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Learning Objectives

1. Discuss why capital budgeting decisions are the most important decisions made by a firms

management.

2. Explain the benefits of using the net present value (NPV) method to analyze capital

expenditure decisions, and be able to calculate the NPV for a capital project.

3. Describe the strengths and weaknesses of the payback period as a capital expenditure

decision-making tool, and be able to compute the payback period for a capital project.

4. Explain why the accounting rate of return (ARR) is not recommended for use as a capital

expenditure decision-making tool.

5. Be able to compute the internal rate of return (IRR) for a capital project, and discuss the

conditions under which the IRR technique and the NPV technique produce different

results.

6. Explain the benefits of a postaudit review of a capital project.

I.

Chapter Outline

10.1

A.

Capital budgeting decisions are the most important investment decisions made by

management.

The goal of these decisions is to select capital projects that will increase the value of

the firm.

Capital investments are important because they involve substantial cash outlays and,

once made, are not easily reversed.

business opportunities in order to decide which are worth undertaking.

Imagine you were to start your own business. No matter what type you started, you would have

to answer the following three questions in some form or another:

1. What long-term investments should you take on? That is, what lines of business will

you be in and what sorts of buildings, machinery, and equipment will you need?

2. Where will you get the long-term financing to pay for your investment? Will you bring in

other owners or will you borrow the money?

3. How will you manage your everyday financial activities such as collecting from

customers and paying suppliers?

Capital Budgeting The first question concerns the firm's long-term investments. The process of

planning and managing a firm's long-term investments is called capital budgeting. In capital

budgeting, the financial manager tries to identify investment opportunities that are worth more to

the firm than they cost to acquire. Loosely speaking, this means that the value of the cash flow

generated by an asset exceeds the cost of that asset. Regardless of the specific investment under

consideration, financial managers must be concerned with how much cash they expect to receive,

when they expect to receive it, and how likely they are to receive it. Evaluating the size, timing,

and risk of future cash flows is the essence of capital budgeting. In fact, whenever we

evaluate a business decision, the size, timing, and risk of the cash flows will be, by far, the most

important things we will consider.

B.

Sources of Information

internally, beginning likely with the sales force.

All this information is then reviewed by the financial managers, who evaluate the

feasibility of the project.

C.

Capital budgeting projects can be broadly classified into three types: (1) independent

projects; (2) mutually exclusive projects; and (3) contingent projects.

1. Independent Projects

bearing on the decision on the other.

precludes the other.

3. Contingent Projects

dependent on another project.

D.

The cost of capital is the minimum return that a capital budgeting project must earn

for it to be accepted.

It is an opportunity cost since it reflects the rate of return investors can earn on

financial assets of similar risk.

Capital rationing implies that a firm does not have the resources necessary to fund

all of the available projects.

Thus, the available capital will be allocated to the set of projects that will benefit the

firm and its shareholders the most.

Does the method account for the time value of money (TVM)?

Are all cash flows included?

Can we adjust for differential project risk?

Is there a decision rule?

Can we measure the effect on the value of the firm?

10.2

It is a capital budgeting technique that is consistent with the goal of maximizing shareholder

wealth.

The method estimates the amount by which the benefits or cash flows from a project exceeds

the cost of the project in present value terms.

Valuing real assets calls for the same steps as valuing financial assets.

However, there are some practical difficulties in following the process for real assets.

First, cash flow estimates have to be prepared in-house and are not readily available

as they are for financial assets in legal contracts.

Second, estimates of required rates of return are more difficult than it is for financial

assets because no market data is available for real assets.

The present value of a project is the difference between the present value of the expected

future cash flows and the initial cost of the project.

accepting a negative NPV project leads to a decline in shareholder wealth.

Projects that have an NPV equal to zero imply that management will be indifferent

between accepting and rejecting the project.

The Basic Idea The NPV measures the increase in firm value, which is also the increase

in the value of what the shareholders own. Thus, making decisions with the NPV rule

facilitates the achievement of our goal making decisions that will maximize

shareholder wealth.

Estimating Net Present Value: Discounted cash flow (DCF) valuation finding the

market value of assets or their benefits by taking the present value of future cash flows by

estimating what the future cash flows would trade for in todays dollars.

Cash flows from the project are estimated.

The riskiness of the projected cash flows is determined, so the appropriate rate of

return is used to discount the cash flows.

Cash flows are discounted to their present value to obtain an estimate of the

assets value to the firm.

The present value of the future expected cash flows is compared with the required

outlay, or cost. If the assets value exceeds its cost, the project should be accepted;

otherwise, it should be rejected. Alternatively, the projects expected rate of return

is compared with the rate of return considered appropriate for the project.

If a firm identifies an investment opportunity with a present value greater than its

cost, the firms value will increase. There is a very direct link between capital

budgeting and stock values. The more effective the firms capital budgeting

procedures, the higher the price of its stock.

Prepared by Jim Keys

Our goal is to compute the net cash flow (NCF) for each time period t, where NCFt = (Cash

inflows Cash outflows) for the period t.

1. Determine the cost of the project.

Identify and add up all expenses related to the cost of the project.

While we are mostly looking at projects whose entire cost occurs at the start of the

project, we need to recognize that some projects may have costs occurring beyond

the first year also.

2. Estimate the projects future cash flows over its expected life.

Both cash inflows (CIF) and cash outflows are likely in each year of the project.

Estimate the net cash flow (NCFt) = CIFt COFt for each year of the project.

Remember to recognize any salvage value from the project in its terminal year.

3. Determine the riskiness of the project and the appropriate cost of capital.

The cost of capital is the discount rate used in determining the present value of the

future expected cash flows.

The riskier the project, the higher the cost of capital for the project.

Determine the difference between the present value of the expected cash flows from

the project and the cost of the project.

Prepared by Jim Keys

5. Make a decision.

Accept the project if it produces a positive NPV or reject the project if NPV is

negative.

n

NPV

t 0

NCFt

,

(1 k) t

where:

NCFt = Net cash flow cash inflows cash outflows) in period t, where t =

1, 2, 3,, n

k = The cost of capital

n = The projects estimated life

Example - Compute the Net Present Value (NPV) given a required return of 12% and the following net

cash flows:

Year

NCFt

0

($20,000)

1

$6,000

2

$7,000

3

$8,000

4

$5,000

5

$4,000

NPV

20,000 6,000

7,000

8,000

5,000

4,000

0

1

2

3

4

(1.12)

(1.12)

(1.12)

(1.12)

(1.12)

(1.12) 5

NPV $20,000 $22,079.04 $2,079.04

(note on Excel NPV function)

Calculator Solution (in class)

What is the NPV if the required return is 17%?

NPV

20,000 6,000

7,000

8,000

5,000

4,000

0

1

2

3

4

(1.17)

(1.17)

(1.17)

(1.17)

(1.17)

(1.17) 5

NPV $20,000 $19,729.45 $270.55

Note: It is not the rather mechanical process of discounting the cash flows that is important. Once we

have the cash flows and the appropriate discount rate, the required calculations are fairly

straightforward. The task of coming up with the cash flows and the discount rate in the first place is

much more challenging.

NPV is superior to the other methods of analysis presented in the text because it has no serious flaws.

The method unambiguously ranks mutually exclusive projects, and can differentiate between projects of

different scale and time horizon. The only drawback to NPV is that it relies on cash flow and discount

rate values that are often estimates and not certain, but this is a problem shared by the other

performance criteria as well.

Suppose the firm uses the NPV decision rule. At a required return of 11 percent, should the firm accept

this project? What if the required return was 16 percent? What if the required return was 27 percent?

The NPV of a project is the PV of the outflows minus by the PV of the inflows. The equation for the

NPV of this project at an 11 percent required return is:

NPV = $130,000 + $68,000/(1.11)1 + $71,000/(1.11)2 + $54,000/(1.11)3

NPV = $28,730.79

At an 11 percent required return, the NPV is positive, so we would accept the project.

The equation for the NPV of the project at a 16 percent required return is:

NPV = $130,000 + $68,000/(1.16)1 + $71,000/(1.16)2 + $54,000/(1.16)3

NPV = $15,980.77

At a 16 percent required return, the NPV is positive, so we would accept the project.

The equation for the NPV of the project at a 27 percent required return is:

NPV = $130,000 + $68,000/(1.27)1 + $71,000/(1.27)2 + $54,000/(1.27)3

NPV = $6,074.35

Prepared by Jim Keys

At a 27 percent required return, the NPV is negative, so we would reject the project.

Recognize that the estimates going into calculating NPV are estimates and not market

data. Estimates based on informed judgments are considered acceptable.

The NPV method of determining project viability is the recommended approach for

making capital investment decisions.

Decision Rule: NPV > 0: Accept the project.

NPV < 0: Reject the project.

Key Advantages

Key Disadvantages

1. Uses the discounted cash flow

1. Difficult to understand without an

valuation technique.

a capital project will increase the value

of the firm.

3. Consistent with the goal of maximizing

shareholder wealth.

10.3

It is one of the most widely used tools for evaluating capital projects.

The payback period represents the number of years it takes for the cash flows from a

project to recover the projects initial investment.

10

This technique can serve as a risk indicatorthe more quickly you recover the cash, the less

risky is the project.

To compute the payback period, we need to know the projects cost and to estimate its

future net cash flows.

PB Years before cost recovery

Cash flow during the year

Example: Compute the Payback Period (PB) given a required return of 12% and the following net cash

flows:

Year

NCFt

Cumulative NCF

0

($20,000)

1

$6,000

$6,000

2

$7,000

$13,000

3

$8,000

$21,000

4

$5,000

5

$4,000

Therefore, payback occurs between two and three years:

PB 2

$20,000 - $13,000

$7,000

2

2.875 years

$8,000

$8,000

Note: The PB period when the cash flows are in the form of an annuity is calculated as: PB

NCF0

NCFn

Year

NCFt

0

($5,000)

1

$2,000

2

$2,000

3

$2,000

4

$2,000

11

PB

NCF0

$5,000

2.50 years

NCFn

$2,000

There is no economic rationale that links the payback method to shareholder wealth

maximization.

If a firm has a number of projects that are mutually exclusive, the projects are selected in

order of their payback rank: projects with the lowest payback period are selected first.

The payback period analysis can lead to erroneous decisions because the rule does not

consider cash flows after the payback period.

A rapid payback does not necessarily mean a good investment. See Exhibit 10.6

Projects D and E.

One weakness of the ordinary payback period is that it does not take into account the

time value of money.

The discounted payback period calculation calls for the future cash flows to be

discounted by the firms cost of capital.

The major advantage of the discounted payback is that it tells management how long it

takes a project to reach a positive NPV.

However, this method still ignores all cash flows after the arbitrary cutoff period, which

is a major flaw.

12

Example - Compute the Discounted Payback Period (DPB) given a required return of 12% and the

following net cash flows:

Year

NCFt

PVNCFt @12% Cumulative NCF

0

($20,000)

1

$6,000

$5,357.14

$5,357.14

2

$7,000

$5,580.36

$10,937.50

3

$8,000

$5,694.24

$16,631.74

4

$5,000

$3,177.59

$19,809.33

5

$4,000

$2,269.71

$22,079.04

DPB 4

$20,000 - $19,809.33

$190.67

4

4.084 years

$2,269.71

$2,269.71

It does not adjust or account for differences in the overall, or total, risk for a project,

which could include operating, financing, and foreign exchange risk.

The biggest weakness of either the standard or discounted payback methods is their

failure to consider cash flows after the payback.

While the payback period is widely used in practice, it is rarely the primary decision criterion. As

William Baumol pointed out in the early 1960s, the payback rule serves as a crude risk screening

device the longer cash is tied up, the greater the likelihood that it will not be returned. The payback

period may be helpful when comparing mutually exclusive projects. Given two similar projects with

different paybacks, the project with the shorter payback is often, but not always, the better project.

13

Despite its shortcomings, the payback period rule is often used by large and sophisticated companies

when they are making relatively minor decisions. There are several reasons for this. The primary reason

is that many decisions simply do not warrant detailed analysis because the cost of the analysis would

exceed the possible loss from a mistake. As a practical matter, an investment that pays back rapidly and

has benefits extending beyond the cutoff period probably has a positive NPV.

In addition to its simplicity, the payback rule has two other positive features. First, because it is biased

towards short-term projects, it is biased towards liquidity. In other words, a payback rule tends to

favor investments that free up cash for other uses more quickly. This could be very important for a small

business; it would be less so for a large corporation. Second, the cash flows that are expected to occur

later in a project's life are probably more uncertain. Arguably, a payback period rule adjusts for the

extra riskiness of later cash flows, but it does so in a rather draconian fashionby ignoring them

altogether.

Summary of Payback Method

Decision Rule: Payback period Payback cutoff point ] Accept the project.

Payback period > Payback cutoff point ] Reject the project.

Key Advantages

Key Disadvantages

1. Easy to calculate and understand for

1. Most common version does not account

people without strong finance

backgrounds.

payback period

liquidity.

research and development and new

product launches.

4. Arbitrary cutoff point.

10.4

This method computes the return on a capital project using accounting numbersthe

projects net income (NI) and book value (BV) rather than cash flow data.

14

ARR

Average NI

Average BV

It has a number of major flaws as a tool for evaluating capital expenditure decisions.

First, the ARR is not a true rate of return. ARR simply gives us a number based on

average figures from the income statement and balance sheet. Since it involves

accounting figures rather than cash flows, it is not comparable to returns in capital

markets.

There is no economic rationale that links a particular acceptance criterion to the goal of

maximizing shareholders wealth.

15

10.5

The NPV and IRR techniques are similar in that both depend on discounting the cash flows

from a project.

When we use the IRR, we are looking for the rate of return associated with a project so we

can determine whether this rate is higher or lower than the firms cost of capital.

The IRR is the discount rate that makes the NPV to equal zero.

n

NPV

t 0

NCFt

0,

(1 IRR) t

The IRR is an expected rate of return, much like the yield to maturity calculation that

was made on bonds.

We will need to apply the same trial-and-error method to compute the IRR.

Example - Compute the Internal Rate of Return (IRR) given a required return of 12% and the following

cash flows:

Year

CFt

0

($20,000)

1

$6,000

2

$7,000

3

$8,000

4

$5,000

5

$4,000

o Set the NPV equation equal to zero and solve for the IRR:

NPV 0

20,000

6,000

7,000

8,000

5,000

4,000

0

1

2

3

4

(1 IRR)

(1 IRR) (1 IRR)

(1 IRR)

(1 IRR)

(1 IRR)5

16

o At this point, unless you are using a financial calculator or spreadsheet, solving for

the IRR is a trial and error process. That is, we would plug in different estimates

for the IRR, work through the calculations, and determine if we have found the rate

that causes NPV to equal $0. We have already computed the NPV of this project at a

12% discount rate and found the NPV to be positive. In addition, we computed the

NPV of the project at a discount rate of 17% and found NPV to be negative.

Therefore, we know that the IRR lies somewhere between 12% and 17% (in fact, we

can see that the IRR is much closer to 17%).

o Using a financial calculator, we find the IRR = 16.3757%.

o Since the IRR > k (16.38% > 12%), the project should be accepted.

Excel Solution (in class)

Calculator Solution (in class)

Note: The calculation of the projects IRR does not depend upon the required rate of return. The IRR is

compared to the required rate of return to determine whether to accept or reject the project. Also, if a

projects NPV is positive, its IRR will exceed the required rate of return. If a projects NPV is negative,

its IRR will be below the required rate of return.

17

NCFn

NCF0

(1/n)

Year

NCFt

0

($750,000)

1

0

2

0

3

0

4

$1,350,000

$1,350,000

$750,000

IRR

(1/4)

1 1.80

(.25)

1 .15829 15.83%

Year

NCFt

0

($32,000)

1

$14,000

2

$14,000

3

$14,000

4

$14,000

NPV = 0 = $14,000(PVIFA 4, IRR) - $32,000

(PVIFA 4, IRR) = $32,000 / $14,000 = 2.285714

Looking down the period column to four periods, we then move to the right to find the interest rate that

corresponds to the PVIFA of 2.285714. This occurs somewhere between 24% and 28%. With a financial

calculator, we find the exact IRR to be 26.86%.

.

B. When the IRR and NPV Methods Agree

The two methods will always agree when the projects are independent and the projects

cash flows are conventional.

After the initial investment is made (cash outflow), all the cash flows in each future year

are positive (inflows).

18

Graphical representation of the relationship between a projects NPVs and various discount rates:

Discount

Rate

0%

5%

10%

13%

14%

15%

20%

19

NPV

$20.00

$11.56

$4.13

$0.09

-$1.20

-$2.46

-$8.33

The point at which the projects NPV profile intersects with the x-axis is by definition the projects IRR,

since the NPV at this point is equal to $0.

The IRR and NPV methods can produce different accept/reject decisions if a project

either has unconventional cash flows or the projects are mutually exclusive.

A positive initial cash flow followed by negative future cash flows.

Future cash flows from a project could include both positive and negative cash

flows.

A cash flow stream that looks similar to a conventional cash flow stream except

for a final negative cash flow.

20

In these circumstances, the IRR technique can provide more than one solution. This

makes the result unreliable and should not be used in deciding about accepting or

rejecting a project.

When you are comparing two mutually exclusive projects, the NPVs of the two

projects will equal each other at a certain discount rate. This point at which the NPVs

intersect is called the crossover point. Depending on whether the required rate of

return is above or below this crossover point, the ranking of the projects will be

21

different. While it is easy to identify the superior project based on the NPV, one

cannot do so based on the IRR. Thus, ranking conflicts can arise.

A second situation arises when you compare projects with different costs. While IRR

gives you a return based on the dollar invested, it does not recognize the difference in

the size of the investments. NPV does!

22

Expected aftertax net cash

flows (NCFt)

Year (t)

0

1

2

3

4

IRR =

Project S

($100)

50

40

30

30

Project L

($100)

20

30

50

65

Crossover rate =

Cash flow

differential

0

30

10

(20)

(35)

14.2978%

Mutually Exclusive Investments Even if there is a single IRR, another problem can arise concerning mutually

exclusive investment decisions, a If two investments, X and Y, are mutually exclusive, then taking one of them

means that we cannot take the other. Given two or more mutually exclusive investments, which one is the best?

Investment

A

B

C

NPV

$10,000

$11,000

$8,000

IRR

22%

20%

24%

PB

2.50 years

7.00 years

3.00 years

.

D. Modified Internal Rate of Return (MIRR)

A major weakness of the IRR compared to the NPV method is the reinvestment rate

assumption.

IRR assumes that the cash flows from the project are reinvested at the IRR, while the

NPV assumes that they are invested at the firms cost of capital.

This optimistic assumption in the IRR method leads to some projects being accepted

when they should not be.

23

An alternative technique is the modified internal rate of return (MIRR). Here, each

operating cash flow is reinvested at the firms cost of capital.

The compounded values are summed up to get the projects terminal value.

The MIRR is the interest rate that equates the projects cost to the terminal value at the

end of the project.

1) Using the required rate of return as the compounding rate, find the terminal value (future value) of all

of the net cash inflows (positive net cash flows) at the end of the project life.

2) Using the required rate of return as the discounting rate, find the present value at t = 0 of all of the net

cash outflows (negative net cash flows).

3) Compute the MIRR.

TVinflows

PVoutflows

(1/n)

MIRR

1,

Example - Compute the Modified Internal Rate of Return (MIRR) given a required return of 12% and

the following net cash flows:

Year

NCFt

0

($20,000)

1

$6,000

2

$7,000

3

$8,000

4

$5,000

5

$4,000

1) TVinflows = $6,000(1.12)4 + $7,000(1.12)3 + $8,000(1.12)2 + $5,000(1.12)1 + $4,000(1.12)0

TVinflows = $9,441.12 + $9,834.50 + $10,035.20 + $5,600.00 + $4,000.00 = $38,910.82

2) PVoutflows = $20,000

Prepared by Jim Keys

24

3)

TVinflows

PVoutflows

MIRR

(1/n)

$38,910.82

$20,000

(1/5)

1 1.945541

(.20)

1 .14238 14.24%

MIRR example with positive and negative cash flows:

Safeway estimates that its required rate of return is 6 percent. The company is considering two mutually

exclusive projects whose after-tax cash flows are as follows:

Year

0

1

2

3

4

Project S

($1,255)

625

905

930

(245)

Project L

($1,060)

(470)

905

780

920

For Project S:

TVinflows = $625(1.06)3 + $905(1.06)2 + $930(1.06)1 = $744.39 + $1,016.86 + $985.80 = $2,747.05

PVoutflows = $1,255 + $245(1.06)-4 = $1,255 + $194.06 = $1,449.06

MIRRS = ($2,747.05 / $1,449.06)1/4 1.0 = 17.34%

For Project L:

TVinflows = $905(1.06)2 + $780(1.06)1 + $920(1.06)0 = $1,016.86 + $826.80 + $920 = $2,763.66

PVoutflows = $1,060 + $470(1.06)-1 = $1,060 + $443.40 = $1,503.40

MIRRL = ($2,763.66 / $1,503.40)1/4 1.0 = 16.44%

Since these projects are mutually exclusive, we would choose Project S.

Prepared by Jim Keys

25

While the IRR has an intuitive appeal to managers because the output is in the form of a

return, the technique has some critical problems.

On the other hand, decisions made based on the projects NPV are consistent with the

goal of shareholder wealth maximization. In addition, the result shows management the

dollar amount by which each project is expected to increase the value of the firm.

For these reasons, the NPV method should be used to make capital budgeting decisions.

Decision Rule: IRR > Cost of capital ] Accept the project.

IRR < Cost of capital ] Reject the project.

Key Advantages

Key Disadvantages

1. Intuitively easy to understand.

1. With nonconventional cash flows, IRR

2. Based on the discounted cash flow

technique.

2. A lower IRR can be better if a cash inflow is

followed by cash outflows.

3. With mutually exclusive projects, IRR can

lead to incorrect investment decisions.

The Profitability Index - present value of the future cash flows divided by the initial investment (both

numerator and denominator are positive). This definition assumes no negative cash flows after year

26

PV in the numerator and the denominator.

PVinflows

PVoutflows

PI

Decision rule

An investment should be accepted if the PI > 1.0 and rejected if the PI < 1.0.

Example - Compute the Profitability Index (PI) given a required return of 12% and the following net

cash flows:

Year

CFt

0

($20,000)

1

$6,000

2

$7,000

3

$8,000

4

$5,000

5

$4,000

PVinflows

6,000

7,000

8,000

5,000

4,000

$22,079.04

1

2

3

4

(1.12)

(1.12)

(1.12)

(1.12)

(1.12)5

PVoutflows $20,000

$22,079.04

1.104

$20,000

PI

10.6

A. Practitioners Methods of Choice

27

choice.

In the late 1950s, less than 20 percent of managers used the NPV or IRR methods.

By 1981, over 65 percent of financial managers surveyed used the IRR, but only 16.5

percent of managers used the NPV.

In a recent study of Fortune 1000 managers, 85 percent of managers used the NPV while

77 percent used the IRR. Surprisingly, over 50 percent of managers used the payback

method.

Management should systematically review the status of all ongoing capital projects and

perform postaudits on all completed capital projects.

28

In a postaudit review, management compares the actual results of a project with what

was projected in the capital budgeting proposal.

A postaudit examination would determine why the project failed to achieve its

expected financial goals.

The review should challenge the business plan, including the cash flow projections

and the operating cost assumptions.

Management must also evaluate people responsible for implementing a capital project.

29

Multiple Choice

Identify the choice that best completes the statement or answers the question.

1. Net present value: Cortez Art Gallery is adding to its existing buildings at a cost of $2 million. The

gallery expects to bring in additional cash flows of $520,000, $700,000, and $1,000,000 over the next

three years. Given a required rate of return of 10 percent, what is the NPV of this project?

a.

b.

c.

d.

$1,802,554

$197,446

-$1,802,554

-$197,446

2. Net present value: Gao Enterprises plans to build a new plant at a cost of $3,250,000. The plant is

expected to generate annual cash flows of $1,225,000 for the next five years. If the firm's required rate

of return is 18 percent, what is the NPV of this project?

a.

b.

c.

d.

$2,875,000

$3,830,785

$580,785

$2,1225,875

3. Payback: Binder Corp. has invested in new machinery at a cost of $1,450,000. This investment is

expected to produce cash flows of $640,000, $715,250, $823,330, and $907,125 over the next four

years. What is the payback period for this project?

a.

b.

c.

d.

2.12 years

1.88 years

4.00 years

3.00 years.

4. Discounted payback: Roswell Energy Company is installing new equipment at a cost of $10 million.

Expected cash flows from this project over the next five years will be $1,045,000, $2,550,000,

$4,125,000, $6,326,750, and $7,000,000. The company's discount rate for such projects is 14 percent.

What is the project's discounted payback period?

a.

b.

c.

d.

4.2 years

4.4 years

4.8 years

5.0 years

5. Internal rate of return: Modern Federal Bank is setting up a brand new branch. The cost of the project

will be $1.2 million. The branch will create additional cash flows of $235,000, $412,300, $665,000 and

$875,000 over the next four years. The firm's cost of capital is 12 percent. What is the internal rate of

return on this branch expansion? (Round to the nearest percent.)

30

a.

b.

c.

d.

20%

23%

25%

27%

6. Internal rate of return: Casa Del Sol Property Development Company is refurbishing a 200-unit

condominium complex at a cost of $1,875,000. It expects that this will lead to expected annual cash

flows of $415,350 for the next seven years. What internal rate of return can the firm earn from this

project? (Round to the nearest percent.)

a.

b.

c.

d.

10%

12%

14%

16%

7. Modified internal rate of return: Jamaica Corp. is adding a new assembly line at a cost of $8.5

million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5

million over the next four years. Its cost of capital is 16 percent.

What is the MIRR on this project?

a.

b.

c.

d.

18.6%

19.8%

20.2%

21.4%

31

Answer Section

MULTIPLE CHOICE

1. ANS: D

Learning Objective: LO 2

Level of Difficulty: Medium

Feedback: Initial investment = $2,000,000

Length of project = n = 3 years

Required rate of return = k = 10%

Net present value = NPV

2. ANS: C

Learning Objective: LO 2

Level of Difficulty: Medium

Feedback: Initial investment = $3,250,000

Annual cash flows = $1,225,000

Length of project = n = 5 years

Required rate of return = k = 18%

Net present value = NPV

3. ANS: A

Learning Objective: LO 3

Level of Difficulty: Medium

Feedback:

Year

0

1

2

3

4

Binder Corp.

CF

Cumulative CF

$(1,450,000)

$(1,450,000)

640,000

(810,000)

715,250

(94,750)

823,330

728,580

907,125

1,635,705

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year

= 2 + ($94,750 / $823,330)

Prepared by Jim Keys

32

= 2.12 years

4. ANS: A

Learning Objective: LO 3

Level of Difficulty: Medium

Feedback:

Roswell Energy

i = 14%

Cumulative PVCF

Year

0

1

2

3

4

5

CF

$(10,000,000)

1,045,000

2,550,000

4,125,000

6,326,750

7,000,000

PVCF

$(10,000,000)

916,667

1,962,142

2,784,258

3,745,944

3,635,581

$(10,000,000

(9,083,333)

(7,121,191)

(4,336,934)

(590,990)

3,044,591

PB = Years before cost recovery + (Remaining cost to recover/ Cash flow during the year

= 4 + ($590,990/ $3,635,581)

= 4.16 years

5. ANS: B

Learning Objective: LO 5

Level of Difficulty: Medium

Feedback: Initial investment = $1,200,000

Length of project = n = 4 years

To determine the IRR, the trial-and-error approach can be used. Set NPV = 0.

Try IRR =23.1%.

The IRR of the project is 23.1 percent. Using a financial calculator, we find that the IRR is 23.119 percent.

6. ANS: B

Learning Objective: LO 5

Level of Difficulty: Medium

Feedback: Initial investment = $1,875,000

Annual cash flows = $415,350

Length of investment = n = 7 years

To determine the IRR, the trial-and-error approach can be used. Set NPV = 0.

Try IRR =12.3%.

33

The IRR of the project is 12.3 percent. Using a financial calculator, we find that the IRR is 12.345 percent.

7. ANS: B

Learning Objective: LO 5

Level of Difficulty: Medium

Feedback: Initial investment = $8,500,000

Length of investment = n = 4 years

Cost of capital = k = 16%

34

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