Chapter 6: Some Alternative Investment Rules

Answers to suggested problems

6.1 a. Payback period of Project A = 1 + ($7,500 - $4,000) / $3,500 = 2 years

Payback period of Project B = 2 + ($5,000 - $2,500 -$1,200) / $3,000 = 2.43 years
Project A should be chosen.
b. NPVA = -$7,500 + $4,000 / 1.15 + $3,500 / 1.152 + $1,500 / 1.153 = -$388.96
NPVB = -$5,000 + $2,500 / 1.15 + $1,200 / 1.152 + $3,000 / 1.153 = $53.83
Project B should be chosen.

6.3 a. Average Investment:

($16,000 + $12,000 + $8,000 + $4,000 + 0) / 5 = $8,000
Average accounting return:
$4,500 / $8,000 = 0.5625 = 56.25%
b. 1. AAR does not consider the timing of the cash flows, hence it does not
consider the time value of money.
2. AAR uses an arbitrary firm standard as the decision rule.
3. AAR uses accounting data rather than net cash flows.

6.6 The IRR is the discount rate at which the NPV = 0.

-$3,000 + $2,500 / (1 + IRRA) + $1,000 / (1 + IRRA)2 = 0
By trial and error, IRRA = 12.87%
Since project B’s cash flows are two times of those of project A, the IRR B = IRRA =
12.87%

6.7 a. Solve x by trial and error:

-$8,000 + $4,000 / (1 + x) + $3,000 / (1 + x)2 + $2,000 / (1 + x)3 = 0
x = 6.93%
b. No, since the IRR (6.93%) is less than the discount rate of 8%.

6.8 Find the IRRs of project A analytically. Since the IRR is the discount rate that makes the
NPV equal to zero, the following equation must hold.
-$2000 + $2000 / (1 + r) + $8000 / (1 + r)2 - $8000 / (1 + r)3 = 0
$2000 [-1 + 1 / (1 + r)] - {$8000 / (1 + r)2}[-1 + 1 / (1 + r)] = 0
[-1 + 1 / (1 + r)] [$2000 - $8000 / (1 + r)2] = 0
For this equation to hold, either [-1 + 1 / (1 + r)] = 0 or [$2000 - $8000 / (1 + r) 2] = 0.
Solve each of these factors for the r that would cause the factor to equal zero. The
resulting rates are the two IRRs for project A. They are either r = 0% or r = 100%.

Note: By inspection you should have known that one of the IRRs of project A is
zero. Notice that the sum of the un-discounted cash flows for project A is zero.
Thus, not discounting the cash flows would yield a zero NPV. The discount rate
which is tantamount to not discounting is zero.

Here are some of the interactions used to find the IRR by trial and error.
Sophisticated calculators can compute this rate without all of the tedium involved in
the trial-and-error method.
NPV = -$1500 + $500 / 1.3 + $1000 / 1.32 + $1500 / 1.33 = $150.91
NPV = -$1500 + $500 / 1.4 + $1000 / 1.42 + $1500 / 1.43 = -$80.60
NPV = -$1500 + $500 / 1.37 + $1000 / 1.372 + $1500 / 1.373 = -$10.89
 NPV = -$1500 + $500 / 1.36 + $1000 / 1.36 2 + $1500 / 1.363 = $4.60
NPV = -$1500 + $500 / 1.36194 + $1000 / 1.361942 + $1500 / 1.361943
= $0.010
NPV = -$1500 + $500 / 1.36195 + $1000 / 1.361952 + $1500 / 1.361953
= -$0.013
NPV = -$1500 + $500 / 1.361944 + $1000 / 1.3619442 + $1500 / 1.3619443
= $0.000906
Thus, the IRR is approximately 36.1944%.

6.9 a. Solve for r in the equation:

$5,000 - $2,500 / (1 + r) - $2,000 / (1 + r)2 - $1,000 / (1 + r)3
- $1,000 / (1 + r)4 = 0
By trial and error,
IRR = r = 13.99%
b. Since this problem is the case of financing, accept the project if the IRR is less than
the required rate of return.
IRR = 13.99% > 10%
Reject the offer.
c. IRR = 13.99% < 20%
Accept the offer.
d. When r = 10%:
NPV = $5,000 - $2,500 / 1.1 - $2,000 / 1.12 - $1,000 / 1.13 - $1,000 / 1.14
= -$359.95
When r = 20%:
NPV = $5,000 - $2,500 / 1.2 - $2,000 / 1.22 - $1,000 / 1.23 - $1,000 / 1.24
= $466.82
e. Yes, they are consistent with the choices of the IRR rule since the signs of the cash
flows change only once.