 + $421,857.20 + $370,050.17
+ $324,605.42 + $284,741.59 + $211,807.78 + $185,796.30 + $162,979.21
+ $103,851.37 = -$614,797.27 and project is rejected using NPV rules.
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