Capital Budgeting Solutions Manual Ch10

CHAPTER 10 The Fundamentals of Capital Budgeting
Before You Go On Questions and Answers

Section 10.1 1. Why are capital investments considered the most important
decisions made by a firm’s management? Capital investments are the most
important decisions made by a firm’s management, because they usually
involve large cash outflows and once made are not easily reversed. These
are usually long-term projects that will define the firm’s line of
business and significantly contribute to the total revenue figure for
years to come. 2. What are the differences between capital projects that
are independent, mutually exclusive, and contingent? A project is
independent if the decision to accept or reject it does not affect the
decision to accept or reject another project. On the other hand, projects
are mutually exclusive if the acceptance of one implies rejection of the
other. Contingent projects are those in which the acceptance of one
project is dependent on another project.
Section 10.2 1. What is the NPV of a project? NPV is simply the

difference between the present value of a project’s expected future cash
flows and its cost. It is the recommended technique used to value capital
investments, as it takes into account both the timing of the cash flows
and their risk.
2.
If a firm accepts a project with a $10,000 NPV, what is the effect on the
value of the firm? If a firm accepts a project with a $10,000 NPV, it
will increase its value by $10,000.
3.
What are the five steps used in NPV analysis? The five-step process used
in the NPV analysis can be listed as follows: (1) Determine the cost of
the project. (2) Estimate the project’s future cash flows over its
expected life. (3) Determine the riskiness of a project and the
appropriate cost of capital. (4) Compute the project’s NPV. (5) Make a
decision.
Section 10.3 1. What is the payback period? The payback period is defined
as the number of years it takes to recover the project’s initial
investment. All other things being equal, the project with the shortest
payback period is usually the optimal investment. 2. Why does the payback
period provide a measure of a project’s liquidity risk? The payback
period determines how quickly you recover your investment in a project.
Thus, it serves as a good measure of the project’s liquidity. 3. What are
the main shortcomings of the payback method? The payback method does not
account for time value of money, nor does it distinguish between high-
and low-risk projects. In addition, there is no rationale behind choosing
the cutoff criteria. For all these reasons, the payback method is not the
ideal capital decision rule.
Section 10.4 1. What are the major shortcomings of using the ARR method
as a capital budgeting method? The biggest shortcoming of using ARR as a
capital budgeting tool is that it uses historical, or book value data
rather than cash flows and thus disregards the time value of money
principle. In addition, as in the payback method, it fails to establish a
rationale behind picking the appropriate hurdle rate.
Section 10.5 1. What is the IRR method? The IRR, or the internal rate of
return, is the discount rate that makes the net present value of the
project’s future cash flows zero. The IRR determines whether the
project’s return rate is higher or lower than the required rate of
return, which is the firm’s cost of capital. As a rule, a project should
be accepted if the IRR exceeds the firm’s cost of capital; otherwise the
project should be rejected. 2. In capital budgeting, what is a
conventional cash flow pattern? A conventional project cash flow in
capital budgeting is one in which an initial cash outflow is followed by
one or more future cash inflows. 3. Why should the NPV method be the
primary decision tool used in making capital investment decisions? Given
all the different methods to evaluate capital investment decisions, the
NPV method is the preferred valuation tool as it accounts for both time
value of money and the project’s risk. Furthermore, NPV is not sensitive
to nonconventional projects, and
therefore it is superior to the IRR technique and it gives a measure of
the value increase/decrease to the firm by undertaking the project.
Section 10.6 1. What changes have taken place in the capital budgeting
techniques used by U.S. companies? Over the years, there has been a shift
from using payback and ARR as the primary capital budgeting tools to
using NPV and IRR instead. Managers today understand the importance of
the time value of money and discounting and thus regard ARR as an
inaccurate and obsolete decision tool.
Self-Study Problems
10.1 Premium Manufacturing Company is evaluating two forklift systems to
use in its plant that produces the towers for a windmill power farm. The
costs and the cash flows from these systems are shown below. If the
company uses a 12 percent discount rate for all projects, determine which
forklift system should be purchased using the net present value (NPV)
approach. Year 0 Otis Forklifts Craigmore Forklifts Solution: NPV for
Otis Forklifts:
−$3,123,450 −$4,137,410
Year 1 $979,225 $875,236
Year 2 $1,358,886 $1,765,225
Year 3 $2,111,497 $2,865,110

NPV = ∑
CFt t t = 0 (1 + k )
n
= −$3,123,450 +
$979,225 $1,358,886 $2,111,497 + + (1 + 0.12)1 (1.12) 2 (1.12) 3 =

−$3,123,450 + $874,308 + $1,083,296 + $1,502,922 = $337,075
NPV for Craigmore Forklifts:

CFt t t = 0 (1 + k )
n
NPV = ∑
$875,236 $1,765,225 $2,865,110 + + (1 + 0.12)1 (1.12) 2 (1.12) 3 =

−$4,137,410 + $781,461 + $1,407,229 + $2,039,227 = $90,606 = −$4,137,410
+
Premium should purchase the Otis forklift since it has a larger NPV.
Rutledge, Inc., has invested $100,000 in a project that will produce cash
flows of $45,000, $37,500, and $42,950 over the next three years. Find
the payback period for the project.
10.2
Solution: Payback period for Rutledge project: Cumulative Year 0 1 2 3 CF

(100,000) 45,000 37,500 42,950 Cash Flow (100,000) (55,000) (17,500)
25,450
Payback period = Years before cost recovery + =2+ $17,500 $42,950 per
year = 2.41years
Remaining cost to recover Cash flow during the year
PB = Years before cost recovery + (Remaining cost to recover/ Cash flow

during the year) = 2 + ($17,500 / $42,950) = 2.41 years Perryman Crafts
Corp. is evaluating two independent capital projects that together will
cost the company $250,000. The two projects will provide the following
cash flows:
10.3
Year 1 2 3 4
Project A $80,750 $93,450 $40,325 $145,655
Project B $32,450 $76,125 $153,250 $96,110
Which project will be chosen if the company’s payback criterion is three

years? What if the company accepts all projects as long as the payback
period is less than five years?
Solution: Payback periods for Perryman projects A and B: Project A

Cumulative Year 0 1 2 3 Cash Flow $(250,000) 80,750 93,450 40,235 Cash
Flows $(250,000) (169,250) (75,800) (35,565)
4
145,655
110,090
Project B Cumulative Year 0 1 2 3 4 Cash Flow $(250,000) 32,450 76,125

153,250 96,110 Cash Flows $(250,000) (217,550) (141,425) 11,825 107,935
Payback period for Project A: Payback period = Years before cost recovery
+ = 3+ $35,565 $145,655 per year = 3.24 years Remaining cost to recover
Cash flow during the year
Payback period for Project B:
Payback period = Years before cost recovery + =2+ $141, 425 $153, 250 per
year = 2.92 years
If the payback period is three years, only project B will be chosen. If

the payback criterion is five years, both A and B will be chosen. Terrell
Corp. is looking into purchasing a machine for its business that will
cost $117,250 and will be depreciated on a straight-line basis over a
five-year period. The sales and expenses (excluding depreciation) for the
next five years are shown in the following table.
10.4
The company’s tax rate is 34 percent.
Year 1 Year 2 Year 3 Year 4 Year 5 The company w ill accept all projects
that provi de an accou$255,440 nting rate of re turn (ARR) of at least 45
percent. Sh $123,450 $176,875 $242,455 $267,125 Sales Expenses
$137,410
$126,488
$141,289
$143,112
$133,556
The company will accept all projects that provide an accounting rate of
return (ARR) of at least 45 percent. Should the company accept the
project?
Solution: Year 1 Year 2 Year 3 Year 4 Year 5
Sales Expenses Depreciation EBIT Taxes (34%) Net Income Beginning Book
Value Less: Depreciation Ending Book Value Average net income Average
book value
$123,450 $176,875 137,410 23,450 12,719 117,250 (23,450) 126,488 23,450

9,159 93,800 (23,450)
$242,455 141,289 23,450 $ 77,716 26,423 $ 51,293 70,350 (23,450) $ 46,900
$255,440 143,112 23,450 $ 88,878 30,219 $ 58,659 46,900 (23,450) $ 23,450
$267,125 133,556 23,450 $110,119 37,440 $ 72,679 23,450 (23,450) $ 0
$ (37,410) $ 26,937 $ (24,691) $ 17,778
$ 93,800 $ 70,350
= (–$24,691 + $17,778 + $51,293 + $58,659 + $72,679) / 5 = $35,143.60 =

(1$117,250 + $93,800 + $70,350 + $46,900 + $23,450 + $02)/6 = $58,625
= $35,143.6 / $58,625 = 0.599 or 59.9%
Accounting rate of return
The company should accept the project.

10.5
Refer to Problem 10.1. Compute the IRR for each of the two systems. Is
the investment decision different from the one determined by NPV?
Solution:
IRR for two forklift systems: Otis Forklifts: First compute the IRR by
the trial-and-error approach: NPV (Otis) = $337,075 > 0 Use a higher
discount rate to get NPV = 0! At k = 15%,
NPVOtis = −$3,123, 450 + $979, 225 $1, 358,886 $2,111, 497 + + (1 +
0.15)1 (1.15) 2 (1.15)3 = −$3,123, 450 + $851,500 + $1, 027,513 + $1,
388, 344 = $143, 907.
Try a higher rate. At k = 17%,
NPVOtis = −$3,123, 450 + $836,944 + $992,685 + $1,318,357 = $24,536.

Try a higher rate. At k = 17.5%,
NPVOtis = −$3,123, 450 + $833,383 + $984, 254 + $1,301,598 = −$4, 215

Thus the IRR for Otis is less than 17.5 percent. Using a financial
calculator, you can find that the exact rate to be 17.43 percent.
Craigmore Forklifts: First compute the IRR by the trial-and-error
approach: NPV (Craigmore) = $90,606 > 0 Use a higher discount rate to get
NPV = 0! At k = 15%,
NPVCraigmore = −$4,137, 410 + = −$157,715 $875, 236 $1, 765, 225
$2,865,110 + + (1.15)1 (1.12) 2 (1.12)3 = −$4,137, 410 + $761,075 +
$1,334, 764 + $1,883,856
Try a lower rate. At k = 13%,
NPVCraigmore = −$4,137,410 + $774,545 + $1,382, 430 + $1,985,665 = $5,

230
Try a higher rate. At k = 13.1%,
NPVCraigmore = −$4,137,410 + $773,860 + $1,379,987 + $1,980, 403 =

−$3,161
Thus the IRR for Craigmore is less than 13.1 percent. The exact rate is
13.06 percent. Based on the IRR, we would still pick Otis over Craigmore
forklift systems. The decision is the same as that indicated by NPV
Critical Thinking Questions

10.1
Explain why the cost of capital is referred to as the “hurdle” rate in

capital budgeting. The cost of capital is the minimum required return on
any new investment that allows a firm to break even. Since we are using
the cost of capital as a benchmark or “hurdle” to compare the return
earned by any project, it is sometimes referred to as the hurdle rate.
a. A company is building a new plant on the outskirts of Smallesville.
The town has
10.2
offered to donate the land, and as part of the agreement, the company
will have to build an access road from the main highway to the plant. How
will the project of building the road be classified in capital budgeting
analysis?
b. Sykes, Inc., is considering two projects: a plant expansion and a new
computer
system for the firm’s production department. Classify these projects as

independent, mutually exclusive, or contingent projects and explain your
reasoning.
c. Your firm is currently considering the upgrading of the operating
systems of all the
firm’s computers. The firm can choose the Linux operating system that a
local
computer services firm has offered to install and maintain. Microsoft has
also put in a bid to install the new Windows operating system for
businesses. What type of project is this?
a. This is a contingent project. Acceptance of the road-building project
is contingent
on the new plant being a financially viable project. If the new plant
will not have a positive value, then the firm will not even consider this
project. However, this project’s cost will have to be considered along
with the cost of building the new plant in the capital budgeting
analysis.
b. These two projects are independent projects. Accepting or rejecting
one will not
influence the decision on the other project. The cash flows of the two
projects are unrelated.
c. These are two mutually exclusive projects. The company’s computers
need only
one operating system. Either the Linux or the Windows operating system
needs to be installed, not both. Hence, the selection of one will
eliminate the other from consideration. In the context of capital
budgeting, what is “capital rationing”? Capital rationing implies that a
firm does not have the resources necessary to fund all of the available
projects. In other words, funding needs exceed funding resources. Thus,
the available capital will be allocated to the projects that will benefit
the firm and its shareholders the most. Projects that create the largest
increase in shareholder wealth will be accepted until all the available
resources have been allocated. Provide two conditions under which a set
of projects might be characterized as mutually exclusive.
10.3
10.4
When projects are mutually exclusive, acceptance of one project precludes
the acceptance of others. Typically, mutually exclusive projects perform
the same function and so only one of them needs to be accepted. A funding
or resource constraint can also cause projects to be mutually exclusive.
10.5
a. A firm invests in a project that would earn a return of 12 percent. If

the appropriate
cost of capital is also 12 percent, did the firm make the right decision.
Explain.
b. What is the impact on the firm if it accepts a project with a negative
NPV? a. We would normally argue that a firm should only accept projects
in which the
project’s return exceeds the cost of capital. In other words, only if the
net present value exceeds zero should a project be accepted. But in
reality, projects with a zero NPV should also be accepted because the
project earns a return that equals the cost of capital. For some firms
like the one above, this could be the situation because they may not have
projects that provide a return greater than the cost of capital for the
firm.
b. When a firm takes on positive NPV projects, the value of the firm
increases. By
the same token, when a project undertaken has a negative NPV, the value
of the firm will decrease by the amount of the net present value.
Identify the weaknesses of the payback period method. There are several
critical weaknesses in the payback period approach of evaluating capital
projects.
ƒ ƒ ƒ
10.6
The payback period ignores the time value of money by not discounting
future cash flows. When comparing projects, it ignores risk differences
between the projects. A firm may establish payback criteria with no
economic basis for that decision and thereby run the risk of losing out
on good projects.
ƒ
The method ignores cash flows beyond the payback period, thus leading to
nonselection of projects that may produce cash flows well beyond the
payback period or more cash flows than accepted projects. This leads to a
bias against longer-term projects.
10.7
What are the strengths and weaknesses of the accounting rate of return
(ARR) approach? The biggest advantage of ARR is that it is easy to
compute since accounting data is readily available, whereas estimating
cash flows is more difficult. However, the disadvantages outweigh this
specific advantage. Similar to the payback, it does not discount cash
flows, but merely averages net income over time. No economic rationale is
used in establishing an ARR cutoff rate. Finally, the ARR uses net income
to evaluate the project and not cash flows or market data. This is a
serious flaw in this approach. Under what circumstances might the IRR and
NPV approaches have conflicting results? IRR and the NPV methods of
evaluating capital investment projects might produce dissimilar results
under two circumstances. First, if the project’s cash flows are not
conventional—that is, if the sign of the cash flow changes more than once
during the life of a project—then multiple IRRs can be obtained as
solutions. We would be unable to identify the correct IRR for decision
making. (See Learning by Doing Application 10.3.) The second situation
occurs when two or more projects are mutually exclusive. The project with
the highest IRR may not necessarily be the one with the highest NPV and
thereby be the right choice. There is an important reason for this. IRR
assumes that all cash flows received during the life of a project are
reinvested at the IRR, whereas the NPV method assumes that they are
reinvested at the cost of capital. Since the cost of capital is the
better proxy for opportunity cost, NPV uses the better proxy, while the
IRR may use an unrealistically higher rate as proxy.
10.8
10.9
The modified IRR (MIRR) alleviates two concerns with using the IRR method
for evaluating capital investments. What are they? IRR assumes that the
cash flows from a project are reinvested at the project’s IRR, while the
NPV assumes that they are invested at the firm’s cost of capital. The NPV
assumption is correct more often than not. The MIRR assumes that each
operating cash flow is reinvested at the firm’s cost of capital. The
second appeal of MIRR is that under this method all of the compounded
operating cash flow values are summed up to get the project’s terminal
value. Since most projects generate positive total net operating cash
flows, MIRR does not suffer from issues associated with unconventional
cash flows.
10.10 Elkridge Construction Company has an overall (composite) cost of

capital of 12 percent. This
cost of capital reflects the cost of capital for an Elkridge Construction

project with average risk. However, the firm takes on projects of various
risk levels. The company experience suggests that low-risk projects have
a cost of capital of 10 percent and high-risk projects have a cost of
capital of 15 percent. Which of the following projects should the company
select to maximize shareholder wealth?
Project
Expected Return
Risk
1. Single-family homes 2. Multifamily residential 3. Commercial 4.

Single-family homes 5. Commercial
13% 12 18 9 13
Low Average High Low High
Project
Risk
Required Return
Expected Return
Decision Accept Accept / Indifferent
1. Single-family homes 2. Multifamily residential
Low Average
10% 12
13% 12
3. Commercial 4. Single-family homes 5. Commercial
High Low High
15 10 15
18 9 13
Accept Reject Reject
Questions and Problems
BASIC
10.1 Net present value: Riggs Corp. management is planning to spend
$650,000 on a new
marketing campaign. They believe that this action will result in

additional cash flows of $325,000 over the next three years. If the
discount rate is 17.5 percent, what is the NPV on this project?
LO 2
Solution:
Initial investment = $650,000 Annual cash flows = $325,000 Length of

project = n = 3 years Required rate of return = k = 17.5% Net present
value = NPV
NPV = ∑ NCFt $325,000 $325,000 $325,000 = −$650,000 + + + t (1.175)1
(1.175) 2 (1.175) 3 t = 0 (1 + k ) = −$650,000 + 276,596 + $235,401 +
$200,341
n
= $62,337
10.2
Net present value: Kingston, Inc. management is considering purchasing a

new machine
at a cost of $4,133,250. They expect this equipment to produce cash flows

of $814,322, $863,275, $937,250, $1,017,112, $1,212,960, and $1,225,000
over the next six years. If the appropriate discount rate is 15 percent,
what is the NPV of this investment?
LO 2
Solution:
Cost of new machine = $4,133,250 Length of project = n = 6 years Required

rate of return = k = 15%
NPV = ∑ NCFt t t = 0 (1 + k )
n
= −$4,133,250 +
$814,322 $863,275 $937,250 $1,017,112 $1,212,960 $1,225,000 + + + + +

(1.15)1 (1.15) 2 (1.15) 3 (1.15) 4 (1.15)5 (1.15) 6 = −$4,133,250 +
708,106 + $$652,760 + $616257 + $581,537 + $603,055 + $529,601 = −
441,933 $
10.3
Net present value: Crescent Industries management is planning to replace

some existing machinery in its plant. The cost of the new equipment and
the resulting cash flows are shown in the accompanying table. If the firm
uses an 18 percent discount rate, should management go ahead with the
project? Year 0 1 2 3 4 5 LO 2 Cash Flow
−$3,300,000
$875,123 $966,222 $1,145,000 $1,250,399 $1,504,445
Solution: Initial investment = $3,300,000 Length of project = n = 5 years

Required rate of return = k = 18%
NPV = ∑
NCFt t t = 0 (1 + k )
n
$875,123 $966,222 $1,145,000 $1,250,399 $1,504,455 + + + + (1.18)1 (1.18)

2 (1.18)3 (1.18) 4 (1.18)5 = −$3,300,000 + $741,630 + $693,926 + $696,882
+ $644,942 + $657,607 = $134,986 = −$3,300,000 + Since the NPV is
positive, the firm should accept the project. 10.4 Net present value:
Franklin Mints, a confectioner, is considering purchasing a new
jellybean-making machine at a cost of $312,500. The company’s management
projects that the cash flows from this investment will be $121,450 for
the next seven years. If the appropriate discount rate is 14 percent,
what is the NPV for the project? LO 2
Solution: Initial investment = $312,500 Annual cash flows = $121,450

Length of project = n = 7 years Required rate of return = k = 14%
NPV = ∑
NCFt t t = 0 (1 + k )
n
$121,450 $121,450 $121,450 $121,450 $121,450 + + + + (1.14)1 (1.14) 2

(1.14)3 (1.14) 4 (1.14)5 $121,450 $121,450 + + (1.14)6 (1.14)7 =
−$312,500 + $106,535 + $93,452 + $81,975 + $71,908 + $63,077 + $55,331 +
$48,536 = $208,315 = −$312,500 + 10.5 Net present value: Blanda
Incorporated management is considering investing in two alternative
production systems. The systems are mutually exclusive, and the cost of
the new equipment and the resulting cash flows are shown in the
accompanying table. If the
firm uses a 9 percent discount rate for their production systems, in
which system should the firm invest? LO 2
Year 0 1 2 3
System 1 ‐15,000 15,000 15,000 15,000
System 2 ‐45,000 32,000 32,000 32,000
Solution The NPV of System 1 is $22,969.42 and the NPV of System 2 is

$36,001.43. Since the NPV of the System 2 is larger than the NPV for
System 1, and the investments are mutually exclusive, the firm should
take System 2. Payback: Refer to problem 10.5. What are the payback
periods for production systems 1 and 2? If the systems are mutually
exclusive and the firm always chooses projects with the lowest payback
period, in which system should the firm invest? LO 3
10.6
Solution System 1 has a payback of exactly one year. System 2 has a

payback of 1.41 years. Given the shorter payback period for system 1, the
investment should be made in System 1 based on the payback criteria.
10.7
Payback: Quebec, Inc., is purchasing machinery at a cost of $3,768,966.

The company’s management expects the machinery to produce cash flows of
$979,225, $1,158,886, and $1,881,497 over the next three years,
respectively. What is the payback period? LO 3
Solution:
Cumulative Year 0 1 2 3 CF $(3,768,966) 979,225 1,158,886 1,881,497 Cash
Flow $(3,768,966) (2,789,741) (1,630,855) 250,642

during the year) = 2 + ($1,630,855 / $1,881,497) = 2.87 years Payback:
Northern Specialties just purchased inventory-management computer
software at a cost of $1,645,276. Cost savings from the investment over
the next six years will be reflected in the following cash flow stream:
$212,455, $292,333, $387,479, $516,345, $645,766, and $618,325. What is
the payback period on this investment? LO 3
10.8
Solution: Cumulative Year 0 1 2 3 4 5 6 CF $(1,645,276) 212,455 292,333

387,479 516,345 645,766 618,325 Cash Flow $(1,645,276) (1,432,821)
(1,140,488) (753,009) (236,664) 409,102 1,027,427

during the year) = 4 + ($236,664 / $645,766) = 4.37 years Payback:
Nakamichi Bancorp has made an investment in banking software at a cost of
10.9
$1,875,000. Management expects productivity gains and cost savings over
the next several years. If the firm is expected to generate cash flows of
$586,212, $713,277, $431,199, and $318,697 over the next four years, what
is the investment’s payback period? LO 3 Solution: Cumulative Year 0 1 2
3 4 CF $(1,875,000) 586,212 713,277 431,199 318,697 Cash Flow $(1,875,000
(1,288,788) (575,511) (144,312) 174,385

during the year) = 3 + ($144,312 / $318,697) = 3.45 years 10.10 Average
accounting rate of return (ARR): Capitol Corp. is expecting a project to
generate after-tax income of $63,435 over each of the next three years.
The average book value of its equipment over that period will be
$212,500. If the firm’s acceptance decision on any project is based on an
ARR of 37.5 percent, should this project be accepted? LO 4
Solution: Annual after-tax income = $63,435 Average after-tax income =

($63,435 +$63,435 + $63,435) / 3 = $63,435 Average book value of
equipment = $212,500
Accounting rate of return =
Average after - tax income Average book value $63,435 = = 29.9% $212,500
Since the project’s ARR is below the acceptance rate of 37.5 percent, the
project should be rejected. 10.11 Internal rate of return: Refer to
Problem 10.4. What is the IRR that Franklin Mints management can expect
on this project? LO 5
Solution: Initial investment = $312,500 Annual cash flows = $121,450

Length of project = n = 7 years Required rate of return = k = 14% To
determine the IRR, a trial-and-error approach can be used. Set NPV = 0.
Since the project had a positive NPV of $134,986, try IRR > k. Try IRR =
25%.
NPV = 0 = ∑
FCFt t t = 0 (1 + IRR )
n
1 ⎤ ⎡ ⎢1 − (1.25) 7 ⎥ 0 ≠ −$312,500 + $121,450 × ⎢ ⎥ ⎢ 0.25 ⎥ ⎢ ⎥ ⎣ ⎦ ≠

−$312,500 + $383,920 ≠ $71,420 Try a higher rate, IRR = 34%.
NPV = 0 = ∑
FCFt t t = 0 (1 + IRR )
n
1 ⎤ ⎡ ⎢1 − (1.34) 7 ⎥ 0 ≠ −$312,500 + $121,450 × ⎢ ⎥ ⎢ 0.34 ⎥ ⎢ ⎥ ⎣ ⎦ ≠

−$312,500 + $311,161 ≠ −$1,339 Try a lower rate, IRR = 33.8%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR )
n
1 ⎡ ⎤ − 1 ⎢ (1.338) 7 ⎥ 0 = −$312,500 + $121,450 × ⎢ ⎥ ⎢ 0.338 ⎥ ⎢ ⎥ ⎣ ⎦ =

−$312,500 + $312,515 = $15 ≅ 0 The IRR of the project is 33.8 percent.
Using a financial calculator, we find that the IRR is 33.8 percent.
10.12 Internal rate of return: Hathaway, Inc., a resort company, is

refurbishing one of its
hotels at a cost of $7.8 million. The firm expects that this will lead to
additional cash flows of $1.8 million for the next six years. What is the
IRR of this project? If the appropriate cost of capital is 12 percent,
should Hathaway go ahead with this project?
LO 5
Solution:
Initial investment = $7,800,000 Annual cash flows = $1,800,000 Length of
project = n = 6 years Required rate of return = k = 12% To determine the
IRR, a trial-and-error approach can be used. Set NPV = 0. Try IRR = 12%.
NPV = 0 = ∑
FCFt t t = 0 (1 + IRR )
n
1 ⎤ ⎡ ⎢1 − (1.12) 6 ⎥ 0 ≠ −$7,800,000 + $1,800,000 × ⎢ ⎥ ⎢ 0.12 ⎥ ⎢ ⎥ ⎣ ⎦ ≠

−$7,800,000 + $7,400,533 ≠ −$399,467 Since NPV < 0, try a lower rate, IRR
= 10%. NPV = 0 = ∑ FCFt t t = 0 (1 + IRR )
n
1 ⎤ ⎡ ⎢1 − (1.10)6 ⎥ 0 ≠ −$7,800,000 + $1,800,000 × ⎢ ⎥ ⎢ 0.10 ⎥ ⎢ ⎥ ⎣ ⎦ ≠

−$7,800,000 + $7,839,469 ≠ $39,469 Try IRR = 10.2%. NPV = 0 = ∑ FCFt t t
= 0 (1 + IRR )
n
1 ⎡ ⎤ ⎢1 − (1.102) 6 ⎥ 0 ≠ −$7,800,000 + $1,800,000 × ⎢ ⎥ ⎢ 0.102 ⎥ ⎢ ⎥ ⎣ ⎦ ≠

−$7,800,000 + $7,793,735 ≠ −$6,265 Try IRR = 10.15%. NPV = 0 = ∑ FCFt t t
= 0 (1 + IRR )
n
1 ⎡ ⎤ ⎢1 − (1.1015) 6 ⎥ 0 ≠ −$7,800,000 + $1,800,000 × ⎢ ⎥ ⎢ 0.1015 ⎥ ⎢ ⎥ ⎣ ⎦ ≠

−$7,800,000 + $7,805,129 ≠ $5,129 The IRR of the project is between 10.15
and 10.2 percent. Using a financial calculator, we find that the IRR is
10.1725 percent. Since IRR < k, reject the project.
INTERMEDIATE
10.13 Net present value: Champlain Corp. is investigating two computer
systems. The Alpha
8300 costs $3,122,300 and will generate annual cost savings of $1,345,500
over the next five years. The Beta 2100 system costs $3,750,000 and will
produce cost savings of $1,125,000 in the first three years and then $2
million for the next two years. If the company’s discount rate for
similar projects is 14 percent, what is the NPV for the two systems?
Which one should be chosen based on the NPV?
LO 2
Solution:
Cost of Alpha 8300 = $3,122,300 Annual cost savings = $1,345,500 Length
of project = n = 5 years Required rate of return = k = 14%
1 ⎤ ⎡ 1− ⎢ FCFt (1.14)5 ⎥ = − + × NPV = ∑ $ 3 , 122 , 300 $ 1 , 345 , 500 ⎥

⎢ t t = 0 (1 + k ) ⎢ 0.14 ⎥ ⎢ ⎥ ⎣ ⎦
n
= −$3,122,300 + $4,619,210 = $1,496,910 Cost of Beta 2100 = $3,750,000

Length of project = n = 5 years Required rate of return = k = 14% 1 ⎤ ⎡ 1−
⎢ FCFt (1.14)3 ⎥ $2,000,000 $2,000,000 = −$3,750,000 + $1,125,500 × ⎢ +
NPV = ∑ ⎥+ t (1.14) 4 (1.14)5 t = 0 (1 + k ) ⎢ 0.14 ⎥ ⎢ ⎥ ⎣ ⎦
n
= −$3,750,000 + $2,611,836 + $1,184,161 + 1,038,737 = $1,084,734 Based on

the NPV, the Alpha 8300 system should be chosen.
10.14 Net present value: Briarcrest Condiments is a spice-making firm.
Recently, it developed a new process for producing spices. This process
requires new machinery that would cost $1,968,450, have a life of five
years and would produce cash flows as shown in the table. What is the NPV
if the firm uses a discount rate of 15.9 percent? Year 1 2 3 4 5 LO 2
Cash Flow $512,496 $(242,637) $814,558 $887,225 $712,642
Solution: Cost of equipment = $1,968,450 Length of project = n = 5 years

Required rate of return = k = 15.9%
FCFt t t = 0 (1 + k )
n
NPV = ∑
$512,496 $242,637 $814,558 $887,225 $712,642 − + + + (1.159)1 (1.159) 2

(1.159) 3 (1.159) 4 (1.159) 5 = −$1,968,450 + $442,188 − $180,630 +
$523,205 + 491,700 + 340,764 = −$351,223 = −$1,968,450 +
10.15 Net present value: Cranjet Industries is expanding its product line
and its production capacity. The costs and expected cash flows of the two
independent projects are given in the following table. The firm typically
uses a discount rate of 16.4 percent. a. b What are the NPVs of the two
projects? Should both projects be accepted? Or either? Or neither?
Explain your reasoning.
Product Line Year 0 1 2 3 4 5 LO 2 Solution: a. Required rate of return =
16.4% Product Line Expansion: Cost of product line expansion = $2,575,000
NPV = ∑ FCFt t t = 0 (1 + k )
n
Production Capacity Expansion $(8,137,250) $2,500,000 $2,500,000

$2,500,000 $3,250,000 $3,250,000
Expansion $(2,575,000) $600,000 $875,000 $875,000 $875,000 $875,000
= −$2,575,000 +
$600,000 $875,000 $875,000 $875,000 $875,000 − + + + (1.164)1 (1.164) 2

(1.164)3 (1.164) 4 (1.164)5 = −$2,575,000 + $515,464 − $645,806 +
$554,816 + 476,646 + 409,490 = $27,222
Production Capacity Expansion: Cost of production capacity expansion =

$8,137,250
NPV = ∑ FCFt t t = 0 (1 + k )
n
1 ⎤ ⎡ ⎢1 − (1.164) 3 ⎥ $3,250,000 $3,250,000 + = −$8,137,250 + $2,500,000 ×

⎢ ⎥+ (1.164) 4 (1.164) 5 ⎢ 0.164 ⎥ ⎥ ⎢ ⎦ ⎣ = −$8,137,250 + $5,578,116 +
$1,770,400 + $1,520,962 = $732,228 b. Since they are independent, and
both have NPV > 0, both projects should be accepted.
10.16 Net present value: Emporia Mills is evaluating two alternative
heating systems. Costs and projected energy savings are given in the
following table. The firm uses 11.5 percent to discount such project cash
flows. Which system should be chosen?
Year 0 1 2 3 4 LO 2
System 100 $(1,750,000) $275,223 $512,445 $648,997 $875,000
System 200 $(1,735,000) $750,000 $612,500 $550,112 $384,226
Solution: Required rate of return = 11.5% System 100: Cost of product

line expansion = $1,750,000
NPV = ∑ FCFt $275,223 $512,445 $648,997 $875,000 = −$1,750,000 + − + + t
(1.115)1 (1.115) 2 (1.115) 3 (1.115) 4 t = 0 (1 + k ) = −$1,750,000 +
$246,837 − $412,190 + $468,186 + 566,120
n
= −$56,667
System 200: Cost of product line expansion = $1,735,000

NPV = ∑ FCFt $750,000 $612,500 $550,112 $384,226 = −$1,735,000 + − + + t
(1.115)1 (1.115) 2 (1.115)3 (1.115) 4 t = 0 (1 + k ) = −$1,735,000 +
$672,446 − $492,670 + $396,850 + 248,592
n
= $75,758
Since System 200 has a positive NPV, select that system. Reject System
100 as it has negative NPV. 10.17 Payback: Creative Solutions, Inc., has
just invested $4,615,300 in equipment. The firm
uses payback period criteria of not accepting any project that takes more
than four years to recover its costs. The company anticipates cash flows
of $644,386, $812,178, $943,279, $1,364,997, $2,616,300, and $2,225,375
over the next six years. Does this investment meet the firm’s payback
criteria? LO 3
Solution: Cumulative Year 0 1 2 3 4 5 6 CF $(4,615,300) 644,386 812,178

943,279 1,364,997 2,616,300 2,225,375 Cash Flow $(4,615,300) (3,970,914)
(3,158,736) (2,215,457) (850,460) 1,765,840 3,991,215
Payback period = Years before cost recovery + =4+ $850, 460 $2,616,300 =
4.33 years
Since the project payback period exceeds the firm’s target of four years,
it should not have been accepted. 10.18 Discounted payback: Timeline
Manufacturing Co. is evaluating two projects. It uses payback criteria of
three years or less. Project A has a cost of $912,855, and project B’s
cost is $1,175,000. Cash flows from both projects are given in the
following table. What are their discounted payback periods, and which
will be accepted with a discount rate of 8 percent? Year Project A
Project B
1 2 3 4 LO 3
$ 86,212 $313,562 $427,594 $285,552
$586,212 $413,277 $231,199
Solution: Project A Cumulative Year 0 1 2 3 4 CF $(912,855) 86,212

313,562 427,594 285,552 CF $(912,855) (826,643) (513,081) (85,487)
200,065 PVCF $(912,855) 79,826 268,829 339,438 209,889 Cumulative PVCF
$(912,855) (833,029) (564,200) (224,762) (14,873)
The payback period exceeds four years. Project B Cumulative Year 0 1 2 3

CF 586,212 413,277 231,199 CF (588,788) (175,511) 55,688 PVCF
$(1,175,000) 542,789 354,318 183,533 $(1,175,000) $(1,175,000) Cumulative
PVCF $(1,175,000) (632,211) (277,893) (94,359)

during the year) = 3 + years Since the firm’s acceptance criteria is
three years, neither project will be accepted. 10.19 Payback: Regent
Corp. is evaluating three competing pieces of equipment. Costs and
cash flow projections for all three are given in the following table.
Which would be the best choice based on payback period?
Year 0 1 2 3 4 5 6 LO 3
Type 1 $(1,311,450) $212,566 $269,825 $455,112 $285,552 $121,396
Type 2 $(1,415,888) $586,212 $413,277 $331,199 $141,442
Type 3 $(1,612,856) $786,212 $175,000 $175,000 $175,000 $175,000 $175,000
Solution: Type 1 Cumulative Year

0 1 2 3 4 5 6
Type 2 Cumulative CF
$(1,415,888) 586,212 413,277 331,199 141,442
Type 3 Cumulative CF
$(1,612,856) 786,212 175,000 175,000 175,000 175,000 175,000
CF
$(1,311,450) 212,566 269,825 455,112 285,552 121,396
CF
$(1,311,450) (1,098,884) (829,059) (373,947) (88,395) 33,001
CF
$(1,415,888) (829,676) (416,399) (85,200) 56,242
CF
($1,612,856) (826,644) (651,644) (476,644) (301,644) (126,644) 48.356
Type 1:
Payback period = Years before cost recovery + =4+ $88,395 $121,396 = 4.73
years

Type 2:
Payback period = Years before cost recovery + = 3+ $85, 200 $141, 442 =
3.6 years
Type 3:
Payback period = Years before cost recovery + = 5+ $126,644 $175,000 =

5.72 years
Select Type 2 because it has the lowest payback period. 10.20 Discounted
payback: Nugent Communication Corp. is investing $9,365,000 in new
technologies. The company expects significant benefits in the first three
years after installation (as can be seen by the cash flows), and smaller
constant benefits in each of the next four years. What is the discounted
payback period for the project assuming a discount rate of 10 percent?
Years 1 Cash flows LO 3 $2,265,433 2 $4,558,721 3 $3,378,911 4–7

$1,250,000
Solution: Discount rate = k = 10% Cumulative Year 0 1 CF 2,265,433 CF

(7,099,567) PVCF $(9,365,000) 2,059,485 $(9,365,000) $(9,365,000)
Cumulative PVCF $(9,365,000) (7,305,515)
2 3 4 5 6 7
4,588,721 3,378,911 1,250,000 1,250,000 1,250,000 1,250,000
(2,540,846) 838,065 2,088,065 3,338,065 4,588,065 5,838,065
3,767,538 2,538,626 853,767 776,152 705,592 641,448
(3,537,977) (999,352) (145,585) 630,567 1,336,159 1,977,607

during the year) = 4 + ($145,585 / $1,250,000) = 4.19 years 10.21
Modified internal rate of return (MIRR): Morningside Bakeries has
recently purchased equipment at a cost of $650,000. The firm expects to
generate cash flows of $275,000 in each of the next four years. The cost
of capital is 14 percent. What is the MIRR for this project? LO 5
Solution: PV of costs = $650,000 Length of project = n = 4 years Cost of

capital = k = 14% Annual cash flows = CFt = $275,000
TV = CF1 (1 + k ) n − 1 + CF2 (1 + k ) n − 2 + LL + CFn (1 + k )n − n =

$275,000(1.14)3 + $275,000(1.14) 2 + $275,000(1.14)1 + $275,000(1.14)0 =
$407,425 + $357,390 + $313,500 + $275,000 = $1,353,315 Now we can solve
for the MIRR using Equation 10.5.
TV (1 + MIRR ) t $1,353,315 $650,000 = (1 + MIRR ) 4 $1,353,315 = 2.0820
(1 + MIRR ) 4 = $650,000 PVCosts = (1 + MIRR ) = (3.5962) 4 = 1.2012 MIRR
= 0.2012 = 20.1%
1
10.22 Modified internal rate of return (MIRR): Sycamore Home Furnishings

is considering
acquiring a new machine that can create customized window treatments. The
equipment will cost $263,400 and will generate cash flows of $85,000 over
each of the next six years. If the cost of capital is 12 percent, what is
the MIRR on this project?
LO 5
Solution:
PV of costs = $263,400 Length of project = n = 6 years Cost of capital =

k = 12% Annual cash flows = CFt = $85,000
TV = CF1 (1 + k ) n −1 + CF2 (1 + k ) n − 2 + LL + CFn (1 + k ) n − n =
$85,000(1.12)5 + $85,000(1.12) 4 + $85,000(1.12) 3 + $85,000(1.12) 2 +
$85,000(1.12)1 + $85,000(1.12)0 = $149,799 + $133,749 + $119,419 +
$106,624 + $95,200 + $85,000 = $689,791 Now we can solve for the MIRR
using Equation 10.5.
TV (1 + MIRR) t $689,791 $263, 400 = (1 + MIRR)6 $689,791 (1 + MIRR)6 = =
2.6188 $263, 400 PVCosts = (1 + MIRR) = (2.6188) 6 = 1.1740 MIRR = 0.1740
= 17.4%
1
10.23 Internal rate of return: Great Flights, Inc., an aviation firm, is

considering purchasing
three aircraft for a total cost of $161 million. The company would lease
the aircraft to an airline. Cash flows from the proposed leases are shown
in the following table. What is the IRR of this project?
Years
1–4 5–7 8–10
Cash Flow
$23,500,000 $72,000,000 $80,000,000
LO 5
Solution:
Years
Initial investment = Length of project = Required rate of 1–4 5–7 8–10
Cash Flow
$23,500,000 $72,000,000 $80,000,000 $161,000,000 n = 10 years return = k
= 15%
To determine the IRR, the trial-and-error approach can be used. Set

NPV=0. Try a higher rate than k = 15%; try IRR = 22%.
NPV = 0 = ∑
FCFt t t = 0 (1 + IRR )
n
1 ⎤ 1 ⎤ ⎡ ⎡ ⎢1 − (1.22) 4 ⎥ ⎢1 − (1.22)3 ⎥ 1 0 ≠ −$161,000,000 + $23,500,000

× ⎢ ⎥ + $72,000,000 × ⎢ ⎥× 4 ⎢ 0.22 ⎥ ⎢ 0.22 ⎥ (1.22) ⎢ ⎥ ⎢ ⎥ ⎣ ⎦ ⎣ ⎦ 1 ⎤ ⎡ ⎢1 −
(1.22)3 ⎥ 1 + $80,000,000 × ⎢ ⎥× 7 ⎢ 0.22 ⎥ (1.22) ⎢ ⎥ ⎣ ⎦ ≠ −$161,000,000 +
$58,600,552 + $66,374,346 + $40,614,233 ≠ $4,589,131
Try IRR = 23%.
NPV = 0 = ∑
FCFt t t = 0 (1 + IRR )
n
1 ⎤ 1 ⎤ ⎡ ⎡ ⎢1 − (1.23) 4 ⎥ ⎢1 − (1.23)3 ⎥ 1 0 ≠ −$161,000,000 + $23,500,000

× ⎢ ⎥ + $72,000,000 × ⎢ ⎥× 4 ⎢ 0.23 ⎥ ⎢ 0.23 ⎥ (1.23) ⎢ ⎥ ⎢ ⎥ ⎣ ⎦ ⎣ ⎦ 1 ⎤ ⎡ ⎢1 −
(1.23) 3 ⎥ 1 + $80,000,000 × ⎢ ⎥× 7 ⎢ 0.23 ⎥ (1.23) ⎢ ⎥ ⎣ ⎦ ≠ −$161,000,000 +
$57,534,386 + $63,271,035 + $37,778,708 ≠ −$2,415,871
Try IRR = 22.7%.
NPV = 0 = ∑
FCFt t t = 0 (1 + IRR )
n
1 1 ⎡ ⎤ ⎡ ⎤ ⎢1 − (1.227) 4 ⎥ ⎢1 − (1.227) 3 ⎥ 1 0 ≠ −$161,000,000 +

$23,500,000 × ⎢ ⎥ + $72,000,000 × ⎢ ⎥× 4 ⎢ 0.227 ⎥ ⎢ 0.227 ⎥ (1.227) ⎢ ⎥ ⎢ ⎥ ⎣ ⎦
⎣ ⎦ 1 ⎡ ⎤ ⎢1 − (1.227) 3 ⎥ 1 + $80,000,000 × ⎢ ⎥× 7 ⎢ 0.227 ⎥ (1.227) ⎢ ⎥ ⎣ ⎦ ≠
−$161,000,000 + $57,850,786 + $64,183,552 + $38,605,355 ≠ −$360,307
The IRR of the project is between 22 and 23 percent. Using a financial

calculator, we find that the IRR is 22.65 percent.
10.24 Internal rate of return: Refer to problem 10.5. Compute the IRR for
both
production system 1 and production system 2. Which has the higher IRR?
Which production system has the highest NVP? Explain why the IRR and NPV
rankings of systems 1 and 2 are different?
LO 5
Solution
The IRR of system 1 is 83.93 percent and the IRR of system 2 is 50.07%.
The NPV of system 1 is $22,969.42 and the NPV of system 2 is $36,001.43.
System 1 delivers a higher IRR because it requires a lower initial
investment and the cost is recovered the first year. Thus, even with
lower cash inflows in the years after startup, system 1is able to deliver
a higher return on the initial investment. System 2 has a higher initial
investment but delivers a higher net cash flow for the firm.
10.25 Internal rate of return: Ancala Corporation is considering
investments in two new golf
apparel lines for next season: golf hats and belts. Due to a funding
constraint, these lines are mutually exclusive. A summary of each
project’s estimated cash flows over its three year life, as well as the
IRRs and NPVs of each are outlined below. The CFO of the firm has decided
to manufacture the belts; however, the CEO of Ancala is questioning this
decision given that the IRR is higher for manufacturing hats. Explain to
the CEO why the IRRs and NPVs of the belt and hat projects disagree? Is
the CFO’s decision the correct .
Year 0 1 2 3 NPV IRR LO 5 Solution
Golf Belts -$1,000 1,000 500 500 $697.97 54%
Golf Hats -$500 500 300 300 $427.87 61%
The IRRs and NPVs of the belt and hat lines disagree because of the
differences in the scale of the project. Hats deliver a higher IRR
because they require a lower initial investment. Thus, even with lower
cash inflows in the years after startup, the hat project is able to
deliver a higher return on the initial investment. While the golf belts
project does cost more, it delivers a higher net cash flow for Ancala
investors. This NPV factors in the initial cost of the project, and
reflects the total net cash flow for the firm’s shareholders. The CFO’s
decision to choose the golf belts project is the right choice because it
yields the higher net cash flows for Ancala’s investors.
10.26 Internal rate of return: Compute the IRR on the following cash flow
streams: a.
An initial investment of $25,000 followed by a single cash flow of
$37,450 in year 6. An initial investment of $1 million followed by a
single cash flow of $1,650,000 in year 4. An initial investment of $2
million followed by cash flows of $1,650,000 and $1,250,000 in years 2
and 4, respectively.
b.
c.
LO 5
Solution: a.
Try IRR = 7%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $37,450 0 ≠ −$25,000 + (1.07)6 ≠
−$25,000 + $24,955 ≠ −$45
n
Try IRR = 6.97%.

NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $37,450 0 ≠ −$25,000 + (1.0697)6 ≠
−$25,000 + $24,997 ≠ −$3
n
The IRR of the project is approximately 6.97 percent. Using a financial

calculator, we find that the IRR is 6.968 percent. Try IRR = 12%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $1,650,000 0 ≠ −$1,000,000 + (1.12) 4
≠ −$1,000,000 + $1,048,605 ≠ $48,605
n
b.
Try IRR = 13%.

NPV = 0 = ∑
FCFt t t = 0 (1 + IRR ) $1,650,000 0 ≠ −$1,000,000 + (1.13) 4 ≠

−$1,000,000 + $1,011,976 ≠ $11,976
n
Try IRR = 13.3%.

NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $1,650,000 0 ≠ −$1,000,000 + (1.133)
4 ≠ −$1,000,000 + $1,1,001,300 ≠ $1,300
n

calculator, we find that the IRR is 13.337 percent. Try IRR = 15%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $1,650,000 $1,250,000 + 0 ≠
−$2,000,000 + (1.15) 2 (1.15) 4 ≠ −$2,000,000 + $1,247,637 + $714,692 ≠
−$37,671
n
c.
Try IRR = 14%.

NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $1,650,000 $1,250,000 0 ≠ −$2,000,000
+ + (1.14) 2 (1.14) 4 ≠ −$2,000,000 + $1,269,621 + $740,100 ≠ $9,721
n
The IRR of the project is between 14 and 15 percent. Using a financial

10.27 Internal rate of return: Compute the IRR for the following project
cash flows. a.
An initial outlay of $3,125,000 followed by annual cash flows of $565,325
for the next eight years
b.
An initial investment of $33,750 followed by annual cash flows of $9,430

for the next five years An initial outlay of $10,000 followed by annual
cash flows of $2,500 for the next seven years
c.
LO 5
Solution: a.
Initial investment = $3,125,000 Annual cash flows = $565,325 Length of
investment = n = 8 years Try IRR = 8%. 1 ⎤ ⎡ 1− ⎢ FCFt (1.08)8 ⎥ NPV = ∑ $
3 , 125 , 000 $ 565 , 325 = − + × ⎢ ⎥ t t = 0 (1 + k ) ⎢ 0.08 ⎥ ⎢ ⎥ ⎣ ⎦
n
= −$3,125,000 + $3,249,006 = $124,006 Try a higher rate, IRR = 9%. 1 ⎤ ⎡

1− ⎢ FCFt (1.09)8 ⎥ NPV = ∑ $ 3 , 125 , 000 $ 565 , 325 = − + × ⎢ ⎥ t t = 0
(1 + k ) ⎢ 0.09 ⎥ ⎢ ⎥ ⎣ ⎦ = −$3,125,000 + $3,129,248
n
= $4,248 The IRR of the project is approximately 9 percent. Using a

financial calculator, we find that the IRR is 9.034 percent. Initial
investment = $33,750 Annual cash flows = $9,430 Length of investment = n
= 5 years Try IRR = 12%.
b.
1 ⎤ ⎡ 1− ⎢ FCFt (1.12)5 ⎥ NPV = ∑ = −$33,750 + $9,430 × ⎢ ⎥ t t = 0 (1 + k )
⎢ 0.12 ⎥ ⎢ ⎥ ⎣ ⎦
n
= −$33,750 + $33,993 = $243
Try IRR = 12.3%.

1 ⎡ ⎤ 1 − ⎢ (1.123)5 ⎥ n FCFt NPV = ∑ = −$33,750 + $9,430 × ⎢ ⎥ t t = 0 (1 +
k ) ⎢ 0.123 ⎥ ⎢ ⎥ ⎣ ⎦ = −$33,750 + $33742 = −$8 ≅ 0

calculator, we find that the IRR is 12.29 percent. Initial investment =
$10,000 Annual cash flows = $2,500 Length of investment = n = 7 years Try
IRR = 16%.
1 ⎤ ⎡ 1 − ⎢ (1.16)7 ⎥ n FCFt NPV = ∑ $ 10 , 000 $ 2 , 500 = − + × ⎢ ⎥ t t =
0 (1 + k ) ⎢ 0.16 ⎥ ⎢ ⎥ ⎣ ⎦ = −$10,000 + $10,096 = $96
c.
Try IRR = 16.3%.

1 ⎡ ⎤ 1− 7 ⎥ ⎢ FCFt (1.163) NPV = ∑ = −$10,000 + $2,500 × ⎢ ⎥ t t = 0 (1 + k
) ⎢ 0.163 ⎥ ⎢ ⎥ ⎣ ⎦ = −$10,000 + $10,008 = $8 ≅ 0
n

ADVANCED
10.28 Draconian Measures, Inc., is evaluating two independent projects.
The company uses a
13.8 percent discount rate for such projects. The cost and cash flows are
shown in the following table. What are the NPVs of the two projects?
Year
0 1 2 3 4 5 6 7
Project 1
$(8,425,375) $3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645
$1,582,156 $1,365,882
Project 2
$(11,368,000) $2,112,589 $3,787,552 $3,125,650 $4,115,899 $4,556,424
LO 2
Solution: Project 1:
Cost of Project 1 = $8,425,375 Length of project = n = 7 years Required
rate of return = k = 13.8%
NPV = ∑ FCFt t t = 0 (1 + k )
n
$3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645 + + + + (1.138)1

(1.138) 2 (1.138) 3 (1.138) 4 (1.138)5 $1,582,156 $1,365,882 + + (1.138)6
(1.138) 7 = −$8,425,375 + $2,834,795 + $1,371,291 + $933,064 + 701,527 +
$635,364 + $728,443 = −$8,425,375 + + $552,608 = −$668,283
Since Project 1 NPV is negative, we reject this project.
Project 2:
Cost of Project 2 = $11,368,000 Length of project = n = 5 years Required
rate of return = k = 13.8% NPV = ∑ FCFt t t = 0 (1 + k )
n
$2,112,589 $3,787,552 $3,125,650 $4,115,889 $4,556,424 + + + + (1.138)1

(1.138) 2 (1.138)3 (1.138) 4 (1.138)5 = −$11,368,000 + $1,856,405 +
$2,924,651 + $2,120,868 + $2,454,119 + $2,387,332 = $375,375 =
−$11,368,000 + Since Project 2 NPV is positive, we accept this project.
10.29 Refer to Problem 10.28. a. b. c. LO 5

What are the IRRs for the projects? Does the IRR criterion indicate a
different decision than the NPV criterion? Explain how you would expect
the management of Draconian Measures to decide.
Solution: a. Project 1:
At the required rate of return of 13.8 percent, Project 1 has a NPV of
$(668,283). To find the IRR, try lower rates. Try IRR = 11%.
NPV = ∑
FCFt t t = 0 (1 + k )
n
$3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645 + + + + (1.11)1

(1.11) 2 (1.11)3 (1.11) 4 (1.11)5 $1,582,156 $1,365,882 + + (1.11)6
(1.11)7 = −$8,425,375 + $2,906,304 + $1,441,346 + $1,005,470 + $775,035 +
$719,646 = −$8,425,375 + + $845,885 + $657,889 = −$73,801
Try a lower rate, IRR=10.7%.

NPV = ∑ FCFt t t = 0 (1 + k )
n
$3,225,997 $1,775,882 $1,375,112 $1,176,558 $1,212,645 + + + + (1.107)1

(1.107) 2 (1.107)3 (1.107) 4 (1.107)5 $1,582,156 $1,365,882 + + (1.107)6
(1.107)7 = −$8,425,375 + $3,225,997 + $1,775,882 + $1,375,112 +
$1,176,558 + $1,212,645 = −$8,425,375 + + $1,582,156 + $1,365,882 =
−$5,235

Project 2:
At the required rate of return of 13.8 percent, Project 1 has a NPV of $
375,375. To find the IRR, try higher rates. Try IRR = 15%. NPV = 0 = ∑
FCFt t t = 0 (1 + IRR ) $2,112,589 $3,787,552 $3,125,650 $4,115,889
$4,556,424 + + + + 0 = −$11,368,000 + (1.15)1 (1.15) 2 (1.15)3 (1.15) 4
(1.15)5 = −$11,368,000 + $1,837,034 + $2,863,933 + $2,055,166 +
$2,353,279 + $2,265,348 = $6,760
n
Try IRR = 15.1%. NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $2,112,589
$3,787,552 $3,125,650 $4,115,889 $4,556,424 + + + + 0 = −$11,368,000 +
(1.151)1 (1.151) 2 (1.151)3 (1.151) 4 (1.151)5 = −$11,368,000 +
$1,835,438 + $2,858,959 + $2,049,814 + $2,345,111 + $2,255,524 = −$23,154
n
The IRR of the project is between 15 and 15.1 percent. Using a financial
calculator, we find that the IRR is 15.023 percent. Based on the IRR,
Project 1 will be rejected and Project 2 will be accepted. These
decisions are identical to those based on NPV. (Given that Project 1 had
a negative NPV, the IRR will always be less than the required rate of
return 0. Management would use the decision spelled out by NPV, although
in this case the IRR has come up with the same decision.
b.
c.
10.30 Dravid, Inc., is currently evaluating three projects that are

independent. The cost of funds
can be either 13.6 percent or 14.8 percent depending on their financing
plan. All three projects cost the same at $500,000. Expected cash flow
streams are shown in the following table. Which projects would be
accepted at a discount rate of 14.8 percent? What if the discount rate
was 13.6 percent?
Year
1 2 3 4
Project 1
0 $125,000 $150,000 $375,000
Project 2
0 0 $500,000 $500,000
Project 3
$245,125 $212,336 $112,500 $74,000
LO 2
Solution:
Cost of projects = $500,000 Length of project = n = 4 years Required rate
of return = k = 14.8%
Project 1:
NPV = ∑ FCFt $0 $125,000 $150,000 $375,000 = −$500,000 + + + + t 1
(1.148) (1.148) 2 (1.148)3 (1.148) 4 t = 0 (1 + k ) = −$500,000 + $0 +
$94,848 + $99,144 + $215,906
n
= −$90,103
Project 2:
NPV = ∑ FCFt $0 $0 $500,000 $500,000 = −$500,000 + + + + t 1 2 (1.148)
(1.148) (1.148)3 (1.148) 4 t = 0 (1 + k ) = −$500,000 + $0 + $0 +
$330,479 + $287,874
n
= $118,353
Project 3:
NPV = ∑ FCFt $245,125 $212,336 $112,500 $74,000 = −$500,000 + + + + t
(1.148)1 (1.148) 2 (1.148)3 (1.148) 4 t = 0 (1 + k ) = −$500,000 +
$213,524 + $161,116 + $74,358 + $42,605
n
= −$8,397
At a discount rate of 14.8 percent, only project 2 will be accepted. At a

discount rate of 13.6 percent, the NPVs of the three projects are -
$75,645, $141,295, and $1,491 respectively. Both projects 2 and 3 have
positive NPVs and will be accepted.
Year
0 1
Project 1
$(500,000)
−
PVCF
$(500,000)
−
Project 2
$(500,000)
−
PVCF
$(500,000)
−
Project 3
$(500,000) 245,125
PVCF
$(500,000) 215,779
2 3 4
125,000 150,000 375,000
96,862 102,319 225,175
212,336 112,500 74,000
164,538 76,739 44,434
500,000 500,000
341,063 300,232
NPV
(75,645)
141,295
1,491
10.31 Intrepid, Inc., is looking to invest in two or three independent

projects. The costs and the
cash flows are given in the following table. The appropriate cost of
capital is 14.5 percent. Compute the IRRs and identify the projects that
will be accepted.
Year
0 1 2 3 4
Project 1
$(275,000) $63,000 $85,000 $85,000 $100,000
Project 2
$(312,500) $153,250 $167,500 $112,000
Project 3
$(500,000) $212,000 $212,000 $212,000 $212,000
LO 5
Cost of Project 1 = $275,000 Length of project = n = 4 years Required
rate of return = k = 14.5% NPV = ∑ FCFt t t = 0 (1 + k )
n
$63,000 $85,000 $85,000 $100,000 + + + (1.145)1 (1.145) 2 (1.145) 3

(1.145) 4 = −$275,000 + 55,022 + $64,835 + $56,624 + $58,181 = −$40,338
= −$275,000 +
$(40,338). To find the IRR, try lower rates. Try IRR = 7.6%.
NPV = 0 = ∑
FCFt t t = 0 (1 + IRR ) $63,000 $85,000 $85,000 $100,000 + + + 0 =

−$275,000 + (1.075)1 (1.075) 2 (1.075)3 (1.075) 4 = −$275,000 + 58,550 +
$73,417 + $68,231 + $74,602 = −$200 ≅ 0
n

Project 2:
rate of return = k = 14.5%
NPV = ∑ FCFt $153,250 $167,500 $112,000 = −$312,500 + + + t (1.145)1
(1.145) 2 (1.145)3 t = 0 (1 + k ) = −$312,500 + $ 133,843 + $127,763 +
$74,611
n
= $23,717

$23,717. To find the IRR, try higher rates. Try IRR =19%. NPV = 0 = ∑
FCFt t t = 0 (1 + IRR ) $153,250 $167,500 $112,000 + + 0 = −$312,500 +
(1.19)1 (1.19) 2 (1.19)3 = −$312,500 + $128,782 + $118,283 + $66,463 =
$1,027
n
Try IRR=19.2%. NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $153,250 $167,500

$112,000 + + 0 = −$312,500 + (1.192)1 (1.192) 2 (1.192) 3 = −$312,500 +
$128,565 + $117,886 + $66,129 = $80 ≅ 0
n
Project 3:
rate of return = k = 14.5% 1 ⎡ ⎤ 1− 4 ⎥ ⎢ FCFt (1.145) = −$500,000 +
$212,000 × ⎢ NPV = ∑ ⎥ t t = 0 (1 + k ) ⎢ 0.145 ⎥ ⎢ ⎥ ⎣ ⎦ = −$500,000 +
$611,429
n
= $111,429

$111,429. To find the IRR, try higher rates. Try IRR =25%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR )
n
1 ⎤ ⎡ ⎢1 − (1.25) 4 ⎥ 0 = −$500,000 + $212,000 × ⎢ ⎥ ⎢ 0.25 ⎥ ⎢ ⎥ ⎣ ⎦ =

−$500,000 + $500,659 ≠ $659
Try IRR=25.1%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR )
n
1 ⎡ ⎤ − 1 ⎢ (1.251) 4 ⎥ 0 = −$500,000 + $212,000 × ⎢ ⎥ ⎢ 0.251 ⎥ ⎢ ⎥ ⎣ ⎦ =

−$500,000 + $500,659 = −$231 ≅ 0
calculator, we find that the IRR is 25.07 percent. Only Projects 2 and 3
will be accepted as the IRRs exceed the required rate of return of 14.5
percent.
10.32 Jekyll & Hyde Corp. is evaluating two mutually exclusive projects.
The cost of capital is
15 percent. Costs and cash flows are given in the following table. Which
project should be accepted?
Year
0 1 2 3 4 5
Project 1
$(1,250,000) $250,000 $350,000 $450,000 $500,000 $750,000
Project 2
$(1,250,000) $350,000 $350,000 $350,000 $350,000 $350,000
LO 5
Cost of project = $1,250,000 Length of project = n = 5 years Required
rate of return = k = 15% NPV = ∑ FCFt t t = 0 (1 + k )
n
$250,000 $350,000 $450,000 $500,000 $750,000 + + + + (1.15)1 (1.15) 2

(1.15)3 (1.15) 4 (1.15)5 = −$1,250,000 + $217,391 + $264,650 + $295,882 +
$285,877 + $372,883 = $186,683
= −$1,250,000 +
At the required rate of return of 15 percent, Project 1 has an NPV of

$186,683.Based on the positive NPV, Project 1 should be accepted.
To find the IRR, try higher rates. Try IRR = 20%. NPV = 0 = ∑ FCFt t t =
0 (1 + k )
n
0 = −$1,250,000 +
$250,000 $350,000 $450,000 $500,000 $750,000 + + + + (1.20)1 (1.20) 2

(1.20)3 (1.20) 4 (1.20)5 = −$1,250,000 + $208,333 + $243,056 + $260,417 +
$241,127 + $301,408 ≠ $4,340
Try IRR = 20.1%. NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $250,000 $350,000

$450,000 $500,000 $750,000 + + + + 0 = −$1,250,000 + (1.201)1 (1.201) 2
(1.201)3 (1.201) 4 (1.201)5 = −$1,250,000 + $208,160 + $242,651 +
$259,767 + $240,324 + $300,155 = $1,057 ≅ 0
n

Project 2:
Cost of project = $1,250,000 Length of project = n = 5 years Required
rate of return = k = 15% 1 ⎤ ⎡ 1− ⎢ FCFt (1.15)5 ⎥ = − + × NPV = ∑ $ 1 ,
250 , 000 $ 350 , 000 ⎢ ⎥ t t = 0 (1 + k ) ⎢ 0.15 ⎥ ⎢ ⎥ ⎣ ⎦ = −$1,250,000 +
$1,173,254
n
= −$76,746

$(76,746). Based on the negative NPV, Project 2 should be rejected.
To find the IRR, try lower rates. Try IRR = 12%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR )
n
1 ⎤ ⎡ ⎢1 − (1.12)5 ⎥ 0 = −$1,250,000 + $350,000 × ⎢ ⎥ ⎢ 0.12 ⎥ ⎥ ⎢ ⎦ ⎣ =

−$1,250,000 + $1,261,672 = $11,672
Try IRR = 12.4%.

NPV = 0 = ∑ FCFt t t = 0 (1 + IRR )
n
1 ⎡ ⎤ ⎢1 − (1.124)5 ⎥ 0 = −$1,250,000 + $350,000 × ⎢ ⎥ ⎢ 0.124 ⎥ ⎢ ⎥ ⎣ ⎦ =

−$1,250,000 + $1,249,269 = −$732 ≅ 0

calculator, we find that the IRR is 12.376 percent. Given a required rate
of return of 15 percent, Project 1 will be accepted as the IRR of 20.1
percent exceeds the required rate of return. Project 2 will be rejected.
10.33 Larsen Automotive, a manufacturer of auto parts, is considering

investing in two projects.
The company typically compares project returns to a cost of funds of 17
percent. Compute the IRRs based on the given cash flows, and state which
projects will be accepted.
Year
0
Project 1
$(475,000)
Project 2
$(500,000)
1 2 3 4
$300,000 $110,000 $125,000 $140,000
$117,500 $181,300 $244,112 $278,955
LO 5
Cost of project = $475,000 Length of project = n = 4 years Required rate
of return = k = 17% NPV = ∑ FCFt t t = 0 (1 + k )
n
$300,000 $110,000 $125,000 $140,000 + + + (1.17)1 (1.17) 2 (1.17)3 (1.17)

4 = −$475,000 + $256,410 + $80,356 + $78,046 + $74,711 = $14,524
= −$475,000 +

$14,524. To find the IRR, try higher rates. Try IRR = 19%. NPV = ∑ FCFt t
t = 0 (1 + k )
n
$300,000 $110,000 $125,000 $140,000 + + + (1.19)1 (1.19) 2 (1.19)3 (1.19)

4 = −$475,000 + $252,101 + $77,678 + $74,177 + $69,814 ≠ −$1,230
= −$475,000 +
Try IRR = 18.8%.

NPV = ∑
FCFt t t = 0 (1 + k )
n
$300,000 $110,000 $125,000 $140,000 + + + (1.188)1 (1.188) 2 (1.188)3

(1.188) 4 = −$475,000 + $252,525 + $77,940 + $74,552 + $70,285 = $302 ≅ 0
= −$475,000 +

Project 2:
Cost of project = $500,000 Length of project = n = 4 years Required rate
of return = k = 17% NPV = ∑ FCFt t t = 0 (1 + k )
n
$117,500 $181,300 $244,312 $278,955 + + + (1.17)1 (1.17) 2 (1.17)3 (1.17)

4 = −$475,000 + $100,427 + $132,442 + $152,416 + $148,864 = $34,150
= −$500,000 +

$34,150. To find the IRR, try higher rates. Try IRR = 20%. NPV = 0 = ∑
FCFt t t = 0 (1 + IRR ) $117,500 $181,300 $244,312 $278,955 + + + 0 =
−$500,000 + (1.20)1 (1.20) 2 (1.20)3 (1.20) 4 = −$475,000 + $97,917 +
$125,903 + $141,269 + $134,527 = −$385 ≅ 0
n
The IRR of the project is approximately 20 percent. Using a financial

calculator, we find that the IRR is 19.965 percent. Both projects can be
accepted since their IRRs exceed the cost of capital of 17 percent.
10.34 Compute the IRR for each of the following projects: Year
0 1 2 3 4 5
Project 1
$(10,000) $4,750 $3,300 $3,600 $2,100
Project 2
$(10,000) $1,650 $3,890 $5,100 $2,750 $800
Project 3
$(10,000) $800 $1,200 $2,875 $3,400 $6,600
LO 5
Cost of project = $10,000 Length of project = n = 4 years NPV = 0 = ∑
FCFt t t = 0 (1 + IRR ) $4,750 $3,300 $3,600 $2,100 + + + 0 = −$10,000 +
(1.16)1 (1.16) 2 (1.16) 3 (1.16) 4 = −$10,000 + $4,095 + $2,452 + $2,306
+ $1,160 = $13 ≅ 0
n
The IRR of the project is approximately 16 percent. Using a financial

Project 2:
FCFt t t = 0 (1 + IRR ) $1,650 $3,890 $5,100 $2,750 $800 + + + + 0 =
−$10,000 + 1 2 3 4 (1.137) (1.137) (1.137) (1.137) (1.137)5 = −$10,000 +
$1,451 + $3,009 + $3,470 + $1,545 + $421 = −$4 ≅ 0
n
Project 3:
FCFt t t = 0 (1 + IRR ) $800 $1,200 $2,875 $3,400 $6,600 + + + + 0 =
−$10,000 + 1 2 3 4 (1.109) (1.109) (1.109) (1.109) (1.109)5 = −$10,000 +
$721 + $976 + $2,108 + $2,248 + $3,934 = −$13 ≅ 0
n

10.35 Primus Corp. is planning to convert an existing warehouse into a

new plant that will
increase its production capacity by 45 percent. The cost of this project
will be $7,125,000. It will result in additional cash flows of $1,875,000
for the next eight years. The company uses a discount rate of 12 percent.
What is the payback period? What is the NPV for this project? What is the
IRR?
a. b. c.
LO 2, LO 3, LO 5
Solution: a. Year
0 1 2 3 4
Project 1
$(7,125,000) 1,875,000 1,875,000 1,875,000 1,875,000
Cumulative CF
$(7,125,000) (5,250,000) (3,375,000) (1,500,000) 375,000
5 6 7 8
1,875,000 1,875,000 1,875,000 1,875,000
2,250,000 4,125,000 6,000,000 7,875,000

during the year) = 3 + ($1,500,000 / $1,875,000) = 3.80 years Cost of
this project = $7,125,000 Required rate of return = 12% Length of project
= n = 8 years
NPV = ∑ FCFt t t = 0 (1 + k )
n
b.
1 ⎤ ⎡ 1 − ⎢ (1.12)8 ⎥ = −$7,1250,000 + $1,875,000 × ⎢ ⎥ ⎢ 0.12 ⎥ ⎥ ⎢ ⎦ ⎣ =

−$7,125,000 + $9,314,325 = $2,189,325
c.
To compute the IRR, try rates higher than 12 percent. Try IRR = 20%.
NPV = 0 = ∑ FCFt t t = 0 (1 + k )
n
1 ⎤ ⎡ 1 − ⎢ (1.20)8 ⎥ 0 = −$7,1250,000 + $1,875,000 × ⎢ ⎥ ⎢ 0.20 ⎥ ⎥ ⎢ ⎦ ⎣ =

−$7,125,000 + $7,194,675 = $69,675
Try IRR = 20.3%.

NPV = 0 = ∑
FCFt t t = 0 (1 + k )
n
1 ⎤ ⎡ ⎢1 − (1.203)8 ⎥ 0 = −$7,1250,000 + $1,875,000 × ⎢ ⎥ ⎢ 0.203 ⎥ ⎥ ⎢ ⎦ ⎣ =

−$7,125,000 + $7,130,832 = $5,832

10.36 Quasar Tech Co. is investing $6 million in new machinery that will
produce the nextgeneration routers. Sales to its customers will amount to
$1,750,000 for the next three years and then increase to $2.4 million for
three more years. The project is expected to last six years and cost,
excluding depreciation will be $898,620 annually. The machinery will be
depreciated to a salvage value of 0 over 6 years using the straight-line
method. The company’s tax rate is 30 percent, and the cost of capital is
16 percent. What is the payback period? What is the average accounting
return (ARR)? Calculate the project NPV. What is the IRR for the project?
a. b. c. d.
LO 2, LO 3, LO 5 Solution:
a. Project 1 Year
0 1 2 3 4 $(104,034) $(104,034) $(104,034) 350,966 $1,000,000 $1,000,000
$1,000,000 $1,000,000
Cumulative CF
$(6,000,000) (5,104,034) (4,208,068) (3,312,102) (1,961,136)
Net Income
Depreciation
Cash Flows
$(6,000,000) 895,966 895,966 895,966 1,350,966
5 6
350,966 350,966
$1,000,000 $1,000,000
1,350,966 1,350,966
(610,170) 740,796

during the year) = 5 + ($610,170 / $1,350,966) = 5.45 years
b. Year 1
Sales Expenses Depreciation EBIT Taxes (30%) Net income Beginning BV
Less: Depreciation Ending BV $ 5,000,000 $ 4,000,000 $ 3,000,000 $
2,000,000 $ 1,000,000 Average after-tax income = $123,466 Average book
value of equipment = $3,000,000
Accounting rate of return = Average after - tax income Average book value
$123,466 = = 4.1% $3,000,000
Year 2
898,620 1,000,000 $(1,48,620) 44,586 $ (104,034) 5,000,000 1,000,000
Year 3
898,620 1,000,000 $(1,48,620) 44,586 $ (104,034) 4,000,000 1,000,000
Year 4
898,620 1,000,000 $ 501,380 (150,414) $ 350,966 3,000,000 1,000,000
Year 5
898,620 1,000,000 $ 501,380 (150,414) $ 350,966 2,000,000 1,000,000
Year 6
898,620 1,000,000 $ 501,380 (150,414) $ 350,966 1,000,000 1,000,000 $ 0
$ 1,750,000 $ 1,750,000 $ 1,750,000 $ 2,400,000 $ 2,400,000 $ 2,400,000

898,620 1,000,000 $(1,48,620) 44,586 $ (104,034) 6,000,000 1,000,000
c.
Cost of this project = $6,000,000 Required rate of return = 16% Length of

project = n = 6 years
NPV = ∑
FCFt t t = 0 (1 + k )
n
1 ⎤ 1 ⎤ ⎡ ⎡ − − 1 1 3 ⎢ (1.16) ⎥ ⎢ (1.16)3 ⎥ 1 = −$6.000,000 + $895,966 × ⎢ ⎥

+ $1,350,966 × ⎢ ⎥× 3 ⎢ 0.16 ⎥ ⎢ 0.16 ⎥ (1.16) ⎢ ⎥ ⎢ ⎥ ⎣ ⎦ ⎣ ⎦ = −$6,000,000 +
$2,012,241 + $1,943,833 = −$2,043,927 d. To compute the IRR, try rates
lower than 16 percent. Try IRR = 3%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR )
n
1 ⎤ 1 ⎤ ⎡ ⎡ ⎢1 − (1.03)3 ⎥ ⎢1 − (1.03)3 ⎥ 1 0 = −$6.000,000 + $895,966 × ⎢ ⎥ +

$1,350,966 × ⎢ ⎥× 3 ⎢ 0.03 ⎥ ⎢ 0.03 ⎥ (1.03) ⎢ ⎥ ⎢ ⎥ ⎣ ⎦ ⎣ ⎦ = −$6,000,000 +
$2,534,340 + $3,497,084 = $31,424 Try IRR = 3.1%. NPV = 0 − ∑ FCFt t t =
0 (1 + IRR )
n
1 1 ⎡ ⎤ ⎡ ⎤ − − 1 1 3 ⎢ (1.031) ⎥ ⎢ (1.031)3 ⎥ 1 0 = −$6.000,000 + $895,966 ×

⎢ ⎥ + $1,350,966 × ⎢ ⎥× 3 ⎢ 0.031 ⎥ ⎢ 0.031 ⎥ (1.031) ⎢ ⎥ ⎢ ⎥ ⎣ ⎦ ⎣ ⎦ =
−$6,000,000 + $2,529,475 + $3,480,225 = $9,700 The IRR of the project is
approximately 3.1 percent. Using a financial calculator, we find that the
IRR is 3.145 percent.
10.37 Skywards, Inc., an airline caterer, is purchasing refrigerated
trucks at a total cost of $3.25 million. After-tax net income from this
investment is expected to be $750,000 for the next five years. Annual
depreciation expense will be $650,000. The cost of capital is 17 percent.
a. b. c. d. What is the discounted payback period? Compute the ARR. What
is the NPV on this investment? Calculate the IRR.
LO 2, LO 3, LO 4, LO 5
Solution: a. Cumulative CF $(3,250,000) (1,850,000) (450,000) 950,000

2,350,000 3,750,000 Cumulative PVCF $(3,250,000) (2,053,419) (1,030,700)
(156,581) 590,529 1,229,085
Year 0 1 2 3 4 5
Project 1 $(3,250,000) 1,400,000 1,400,000 1,400,000 1,400,000 1,400,000
PVCF $(3,250,000) 1,196,581 1,022,719 874,119 747,110 638,556
Discount payback period = Years before recovery + (Remaining cost / Next

year’s CF) = 3 + ($156,581 / $747,110) = 3.21 years b. Net income
Beginning BV Less: Depreciation Ending BV Year 1 $ 750,000 3,250,000
650,000 $2,600,000 Year 2 $ 750,000 2,600,000 650,000 $1,950,000 Year 3 $
750,000 1,950,000 650,000 $1,300,000 Year 4 $ 750,000 1,300,000 650,000 $
650,000 Year 5 $ 750,000 650,000 650,000 $ 0
Average after-tax income = $750,000 Average book value of equipment =

$1,625,000
Accounting rate of return =
Average after - tax income Average book value $750,000 = = 46.2%

$1,625,000
c.

project = n = 5 years 1 ⎤ ⎡ − 1 ⎢ (1.17) 5 ⎥ n FCFt NPV = ∑ = − + × $ 3 ,
250 , 000 $ 1 , 400 , 000 ⎢ ⎥ t t = 0 (1 + k ) ⎢ 0.17 ⎥ ⎢ ⎥ ⎣ ⎦ = −$3,250,000
+ $4,479,085 = $1,229,085
d.
To compute the IRR, try rates much higher than 17 percent. Try IRR = 30%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR )
n
1 ⎤ ⎡ − 1 ⎢ (1.30) 5 ⎥ 0 = −$3,250,000 + $1,400,000 × ⎢ ⎥ ⎢ 0.30 ⎥ ⎢ ⎥ ⎣ ⎦ =

−$3,250,000 + $3,409,798 = $159,798 Try IRR = 32.5%.
NPV = 0 = ∑
FCFt t t = 0 (1 + IRR )
n
1 ⎡ ⎤ ⎢1 − (1.325) 5 ⎥ 0 = −$3,250,000 + $1,400,000 × ⎢ ⎥ ⎢ 0.325 ⎥ ⎢ ⎥ ⎣ ⎦ =

−$3,250,000 + $3,252,904 = $2,904 ≅ 0
calculator, we find that the IRR is 32.548 percent. 10.38 Trident Corp.
is evaluating two independent projects. The costs and expected cash flows
are given in the following table. The company’s cost of capital is 10
percent. Year 0 1 2 3 4 5 Calculate the projects’ NPV. Calculate the
projects’ IRR. Which project should be chosen based on NPV? Based on IRR?
Is there a conflict? d. If you are the decision maker for the firm, which
project or projects will be accepted? Explain your reasoning. LO 2, LO 5
A $(312,500) $121,450 $121,450 $121,450 $121,450 $121,450 B $(395,000)
$153,552 $158,711 $166,220 $132,000 $122,000
a. b. c.
Solution: a. Project A: Cost of this project = $312,500 Annual cash flows

= $121,450 Required rate of return = 10% Length of project = n = 5 years
1 ⎤ ⎡ 1− ⎢ FCFt (1.10)5 ⎥ = − + × NPV = ∑ 312 , 500 $ 121 , 450 ⎢ ⎥ t t = 0
(1 + k ) ⎢ 0.10 ⎥ ⎢ ⎥ ⎣ ⎦
n
= −$312,5000 + 460,391 = $147,891 Project B: Cost of this project =

$395,000 Required rate of return = 10% Length of project = n = 5 years
NPV = ∑ FCFt t t = 0 (1 + k )
n
= −$395,000 +
$153,552 $158,711 $166,220 $132,000 $122,000 + + + + (1.10)5 (1.10)1

(1.10)2 (1.10)3 (1.10) 4 = −395,000 + $139,553 + $131,166 + $124,884 +
90,158 + 75,752 = $166,553
b.
Project A: Since NPV > 0, to compute the IRR, try rates higher than 10
percent. Try IRR = 27%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR )
n
1 ⎤ ⎡ ⎢1 − (1.27)5 ⎥ 0 = −312,500 + $121,450 × ⎢ ⎥ ⎢ 0.27 ⎥ ⎥ ⎢ ⎦ ⎣ =

−$312,5000 + 313,666 ≠ $1,166
Try IRR = 27.2%,

NPV = 0 = ∑
FCFt t t = 0 (1 + IRR )
n
1 ⎡ ⎤ ⎢1 − (1.272)5 ⎥ 0 = −312,500 + $121,450 × ⎢ ⎥ ⎢ 0.272 ⎥ ⎢ ⎥ ⎣ ⎦ =

−$312,5000 + 313,666 = −$82 ≅ 0
The IRR of Project A is approximately 27.2 percent. Using a financial

calculator, we find that the IRR is 27.187 percent. Project B: Since NPV
> 0, to compute the IRR, try rates higher than 10 percent. Try IRR = 26%.
NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $153,552 $158,711 $166,220 $132,000
$122,000 0 = −$395,000 + + + + + (1.26)1 (1.26)2 (1.26)3 (1.26) 4 (1.26)5
= −395,000 + $121,867 + $99,969 + $83,094 + 52,371 + 38,416 ≠ $717
n
Try IRR = 26.1%. NPV = 0 = ∑ FCFt t t = 0 (1 + IRR ) $153,552 $158,711

$166,220 $132,000 $122,000 0 = −$395,000 + + + + + (1.261)5 (1.261)1
(1.261) 2 (1.261)3 (1.261) 4 = −395,000 + $121,770 + $99,811 + $82,897 +
52,205 + 38,263 = −$54 ≅ 0
n
The IRR of Project B is approximately 26.1 percent. Using a financial

calculator, we find that the IRR is 26.093 percent. Since both projects
have positive NPVs and they are independent projects, both should be
accepted under the NPV decision criteria. Under the IRR decision
criteria, since both projects have IRRs greater than the cost of capital,
both will be accepted. Thus, there is no conflict between the NPV and IRR
decisions.
c.
d.
Based on NPV, both projects will be accepted.
10.39 Tyler, Inc., is considering switching to a new production

technology. The cost of equipment will be $4 million. The discount rate
is 12 percent. The cash flows that the firm expects to generate are as
follows. Years 0 1-2 3–5 6–9 CF $(4,000,000) 0 $845,000 $1,450,000
a. b. c.
Compute the payback and discounted payback period for the project. What
is the NPV for the project? Should the firm go ahead with the project?
What is the IRR, and what would be the decision under the IRR?
LO 2, LO 3, LO 5
Solution: a. Cumulative Year 0 1 2 3 4 5 6 7 8 9 Cash Flows $(4,000,000)

--845,000 845,000 845,000 1,450,000 1,450,000 1,450,000 1,450,000 PVCF
$(4,000,000) --601,454 537,013 479,476 734,615 655,906 585,631 522,885 CF
$(4,000,000) $(4,000,000) $(4,000,000) (3,155,000) (2,310,000)
(1,465,000) (15,000) 1,435,000 2,885,000 4,335,000 Cumulative PVCF
$(4,000,000) $(4,000,000) $(4,000,000) (3,398,546) (2,861,533)
(2,382,057) (1,647,442) (991,536) (405,905) 116,979.48
Payback period = Years before cost recovery + = 6+ $15,000 $1, 450,000 =
6.01 years
Discounted Payback period = Years before cost recovery + =8+ $405,905

$522,885 = 8.8 years
b.

project = n = 9 years
1 ⎤ ⎡ 1− ⎢ FCFt 1 (1.12)3 ⎥ = − + + + × NPV = ∑ $ 4 . 000 , 000 0 0 $ 845 ,
000 ⎢ ⎥× t 2 t = 0 (1 + k ) ⎢ 0.12 ⎥ (1.12) ⎢ ⎥ ⎣ ⎦
n
1 ⎤ ⎡ ⎢1 − (1.12) 4 ⎥ 1 + $1,450,000 × ⎢ ⎥× 5 ⎢ 0.12 ⎥ (1.12) ⎢ ⎥ ⎣ ⎦ =

−$4,000,000 + 0 + 0 + $1,617,943 + $2,499,037 = $116,980 Since NPV > 0,
the project should be accepted. c. Given a positive NPV, to compute the
IRR, one should try rates higher than 12 percent. Try IRR = 12.5%.
1 ⎡ ⎤ 1− 3 ⎥ ⎢ FCFt 1 (1.125) = −$4.000,000 + 0 + 0 + $845,000 × ⎢ NPV = ∑
⎥× t 2 t = 0 (1 + k ) ⎢ 0.125 ⎥ (1.125) ⎢ ⎥ ⎣ ⎦
n
1 ⎡ ⎤ − 1 ⎢ (1.125) 4 ⎥ 1 + $1,450,000 × ⎢ ⎥× 5 ⎢ 0.125 ⎥ (1.125) ⎢ ⎥ ⎣ ⎦ =

−$4,000,000 + 0 + 0 + $1,589,915 + $2,418,479 = $8,394 The IRR is
approximately 12.5 percent. Using the financial calculator, we find that
the IRR is 12.539 percent. Based on the IRR exceeding the cost of capital
of 12 percent, the project should be accepted.
CFA Problems
10.40. Given the following cash flows for a capital project, calculate
the NPV and IRR. The required rate of return is 8 percent. Year 0 CASH
FLOW –50,000 1 15,000 2 15,000 3 20,000 4 10,000 5 5,000
NPV a. b. c. d. $1,905 $1,905 $3,379 $3,379
IRR 10.9% 26.0% 10.9% 26.0%
LO 2
SOLUTION:
c is correct.
NPV = −50, 000 + 15, 000 15, 000 20, 000 10, 000 5, 000 + + + + 1.08
1.082 1.083 1.084 1.085
NPV = –50,000 + 13,888.89 + 12,860.08 + 15,876.64 + 7,350.30 + 3,402.92

NPV = –50,000 + 53,378.83 = $3,378.83 The IRR, found with a financial
calculator, is 10.88 percent.
10.41. Given the following cash flows for a capital project, calculate
its payback period and discounted payback period. The required rate of
return is 8 percent. Year 0 CASH FLOW –50,000 1 15,000 2 15,000 3 20,000
4 10,000 5 5,000
The discounted payback period is a. b. c. d. 0.16 years longer than the

payback period. 0.80 years longer than the payback period. 1.01 years
longer than the payback period. 1.85 years longer than the payback
period.
LO 3
SOLUTION: c is correct.
YEAR CASH FLOW CUMULATIVE CASH
FLOW
0 –50,000 –50,000 –50,000 –50,000
1 15,000 –35,000 13,888.89 –36,111.11
2 15,000 –20,000 12,860.08 –23,251.03
3 20,000 0 15,876.64 –7,374.38
4 10,000 10,000 7,350.30 –24.09
5 5,000 15,000 3,402.92 3,378.83
DISCOUNTED CASH
FLOW
CUMULATIVE DCF
As the table shows, the cumulative cash flow offsets the initial
investment in exactly three years. The payback period is 3.00 years. The
discounted payback period is between four and five years. The discounted
payback period is 4 years plus 24.09/3,402.92 = 0.007 of the fifth year
cash flow, or 4.007 = 4.01 years. The discounted payback period is 4.01 –
3.00 = 1.01 years longer than the payback period.
10.42. An investment of $100 generates after-tax cash flows of $40 in
Year 1, $80 in Year 2, and $120 in Year 3. The required rate of return is
20 percent. The net present value is closest to a. b. c. d. $42.22 $58.33
$68.52 $98.95
LO 2
SOLUTION: b is correct.
NPV = ∑
t =0 3
CFt 40 80 120 = −100 + + + = $58.33 t 2 (1 + r ) 1.20 1.20 1.203

10.43. An investment of $150,000 is expected to generate an after-tax
cash flow of $100,000 in one year and another $120,000 in two years. The
cost of capital is 10 percent. What is the internal rate of return? a. b.
c. d. 28.19 percent 28.39 percent 28.59 percent 28.79 percent
LO 5
SOLUTION: d is correct. The IRR can be found using a financial calculator

or with trial and error. Using trial and error, the total PV is equal to
zero if the discount rate is 28.79 percent.
YEA
R
CASH FLOW –150,000 100,000 120,000
PRESENT VALUE 28.19% –150,000 78,009 73,025 1,034 28.39% –150,000 77,888
72,798 686 28.59% –150,000 77,767 72,572 338 28.79% –150,000 77,646
72,346 –8
0 1 2 Total
A more precise IRR of 28.7854 percent has a total PV closer to zero.

10.44. An investment requires an outlay of 100 and produces after-tax
cash flows of $40 annually for four years. A project enhancement
increases the outlay by $15 and the annual after-tax cash flows by $5.
How will the enhancement affect the NPV profile? The vertical intercept
of the NPV profile of the project shifts: a. b. c. up and the horizontal
intercept shifts left. up and the horizontal intercept shifts right. down
and the horizontal intercept shifts left.
d.
down and the horizontal intercept shifts right.
LO 2
SOLUTION: a is correct. The vertical intercept changes from $60 to $65,

and the horizontal intercept
changes from 21.86 percent to 20.68 percent.
Sample Test Problems

10.1 Net present value: Techno Corp. is considering developing new
computer software. The
cost of development will be $675,000, and the company expects the revenue
from the sale of the software to be $195,000 for each of the next six
years. If the company uses a discount rate of 14 percent, what is the net
present value of this project?
Solution:
Cost of this project = $675,000 Annual cash flows = $195,000 Required
rate of return = 14% Length of project = n = 6 years 1 ⎤ ⎡ 1− ⎢ FCFt
(1.14)6 ⎥ NPV = ∑ $ 675 , 000 $ 195 , 000 = − + × ⎥ ⎢ t t = 0 (1 + k ) ⎢
0.14 ⎥ ⎥ ⎢ ⎦ ⎣
n
= −$675,000 + $758,290 = $83,290
10.2
Payback method: Parker Office Supplies is considering replacing the

company’s outdated
inventory-management software. The cost of the new software will be
$168,000. Cost savings is expected to be $43,500 for each of the first
three years and then to drop off to $36,875 for the following two years.
What is the payback period for this project?
Solution: Cumulative Year
0 1 2 3 4 5
CF
$(168,000) 43,500 43,500 43,500 36,875 36,875
CF
$(168,000) (124,500) (81,000) (37,500) (625) 36,250

during the year) = 4 + ($625 / $36,875) = 4.02 years
10.3
Accounting rate of return: Fresno, Inc., is expecting to generate after-

tax income of
$156,435 in each of the next three years. The average book value of its
equipment over that period will be $322,500. If the firm’s acceptance
decision on any project is based on an ARR of 40 percent, should this
project be accepted?
Solution:
Annual after-tax income = $156,435 Average after-tax income = $156,435
Average book value of equipment = $322,500
Accounting rate of return = Average after - tax income Average book value
$156,435 = = 48.5% 322,500
Since the project’s ARR is above the acceptance rate of 40 percent, the
project should be accepted.
10.4
Internal rate of return: Refer to Sample Test Problem 10.1. What is the
IRR on this
project?
Solution:
Cost of this project = $675,000 Annual cash flows = $195,000 Required

(1.14)6 ⎥ NPV = ∑ $ 675 , 000 $ 195 , 000 = − + × ⎥ ⎢ t t = 0 (1 + k ) ⎢
0.14 ⎥ ⎥ ⎢ ⎦ ⎣
n
= −$675,000 + $758,290 = $83,290 Since NPV > 0, try IRR > k. Try IRR =
18%. 1 ⎤ ⎡ 1− ⎢ FCFt (1.18) 6 ⎥ NPV = 0 = ∑ 0 $ 675 , 000 $ 195 , 000 = − +
× ⎥ ⎢ t t = 0 (1 + IRR ) ⎢ 0.18 ⎥ ⎥ ⎢ ⎦ ⎣ = −$675,000 + $682,033
n
≠ $7,033 Try IRR = 18.4%.

1 ⎤ ⎡ 1 − ⎢ (1.184)6 ⎥ n FCFt NPV = 0 = ∑ = −$675,000 + $195,000 × ⎢ ⎥ t t =
0 (1 + IRR ) ⎢ 0.184 ⎥ ⎥ ⎢ ⎦ ⎣ = −$675,000 + $675,096 = $96 ≅ 0
The IRR is approximately 18.4 percent. Using the financial calculator, we

find that the IRR is 18.406 percent.
10.5
Net present value: Raycom, Inc. needs a new overhead crane and two
alternatives are
available. Crane T costs $1.35 million and will produce cost savings of
$765,000 for the next three years. Crane R will cost $1.675 million and
will yield cost savings of $815,000
for the next three years. The required rate of return is 15 percent.
Which of the two options should Raycom choose based on NPV criteria and
why?
Solution: Crane T:
Cost of this project = $1,350,000 Annual cash flows = $765,000 Required
(1.15) 3 ⎥ NPV = ∑ $ 1 , 350 , 000 $ 765 , 000 = − + × ⎥ ⎢ t t = 0 (1 + k
) ⎢ 0.15 ⎥ ⎥ ⎢ ⎦ ⎣ = −$1,350,000 + $1,746,667
n
= $396,667
Crane R:
Cost of this project = $1,675,000 Annual cash flows = $815,000 Required
rate of return = 15% Length of project = n = 3 years 1 ⎤ ⎡ 1 − ⎢ (1.15)3 ⎥
n FCFt NPV = ∑ $ 1 , 675 , 000 $ 815 , 000 = − + × ⎥ ⎢ t t = 0 (1 + k ) ⎢
0.15 ⎥ ⎥ ⎢ ⎦ ⎣ = −$1,675,000 + $1,860,829 = $185,829 Raycom should choose
Crane T since it has the higher NPV.

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CHAPTER 10 The Fundamentals of Capital Budgeting

Before You Go On Questions and Answers

Section 10.2 1. What is the NPV of a project? NPV is simply the

Year 1 $979,225 $875,236

Year 2 $1,358,886 $1,765,225

Year 3 $2,111,497 $2,865,110

$979,225 $1,358,886 $2,111,497 + + (1 + 0.12)1 (1.12) 2 (1.12) 3 =

NPV for Craigmore Forklifts:

$875,236 $1,765,225 $2,865,110 + + (1 + 0.12)1 (1.12) 2 (1.12) 3 =

Solution: Payback period for Rutledge project: Cumulative Year 0 1 2 3 CF

Remaining cost to recover Cash flow during the year

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

Project A $80,750 $93,450 $40,325 $145,655

Project B $32,450 $76,125 $153,250 $96,110

Which project will be chosen if the company’s payback criterion is three

Solution: Payback periods for Perryman projects A and B: Project A

Project B Cumulative Year 0 1 2 3 4 Cash Flow $(250,000) 32,450 76,125

Payback period for Project B:

Remaining cost to recover Cash flow during the year

If the payback period is three years, only project B will be chosen. If

Solution: Year 1 Year 2 Year 3 Year 4 Year 5

$123,450 $176,875 137,410 23,450 12,719 117,250 (23,450) 126,488 23,450

$242,455 141,289 23,450 $ 77,716 26,423 $ 51,293 70,350 (23,450) $ 46,900

$255,440 143,112 23,450 $ 88,878 30,219 $ 58,659 46,900 (23,450) $ 23,450

$267,125 133,556 23,450 $110,119 37,440 $ 72,679 23,450 (23,450) $ 0

$ (37,410) $ 26,937 $ (24,691) $ 17,778

= (–$24,691 + $17,778 + $51,293 + $58,659 + $72,679) / 5 = $35,143.60 =

Accounting rate of return

The company should accept the project.

Try a higher rate. At k = 17%,

NPVOtis = −$3,123, 450 + $836,944 + $992,685 + $1,318,357 = $24,536.

NPVOtis = −$3,123, 450 + $833,383 + $984, 254 + $1,301,598 = −$4, 215

NPVCraigmore = −$4,137,410 + $774,545 + $1,382, 430 + $1,985,665 = $5,

NPVCraigmore = −$4,137,410 + $773,860 + $1,379,987 + $1,980, 403 =

Critical Thinking Questions

Explain why the cost of capital is referred to as the “hurdle” rate in

system for the firm’s production department. Classify these projects as

a. A firm invests in a project that would earn a return of 12 percent. If

10.10 Elkridge Construction Company has an overall (composite) cost of

cost of capital reflects the cost of capital for an Elkridge Construction

1. Single-family homes 2. Multifamily residential 3. Commercial 4.

Low Average High Low High

Decision Accept Accept / Indifferent

1. Single-family homes 2. Multifamily residential

High Low High

Accept Reject Reject

Questions and Problems

marketing campaign. They believe that this action will result in

Initial investment = $650,000 Annual cash flows = $325,000 Length of

Net present value: Kingston, Inc. management is considering purchasing a

at a cost of $4,133,250. They expect this equipment to produce cash flows

Cost of new machine = $4,133,250 Length of project = n = 6 years Required

$814,322 $863,275 $937,250 $1,017,112 $1,212,960 $1,225,000 + + + + +

Net present value: Crescent Industries management is planning to replace

$875,123 $966,222 $1,145,000 $1,250,399 $1,504,445

Solution: Initial investment = $3,300,000 Length of project = n = 5 years

$875,123 $966,222 $1,145,000 $1,250,399 $1,504,455 + + + + (1.18)1 (1.18)

Solution: Initial investment = $312,500 Annual cash flows = $121,450

$121,450 $121,450 $121,450 $121,450 $121,450 + + + + (1.14)1 (1.14) 2

System 1 ‐15,000 15,000 15,000 15,000

System 2 ‐45,000 32,000 32,000 32,000

Solution The NPV of System 1 is $22,969.42 and the NPV of System 2 is