CH 13

Chapter 13: Capital Budgeting, Risk Considerations, and Other Special Issues
Multiple Choice Questions

1. What will probably happen if a firm does not invest effectively?
A. The firm could still maintain its competitive advantage.
B. The cost of capital of the firm will be unchanged.
C. The long-term survival of the firm will be affected.
D. The short-term performance will be unaffected.
Level of difficulty: Medium
Solution: C. If a firm fails to invest effectively, both of its short-term performance and long-
term survival will be affected. Market value of its debt and equity will decline and the cost of
capital will increase. The firm will find itself in a competitive disadvantage.
2. Which of the following is not a critical factor that Porter identified in determining industry
attractiveness?
A. Bargaining power of suppliers
B. Entry barriers
C. Rivalry among competitors
D. Bargaining power of government
Level of difficulty: Easy
Solution: D. The five factors are entry barriers, threat of substitutes, bargaining power of
buyers, bargaining power of suppliers, and rivalry among existing competitors.
3. What is the NPV for a project with an after-tax initial investment of $17,000 and five equal
cash flows of $8,000 at the start of each year, beginning with the third year? The appropriate
discount rate is 20 percent. Should it be accepted or not?
A. $2,937.41; accept.
B. $6,924.90; accept.
C. $385.49; reject.
D. $1,998.35; accept.
Solution: A
Using a financial calculator (TI BA II Plus):
[CF][2nd][CLR WORK]
17,000 [Enter][]
0 [Enter][] []
8,000 [Enter][]
5 [Enter][]
[NPV][20][Enter] []
[CPT] gives $2,937.41
4. Which of the following statements about IRR and NPV is incorrect?
A. NPV and IRR yield the same ranking when evaluating projects.
B. NPV assumes that cash flows are reinvested at the cost of capital of the firm.
C. IRR may have multiple IRRs when the sign of cash flow changes more than once.
D. IRR is the discount rate that makes NPV equal zero.
Solutions Manual 1 Chapter 13
Copyright 2008 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Solution: A.
NPV and IRR yield the same ranking when evaluating independent projects. They may have
different rankings when evaluating mutually exclusive projects.
5. When will NPV and IRR have different rankings when we evaluate two mutually exclusive
projects? IRR
A
< IRR
B.
A. Discount rate (k) < crossover rate
B. Discount rate (k) < IRR
A
C. Discount rate (k) > crossover rate
D. Discount rate (k) < IRR
B
Level of difficulty: Difficult
Solution: A. Refer to Figure 13-2. When k < crossover rate, Project A is preferred because it
has a higher NPV despite the fact that its IRR is smaller.
6. Which project(s) should a firm choose when the projects are independent? When they are
mutually exclusive? Suppose both are within the capital budget and k = 15% for both
projects.
Project A: CF
0
= $2,000; CF
1
= $1,000; CF
2
= $2,000; CF
3
= $1,500.
Project B: CF
0
= $2,000; CF
1
= $1,000; CF
2
= $1,000; CF
3
= $4,500.
A. Both projects; project A
B. Both projects; project B
C. Project B; project B
D. Neither of the projects; neither of the projects
Solution: B.
Project A: Project B:
[CF][2nd][CLR WORK] [CF][2nd][CLR WORK]
2,000 [Enter][] 2000 [Enter][]
1,000 [Enter][] [] 1,000 [Enter][] []
2,000 [Enter][] [] 1,000 [Enter][] []
1,500 [Enter][] [] 4,500 [Enter][] []
[NPV][15][Enter] [] [NPV][15][Enter] []
[CPT] gives $1,368.13 [CPT] gives $2,584.53
Since NPV of both projects are positive, we should accept both when they are independent
and are within the capital budget. However, when they are mutually exclusive, we should
accept the project with the higher NPV, which, in this case, is Project B.
7. What is the IRR of the following project? After-tax initial investment = $6,000; CF
1
= $2,500;
CF
2
= $4,000; CF
3
= $5,000. If k = 20%, should you accept the project?
A. 15%; no
B. 35.87%; yes
C. 25.65%; yes
D. 35.87%; no
Solution: B
[CF][2nd][CLR WORK]
6,000 [Enter][]
2,500[Enter][] []
4,000[Enter][] []
5,000[Enter][] []
[IRR][CPT] gives 35.87%
Since 35.87% > 20%, we should accept the project.
8. Which of the following would not happen if a firm uses WACC for all projects, regardless of
the individual risks of the projects?
A. Accept a high-risk project with negative NPV.
B. Reject a low-risk project with positive NPV.
C. Accept an average-risk project with positive NPV.
D. Reject a high-risk project with positive NPV.
Level of difficulty: difficult.
Solution: D. When a firm uses WACC for a high-risk project, which has a positive NPV
using the proper discount rate (k > WACC) will have an even higher NPV. Therefore, it is
not possible the firm will reject the project.
9. To estimate risk-adjusted discount rates, a firm could use all of the following methods, except
A. cost of capital risk premium.
B. regress ROA of the project on the ROA of the whole firm.
C. regress the ROA of the project on the ROA of market index.
D. pure play approach.
Solution: B.
10. We should reject a project if:
A. NPV > 0.
B. IRR > required rate of return.
C. discounted payback period < required period.
D. PI < 1.
Solution: D. We reject a project if NPV < 0, or IRR < required rate of return, or discounted
payback period > required period, or PI < 1. Otherwise, we accept the project.
11. State the drawbacks of payback period and discounted payback period.
Solution: Payback period doesnt take into account of the time value of money. In addition, it
does not account for the cash flows beyond the cut-off date. The choice of the cut-off date is
arbitrary.
Discounted payback period has all the drawbacks payback period has except that it accounts
for the time value of money.
12. The LargeCo has a capital budget of $100 million to invest in projects. It has evaluated six
independent projects and the results of the analysis are summarized below:
Project Initial investment NPV Salvage value
A $10 million $5 million $3 million
B $90 million $15 million $5 million
C $25 million $8 million $2 million
D $40 million $7 million $1 million
E $25 million $3 million $5 million
F $15 million $2 million $8 million
A. If the company was not capital constrained, which projects should they undertake?
B. Given their capital constraint, which projects do you recommend that they undertake?
C. How can the firm increase its capital budget?
Solution:
A. With no capital constraint, the firm should invest in all positive NPV projects; therefore, it
should invest in all the projects (A to F)
B. The firm has a total of $100 million to invest; it should maximize the NPV earned.
Alternatives:
B + A NPV = $20 million
D+C+A+E NPV = 7+8+5+3=$23 million
Recommendation: invest in projects: A, C, D and E (maximizes the NPV).
C. The firm needs to have more funds available to invest. Possible ways to increase available
capital are: cut costs elsewhere (i.e., sell unproductive assets); issue equity or debt to
raise money; or cut dividends.
13. Bert has just been hired by the Absent Minded Profs as a summer co-op student and has been
assigned to assist you. Bert is puzzled about why the Absent Minded Profs are calculating
IRR and Payback Periods for investment projects. According to Berts finance textbook,
NPV gives the best measure of the impact of a project on shareholder wealth.
A. Explain to Bert the advantages and disadvantages of Payback and IRR.
B. Which evaluation techniques are the most popular with companies (i.e. the Profs clients)?
C. Given the disadvantages and limitations of Payback and IRR, why do you think so many
CFOs continue to use them as criteria for evaluating projects?
Solution:
A. Payback period:
o determines how long it takes for the project cash flows to add up to the
investment
o useful to gauge the possible liquidity impact of the project (how long is the
firms capital tied up in the project)
o easy to calculate, quick back of the envelope type of calculation
IRR (internal rate of return)
o Determines the rate of return at which the NPV = 0. Intuitively, it is the rate of
return promised by the project
o Easy to interpret and compare to other projects
o Technically, can be very misleading (i.e. project scale, reinvestment rates,
multiple solutions)
B. The most popular approaches (according to Figure 13-3) are IRR and NPV, with Hurdle-
Rates and Payback periods next most popular.
C. Possible reasons can include:
Comfort: CFOs have been using these approaches for many years and have developed
rules of thumb based on their experience and that, they believe, help them reach
good decisions.
Intuitive nature: both the IRR and the Payback are easy to understand on an intuitive
basis. If you have to explain the decision to a large group (i.e. shareholders) with
differing levels of financial education, IRR and Payback can be an easily
understandable measure.
Ease: Payback is quick and easy to calculate
14. For each pair of investment opportunities, indicate if they are more likely to be mutually
exclusive or independent projects. Explain your choices.
A. Cruise line
i) Build a cruise ship to carry 10,000 passengers
ii) Build two ships each carrying 5,000 passengers
B. Mining company in Northern Alberta
i) Use old open pit mine for waste disposal
ii) Use old open pit mine for fishing and hunting lodge
C. University
i) Use classroom for tutorials
ii) Use classroom for faculty meetings
D. You:
i) Latte
ii) Cappuccino
E. You:
i) Salad
ii) Steak
Solution:
A. The two projects are mutually exclusive. This assumes that the cruise line needs to carry a
total of 10,000 passengers and/or the ship builder has limited capacity in its dry docks for
vessel construction.
B. The two projects are mutually exclusive. Garbage dumps and hunting lodges cant (in
general) exist in the same place.
C. This depends on your assumptions about timing. In general, one would assume that the
two projects are independent. Classroom is unlikely to be used for tutorials (or faculty
meetings) all the time and so could satisfy both projects. If one assumes that the class
room will be used exclusively for tutorials (or faculty meetings), then the two projects
will be mutually exclusive.
D. In general, these would be mutually exclusive. Most people do not mix the two drinks.
E. This depends on tastes. Some people prefer salad with steak, and others prefer to keep
them separate; therefore, the two dishes are independent.
Use the following information to answer questions 15 to 23.
The Absent Minded Profs have been hired as consultants for the BigCo Manufacturing
Company. BigCo is considering several projects and has provided the forecasted annual after tax
cash flows in Table 1.

Table 1
Annual cash flows (all amounts in $millions)
Project
A
Project
B
Project
C
Project
D
Project
E
Project
F
Project
G
Year 0 -1,000 -2,000 -8,000 -5,000 -5,000 -10,000 -3,000
Year 1 500 1,500 2,000 4,800 2,000 3,000 1,500
Year 2 1,000 1,000 2,000 1,000 3,000 2,000 1,200
Year 3 1,200 300 8,000 6,000 5,000 1,000 300
Year 4 2,500 500 2,000 -3,000 1,000 1,000
Year 5 3,000 200 2,500 -4,000 3,000 3,000
15. Assume that BigCos cost of capital for all the projects is 7 percent. Calculate the NPV, IRR,
Payback period, Discounted Payback and Profitability index for each project in Table 1. The
firm requires a payback period of 2 years and a discounted payback period of 2.5 years.
Project
A
Project
B
Project
C
Project
D
Project
E
Project F Project
G
NPV
IRR
Payback
Discounted
Payback
Profitability
index
Solution:
Discounted cash flows
Year Project
A
Project
B
Project
C
Project
D
Project
E
Project F Project
G
0 -
1,000.0
0
-
2,000.0
0
-
8,000.0
0
-
5,000.0
0
-
5,000.0
0
-
10,000.0
0
-3,000
1 467.29 1,401.8 1,869.1 4,485.9 1,869.1 2,803.74 1,401.87
7 6 8 6
2
873.44 873.44
1,746.8
8 873.44
2,620.3
2 1,746.88
1,048.13
3
979.56 244.89
6,530.3
8
4,897.7
9
4,081.4
9 816.30
244.89
4
1,907.2
4 381.45
1,525.7
9
-
2,288.6
9 762.90 762.90
5
2,138.9
6 142.60
1,782.4
7
-
2,851.9
4
2,138.9
6 2,138.96
Project AProject B Project C
Project
D
Project E Project F
Project G
NPV $5,366.48$1,044.24 $5,454.68 $116.58 $6,472.82 -$1,731.23
-$305.11
IRR 92% 34% 28% 3.5% 47% 0%
0%
Payback
period
1.5 1.5 2.5 2 2 5
3
Discounted
payback
1.6099 1.6848 2.6713 1.5885 2.1251 >5
Discounted future cash
flows do not cover initial
outlay
Profitability
index
6.37 1.52 1.68 1.02 2.29 0.83
0.90
16. If the firm is not capital constrained and the projects in Table 1 are independent, which
projects should the firm undertake using the following criteria:
A. NPV
B. IRR
C. Payback period
D. Discounted payback period
E. Are any of your recommendations, based on the above criteria, contradictory? Explain
how it would be possible.
Solution:
A. NPV: accept all positive NPV projects A, B, C, D, and E
B. IRR: accept all projects with IRR > 7% A, B, C, and E (notice that we should exclude
D from the IRR consideration due to the change in signs)
C. Payback period: Accept all projects with payback less than or equal to 2 years A, B, D
and E
D. Discounted payback period: Accept all projects with discounted payback less than or
equal to 2.5 years A, B, D and E
E. Are any of your recommendations, based on the above criteria, contradictory? Explain
how it would be possible. Yes, the payback and discounted payback did not recommend
project C. This project took longer to repay the capital invested and therefore was
rejected by the payback criteria. According to the NPV criteria, this project would be one
of the most profitable (generate a very large NPV). The reason for this contraction is that
the payback and discounted payback use arbitrary criteria; there is no economic reasoning
behind using a 2 or 2.5 year cutoff.
17. If the firm is not capital constrained and the projects in Table 1 are mutually exclusive, which
project should the firm undertake using the following criteria:
A. NPV
B. IRR
C. Payback period
D. Discounted payback period
E. Profitability index
F. Are any of your recommendations, based on the above criteria, contradictory? Explain
how it would be possible.
Solution:
A. Take the project with the greatest NPV E
B. Take the project with the greatest IRR that is greater than 7% (the firms cost of capital)
and excluding D (due to the change in signs) A
C. Take the project with the shortest payback period that is less than 2 years (Note: this
criteria is arbitrary) indifferent between A and B
D. Take the project with the shortest discounted payback period that is less than 2.5 years
(Note: this criteria is arbitrary) Project D
E. Take the project with the highest profitability index Project A
F. Many of the results are contradictory. NPV and IRR make completely different
recommendations due to scale differences in the projects. The criteria used in the payback
and discounted payback criteria are arbitrary. The profitability index recommendation is
also very different from the NPV recommendation; again, the criteria didnt take into
account the amount invested and therefore, ignored the total amount of wealth generated
by the project.
18. The BigCo Manufacturing Company is also debating whether to invest in Project G (a three
year project) with Project D. Determine which project is preferred (assuming the appropriate
cost of capital is 7 percent) using the:
A. Chain replication approach
B. Equivalent annual NPV approach
Solution:
A. Project D life = 5 years, NPV (using discount rate of 7% given earlier) = $116.58.
Project G life = 3 years, NPV = $ -305.12
Since the NPV of project G is negative, there is no point in proceeding, but the solution is
given below anyway.

Annual cash flows
Project D Project G
Initial investment -$5,000 -3,000
Year 1 4,800 1,500
Year 2 1,000 1,200
Year 3 6,000 300
Year 4 -3,000
Year 5 -4,000
The chain replication will require repeating Project D three times and Project G 5 times.
Project D:
5 10
116.58 116.58
116.58 116.58 83.12 59.26 $258.96
1.07 1.07
D
NPV + + + +
Project G:
95 . 058 , 1 $
07 . 1
12 . 305
07 . 1
12 . 305
07 . 1
12 . 305
07 . 1
12 . 305
12 . 305
12 9 6 3

+
G
NPV
The NPV of project D is greater than G, so we would choose D.
B.
Project D life = 5 years, NPV (using discount rate of 7% given earlier) = $116.58. Project
G life = 3 years, NPV = $-305.12
Project D: find the annuity of 5 years that has the same PV as the project.
N= 5, PV = 116.58, I=7%, solve for PMT. Annuity = $28.43
Project G: N=3, PV = -305.12, I=7%, solve for PMT. Annuity = -$116.27
Choose project D as it has the higher equivalent annual NPV.
19. Using Projects A to F in Table 1, construct the BigCos investment opportunity schedule. If
the BigCo has $8,000 available for investment, which projects should it undertake (assume
all projects are independent)? Justify your recommendations to the CEO of BigCo.
Solution:
We begin by determining which projects are valid possibilities by calculating the NPV of
each project. As the NPV of Project F is negative, we will eliminate it from consideration.
The investment and NPV is summarized in the following table:
Project A Project B Project C Project D Project E Project F
Initial
investment
-$1,000 -$2,000 -$8,000 -$5,000 -$5,000 -$10,000
IRR 92% 34% 28% 3% 47%
NPV $5,366.48 $1,044.24 $5,454.68 $116.58 $6,472.82 -$1,731.23
The investment opportunities available for the $8,000 budget are:
C: total NPV = $5,454.58
D+A+B: total NPV = $116.58 + 5,366.48 +1,044.24 = $6,257.30
E+A+B: total NPV = $6,472.48 +5,366.48+1,044.24 = $12,883.20
Recommendation: that the BigCo invest in projects A, B and E as this results in the greatest
increase in wealth for the firm (maximizes the NPV).
20. The CFO of BigCo is concerned about the sensitivity of his decisions to the choice of
discount rate. For projects A, C and E, plot the NPV profiles on the same graph. Does the
NPV ranking of the three projects remain the same for every possible discount rate? Explain
your observations.
Solution:
In the plot of the three NPV profiles we can see that the NPV ranking of the three projects
does not remain constant as discount rates increase. For very low discount rates, Project E
dominates A and C; while for very high discount rates, Project A dominates. The reason for
the change in rankings is due to the timing of the cash flows and the scale of the investment.
For very low discount rates, the higher investment required by Project E is offset by the later,
relatively large cash flows. In contrast, when interest rates are very high, cash flows received
in the future have very low present values and the relative initial investments dominate (A
requires a much lower initial investment than E) hence, A dominates E.
NPV profiles of Projects C, A and E
-$4,000
-$2,000
$0
$2,000
$4,000
$6,000
$8,000
$10,000
0 0.1 0.2 0.3 0.4 0.5
Discount rates
N
P
V
Project C Project A Project E
21. Calculate the crossover rate for projects B and C from Table 1.
Solution:
To determine the crossover rate, determine the discount rate at which the NPV of the two
projects are equal. One way to solve this is to determine the incremental cash flows and then
solve for the IRR.
Project Annual cash flows
Incremental
cash flows:
B-C
Project B Project C
Initial
investment -$2,000 -$8,000 $6,000
Year 1 1500 2,000
-$500
Year 2 1000 2,000
-$1,000
Year 3 300 8,000
-$7,700
Year 4 500 2,000
-$1,500
Year 5 200 2,500
-$2,300
The IRR of the incremental cash flows is: 27.31%
To check your result, plot the NPV profiles of the two projects and we can see that the two
profiles cross at approximately 27% (hard to see exactly on the graphhence we need the
calculation)

NPV profiles of B and C
-$4,000
-$2,000
$0
$2,000
$4,000
$6,000
$8,000
$10,000
0 0.1 0.2 0.3 0.4 0.5
Discount rates
N
P
V
Project B Project C
22. The Absent Minded Profs have conducted an analysis of BigCo and have found that the firm
is made up of two different divisions: SatellitesRUs (a satellite launching service) and a
bank. Projects A to G are all related to satellite launching technology. The Absent Minded
Profs have also examined the industry of each division and found the following:
Firm Industry Cost of capital
Crashn Burn Satellite Launching 27%
Liddys Launchers Satellite Launching 20%
Reliable Bankers Banking 5%
Reliance Bank Banking 4%
VBigCo Satellite Launching and
Banking
10%
A. What is the appropriate discount rate for projects A to G? Describe your assumptions.
B. What will be the impact on the shareholder value of BigCo if the firm used 7 percent, the
overall WACC, in the valuation of the satellite launching projects (A to G)?
Solution:
A. As projects A to G are related to satellite launching, we will compute the cost of capital by
considering only those firms in the satellite launching industry (they are the closest to the
nature of the project). The average cost of capital of the two firms that are in only satellite
launching (Crashn Burn and Liddys Launchers) is 23.5%.
B. Shareholder value would decrease. The firm would be accepting projects that are too
risky; shareholders are demanding a return of 7% for projects that have a risk profile that
is comparable to a mix of very risky (satellite launching) and safe (banking). However,
the project is very risky and the firm should only accept projects that provide an
appropriate risk adjusted rate of return; failing to do so will increase the riskiness of the
firm without a compensating increase in expected returns.
23. The CEO of BigCo has just bought a fancy financial calculator and calculated the IRR and
NPV of Project D from Table 1 and is utterly confused. His calculator is telling him that the
IRR is 26 percent, but when he uses a cost of capital of 1 percent, the NPV is negative. The
CEO expects that if the IRR is greater than the cost of capital then the NPV should be
positive. How are the CEOs observations possible? Hint: See the NPV profile of Project D.
Solution:
Yes this is possible. Project D is an example of a project with more than one change of sign
so we can have multiple IRRs implying that we cant rely on the standard result of
decreasing the discount rate will increase the NPV. We can see this behaviour graphically in
the NPV profile of project D:
24. For the following decisions, indicate whether they are examples of a bottom up analysis or
a top down analysis
A. Replacing the printing press at a newspaper
B. A newspapers decision to sell all its print services and move into on-line data services
C. A pharmaceutical companys research investment in developing a cholesterol drug
D. A car companys research investment in developing a cholesterol drug
E. Your decision to take an English literature elective rather than a sociology elective this
semester
F. Your decision to do a degree in business rather than medicine
Solution:
A. Bottom up
B. Top down
C. Bottom up (unless this reflects a change in the strategic direction of the firm)
D. Top down
E. Bottom up
F. Top down
25. Cutler Compacts will generate cash flows of $30,000 in year one, and $65,000 in year two.
However, if they make an immediate investment of $20,000, they can expect to have cash
streams of $55,000 in year one and $63,000 in year two instead. The appropriate discount
rate is 9 percent.
A. Calculate the NPV of the proposed project.
B. Why would IRR be a poor choice in this situation?
Solution:
A. To determine the NPV of the project we need to determine the incremental cash flows:
Year
Projected
cash flow
Current
cash flow
Projected current
cash flows
0 -20,000 -20,000
1 55,000 30,000 25,000
2 63,000 65,000 -2,000
The NPV of the project is $1,252.42
B. The IRR is a poor choice due to the change in the signs of the incremental cash flows.
This may result in multiple IRRs.

26. Frank is evaluating two investmentinvestment 1 has a Profitability Index (PI) of 2.4 while
investment 2 has a PI of 1.2. As these investments are mutually exclusive, Frank is
recommending investment 1. The Chairman of the Board of BigCo has asked for your
comments on Franks recommendation.
Solution: The PI is calculated as the ratio of the PV of inflows to the PV of outflows. As the
firm must choose between the two mutually exclusive projects, the firm would prefer the
project with the greatest NPV. The PI provides a relative ranking of the two projects, but not
a measure of the absolute increase in wealth generated by the two projects. If the PV of the
cash outflows is approximately the same for the two projects, then using the PI provides a
sound decision. However, what if the PV of cash outflows for project 1 is $100 while the PV
of cash outflows of project 2 is $1 million (in other words, the amount invested differs
substantially between the two projects). The NPV of project 1 will be 2.4*100 100 =
$2,300 while the NPV of project 2 will be $200,000. The firm will generate the greatest
wealth by selecting project 2. Franks recommendation is incomplete. The firm needs to
consider more than the PI in choosing projects.
27. Fred is evaluating two investmentsinvestment 1 will produce cash flows for the next 5
years and has an NPV of $1,000. Investment 2 will produce cash flows for the next 15 years
and has an NPV of $700. Based on this analysis Fred recommends investment 1. Discuss
whether this conclusion is appropriate.
Solution:
The two projects do not have the same lifetimes and therefore, either a chain-replication or
EANPV analysis needs to be done to determine which project is better.
In this case, however, we can reach a conclusion using the chain approach and comparing the
NVP of investment 1 and the NPV of investment 2:
( ) ( ) {
5 10
NPV(Investment2)
NPV(Investment1)
1, 000 1, 000 700
1, 000 0
1 1 i i
+ + >
+ +
1 4 4 442 4 4 4 43
As long as the discount rate is greater than or equal to zero, the NPV of investment 1 will be
greater than investment 2 and Freds conclusion is appropriate.
However, what would you conclude if the NPV of investment 2 was $2,000? Now the choice
between investments 1 and 2 will depend on the discount rate.
28. Given Project A: CF
0
= $23,000; CF
1
= $6,000; CF
2
= $9,000; CF
3
= $15,600
Project B: CF
0
= $20,000; CF
1
= $4,000; CF
2
= $8,000; CF
3
= $15,000.
What is the crossover rate (r)?
Solution:
Crossover rate is the discount rate that makes the NPVs of both projects be the same.

20000
) 1 (
15000
) 1 (
8000
) 1 (
4000
23000
) 1 (
15600
) 1 (
9000
) 1 (
6000
3 2 1 3 2 1

+
+
+
+
+

+
+
+
+
+ k k k k k k
We can write it in this way to mirror a single projects cash flows:
0 3000
) 1 (
600
) 1 (
1000
) 1 (
2000
3 2 1

+
+
+
+
+ k k k
[CF][2nd][CLR WORK]
3,000 [Enter][]
2,000 [Enter][] []
1,000 [Enter][] []
600 [Enter][] []
[IRR] [CPT] gives 12.24%.
If you use 12.24% to calculate NPVs of both projects, you will get the same NPV of
$522.47.
29. If NPV of a project = $5,090 and its after-tax initial investment is $10,050, what is its PI?
Should the firm accept the project? Does PI yield the same decision as NPV? (Assume all the
cash flows except for the initial investment are inflows.)
Solution:
PI = PV (cash inflows)/ PV (cash outflows)
NPV = - 10,050 + PV (cash inflows)
PV (cash inflows) = NPV + 10,050 = 5,090 + 10,050 = $15,140
PI = 15,140/10,050 = 1.51
Since PI > 1, we accept the project.
Since NPV > 0, we accept the project as well.
Therefore, in this case, PI and NPV have the same decision.
30. SK Inc. has two projects as follows:
Projects Initial CF CF1 CF2 CF3 CF4
A 2,500 800 1,200 900 2,000
B 3,000 750 1,500 1,000 4,000
If SK set 2.6 years as a cut-off period for screening projects, which projects will be selected,
using the payback period method?
Solution:
Project A:
2500 (800 + 1,200) = 500
500 900 = 0.56
Payback period = 2 + 0.56 = 2.56 years.
Project B:
3000 (750 + 1500) = 750
750 1,000 = 0.75
Payback period = 2 + 0.75 = 2.75 years.
Since Payback Period
A
< 2.6 years < Payback Period
B
, Project A will be selected.
31. Which project(s) will be selected if a company uses the discounted payback period method in
Problem 30 and the discount rate is 12 percent?
Solution:
Projects Initial CF CF1 CF2 CF3 CF4
A 2,500 800 1,200 900 2,000
discounted CF 714.2857 956.6327 640.6022 1,271.036
B 3,000 750 1,500 1,000 4,000
discounted CF 669.6429 1,195.7908 711.7802 2,542.072
Project A:
2,500 714.2857 956.6327 640.6022 = 188.4794
188.4794 1271.036 = 0.15
Discounted Payback Period
A
= 3 + 0.15 = 3.15 years.
Project B:
3,000 669.6429 1195.7908 711.7802 = 422.7861
422.7861 2,542.072 = 0.17
Discounted Payback Period
B
= 3 + 0.17 = 3.17 years.
Since both projects discounted payback periods > 2.6 years, neither project will be selected.
32. State the decision rules for NPV, IRR, PI and the discounted drawback period. List two
possible consequences of using IRR.
Solution:
Accept the project if: NPV > 0, or IRR > required rate of return, or PI >1, or discounted
drawback period < the cut-off period.
There might be two IRRs if the sign of cash flows change direction. Moreover the higher
IRR project may have a lower NPV, and vice-versa, depending on the appropriate discount
rate, and also depending on the size of the project.
33. What are independent projects? What are mutually exclusive projects?
Solution:
Independent projects are those that have no relationship with one another. A firms decision
to accept one project has no impact on its decision to accept another project that is
independent of it. The decision rule is to accept projects whenever NPV > 0 or IRR > k, or PI
> 1 assuming no capital constraints.
Mutually exclusive projects are those that we must choose between two or more alternatives.
Therefore simply using the decision rules for independent projects may not be sufficient.
Ranking the projects is the best way to choose the one with the highest NPV based on the
same time horizon.
34. Briefly explain the pure-play method for estimating beta.
Solution:
Pure play approach involves finding the beta of a company that operates almost exclusively
(i.e., pure play) in the industry associated with the project under consideration and adjusting
this companys beta for the leverage associated with that company.
35. MedCo is a large manufacturing company, currently uses a large printing press in its
operations and is considering two replacements: the PDX341 and PDW581. The PDX costs
$500,000 and has annual maintenance costs of $10,000 for the first 5 years and $15,000 for
the next 10 years. After 15 years, the PDX will be scrapped (salvage value is zero). In
contrast the PDW can be acquired for $50,000 and requires maintenance of $30,000 a year
for its 10 year life. The salvage value of the PDW is expected to be zero in 10 years.
Assuming that MedCo must replace their current printing press (it has stopped functioning),
has a 10 percent cost of capital and all cash flows are after tax, which replacement press is
the most appropriate?
Solution:
First, note that the life of the two projects is not the same and consequently, we need to do
more than just take the present value of each project. Second, note are the costs; we will be
making the lowest cost choice.
There are two approaches: chain replication and the equivalent annual NPV approach.
The NPV of PDX341:
= -500,000
+ PV of 5 year annuity of -10,000 at 10%
+ PV of 10 year annuity of -15,000 at 10 % discounted back another 5 years at 10%
Formula:
5 10
5
1 1
1 1
1.10 1.10
500, 000 10, 000 10, 000 / 1.1
.1 .1
500, 000 10, 000*3.7908 10, 000*6.1446 / 1.6105
$576, 061.3685
_ _ 1 1

1 1
+ +

1 1

1 1

] ] , ,

BAII+: using the CF worksheet:
CF0 = 500,000
C01 = 10,000
F01 = 5
C02 = 10,000
F02 = 10
NPV I=10, solve for NPV = $576,060.7951
NPV of PDW581:
BAII+: using the CF worksheet:
CF0 = 50,000
C01 = 30,000
F01 = 10
NPV I=10, solve for NPV = $234,337.0132
Approach 1: The Chain Approach:
PDX (repeats twice):
15
576, 060.7951
576, 060.7951
1.1
576, 060.7951 38, 404.0530
$614, 464.8481
+

PDW (repeats three times):
10 20
234, 337.0132 234, 337.0132
234, 337.0132
1.1 1.1
234, 337.0132 90, 347.0629 34,832.7038
$359, 516.7799

+ +

Based on this analysis, we would prefer PDW as its cost is lower.
Approach 2: Using the EANPV approach:
15
576, 060.7951 576, 060.7951
$113, 605.7734
1 5.0707
1
1.1
.15
PDX
EANPV

_

,
Using the BAII+ for the PDW project:
N= 10, I/Y= 10, PV = -234,337.0132 solve for PMT.
PMT = -$38,137.2697 (note: the BAII+ will give you PMT as a positive, as we are
dealing with outflows, we have to change the sign of the pmts).
Using the EANPV approach, we prefer the PDW machine (lower cost).
36. Malcolm, a very junior reporter, has asked for your help with his first article in a major
national newspaper. He has provided you with the following excerpt from his article and
would like your comments:
The BathGate Group, one of the few all equity firms left in Canada, has recently
built a Widget manufacturing plant in Whitby. The firm has invested $1 million
and according to our sources the promised return on the investment (IRR) is
over 27 percent! The shareholders of the firm must be ecstaticthey are
currently only require a return of 10 percent. Just thinkin 10 years the value
of the plant is expected to be close to $11 million
A. What is Malcolm assuming about the reinvestment rate? Does it make sense?
B. What is Malcolm assuming about the riskiness of the project? Are the shareholders
necessarily happy with this decision?
Solution:
A. Malcolm is assuming that the investors (or the company) will be able to reinvest any cash
generated by the project at 27%. If the investors required a return of 10%, it would seem
unlikely that they will be able to find another project that pays 27% with the same risk.
For example: investors require 10% for a project with a risk of X. Malcolm is assuming
that the investors can find another project with risk X that returns 27%. This is unlikely.
B. Malcolm is assuming that the risk of the project is the same as the risk of the firm. If the
risk is much higher, this is likely given the high promised rate of return; the investors
may be very unhappy. For example, if they require a return of 30% for projects with a
comparable level of risk, then they will be very unhappy with the firm accepting a project
that is only expected to return 27%.

37. The Longlife Company is considering an investment in the Ponce Leon Mineral Baths. The
investment has the same risk characteristics as the firm. It is assumed that all cash flows are
assumed to be perpetuities and that there are no taxes. Currently the firm has cash flows of
$1,000 a year with required debt payments of $300 per year. The current market value of the
firm (debt plus equity) is $13,000. The firm is considering investing $5,000 in a project that
will generate $610 a year forever. Assume that the firm can continue to borrow at 5 percent.
A. Should the firm undertake the investment?
B. Demonstrate that the investment will increase/decrease shareholder value (show impact on
cash flows to debt holders and equity holders)
Solution:
A. Begin by determining the required rate of return (WACC) for the firm. The firm
generates $1,000 per year which is used to satisfy the shareholders and the debt holders.
The combined value of the firm is $13,000 implying that the WACC of the firm is:
$1,000/$13,000 = 7.6923%
The NPV of the project is $610/.076923 $5000 = $2,930. As this is a positive NPV, the
firm should accept the project.
Alternative approach: the expected return on the project is $610/$5,000 = 12.2%. As the
expected return is greater than the required, the firm should accept the project.
B. To demonstrate the impact on the cash flows to shareholders and debt holders begin by
determining the capital structure of the firm (to determine how much of the $5,000 will
be financed by borrowing).
The firm makes annual debt payments of $300 and its cost of debt is 5%, so the market
value of the debt is $300/0.05 = $6,000. The equity value is then $7,000.
To maintain the same capital structure, the firm will finance (7,000/13,000)($5,000) =
$2,692.31 using equity, and the remaining $2,307.69 (i.e., $5,000 - $2,692.31) using debt.
Therefore, at a 5% borrowing rate, the firm will have to pay $115.38 (i.e., $2,307.69 .
05) per year in associated interest payments. So, the remaining additional $494.62 (i.e.,
$610 - $115.38) belongs to the equityholders.
Now, we can determine the required rate of return on equity as follows:
WACC equals 7.6923%, so we can solve for k
e
as follows:
7.6923 = (6,000/13,000)(5%) + (7,000/13,000) k
e
(7,000/13,000) k
e
= 7.6923 2.3076 = 5.3846%
So, k
e
= (13,000/7,000) (5.3846%) = 10.00%
So, the shareholder value will be enhanced since the annual (perpetual) return on the
extra $2,692.31 of equity equals $494.62 / $2,692.31 = .1837, which is greater than the
required return on equity of 10%.

38. The analysis of a two division company (DV2) has indicated that the beta of the entire
company is 1.35. The company is 100 percent equity funded. The company has two
divisions: Major League TV (MLTV) and Minor League Shipping (MLS) which have very
different risk characteristics. The beta of a pure-play company comparable to MLTV is 1.85
while for MLS the beta of a comparable pure-play is only 0.75. The risk free rate is 3 percent
and the market risk premium is 5 percent. Assume all cash flows are perpetuities and the tax
rate is zero.
A. Calculate the cost of capital of the entire company.
B. The company is evaluating a project that has the same type of risk as MLTV. The project
requires an initial investment of $10,000 and pays $1,000 per year forever. Should the
company undertake this project? Why or why not?
Solution:
A. Required return on the entire company is determined using the beta of the firm: 3% +
1.35*5% = 9.75%. As the firm is 100% equity financed, we dont have to worry about
the cost of debt.
B. To answer this question first address the fact that the project is of the same risk class as
MLTV and therefore we need to determine the required rate of return for MLTVs assets.
Using the comparable firms beta of 1.85, we find the required return is 3% + 1.85*5% =
12.5%. As the expected return on the project is only 10%, the company should not
undertake the project.
Note: We cannot use the WACC for the entire company to evaluate this project. The risk
of the project is not the same as the risk of the overall firm.
39. Westlake Corp. has a capital structure that has 60 percent debt at a cost of 12 percent and 40
percent equity. Westlakes stock has a beta of 1.2. Market risk premium = 8% and risk-free
rate = 5%. The firm has a potential project on hand, which requires an initial investment of
$120,000 and generates an annual year-end cash flow of $37,500 for five years. Calculate the
IRR of this project. Decide if the project should be accepted or not, assuming the project is
less risky than the firm. T
c
= 40%.
Solution:
r
e
= 5% + 1.2(8%) = 14.6%
WACC = 12% (0.6)(1 -.40) + (14.6%) (0.4) = 10.16%
Cost of capital (project) = 10.16% (WACC)
[CF][2nd][CLR WORK]
120,000 [Enter][]
37,500 [Enter][]
5 [Enter][]
[IRR][CPT] gives 16.99%
Since 16.99% > 10.16% > cost of capital of the project, accept the project.
40. A project has an NPV of $50,000. Calculate the cost of capital of this project if it generates
the following cash flows for 6 years after an initial investment of $200,000:
Year 1: $50,000
Year 2: $50,000
Year 3: $30,000
Year 4: $80,000
Year 5: $60,000
Year 6: $70,000
Solution:
NPV CF
k
CF
k
CF
k
CF
CF
k
CF
k
CF
k
CF
NPV
+
+
+
+
+
+
+
+
+
+
+
+
0 3
3
2
2
1
1
0 3
3
2
2
1
1
...
) 1 ( ) 1 ( ) 1 (
0
...
) 1 ( ) 1 ( ) 1 (
Using a financial calculator (TI BA II Plus) to calculate k by using the same method of
calculating IRR:
CF
0
NPV= -50,000 200,000 = 250,000 and use 250,000 as an initial investment
[CF][2nd][CLR WORK]
-250000 [Enter][]
50000 [Enter][]
50000 [Enter][] []
30000 [Enter][] []
80000 [Enter][] []
60000 [Enter][] []
70000 [Enter][] []
[IRR][CPT] gives 8.82%.
Therefore, for this project, 8.82% is actually the cost of capital, k.
To test 8.82%:
965 , 49
000 , 200 155 , 42 319 , 39 050 , 57 281 , 23 223 , 42 947 , 45
000 , 200
) 0882 . 1 (
70000
) 0882 . 1 (
60000
) 0882 . 1 (
80000
) 0882 . 1 (
30000
) 0882 . 1 (
50000
0882 . 1
50000
...
) 1 ( ) 1 ( ) 1 (
6 5 4 3 2
0 3
3
2
2
1
1
+ + + + +
+ + + + +
+
+
+
+
+
+
CF
k
CF
k
CF
k
CF
NPV
(Rounding error)
41. Based on the cash flows given below, calculate the PI of a project that has a required rate of
return of 15 percent. Also, indicate whether the project should be accepted.
Year 0: -$90,000
Year 1: $20,000
Year 2: $40,000
Year 3: -$15,000
Year 4: $100,000
Solution:
1 05 . 1
863 , 99
812 , 104
863 , 99 000 , 90
15 . 1
000 , 15
812 , 104 175 , 57 246 , 30 391 , 17
15 . 1
000 , 100
15 . 1
000 , 40
15 . 1
000 , 20
3
4 2
>
+
+ + + +
PI
PV
PV
PV
PV
PI
s CahOutflow
s CashInflow
w CashOutflo
s CashInflow
Accept the project.
42. GiS Inc. has the following four projects on hand:
Projects Initial CF Accum.CF
1
Accum.CF
2
Accum.CF
3
Accum.CF
4
#1 15,067 3,385 8,965 14,078 21,495
#2 14,543 2,578 6,865 12,095 19,067
#3 8,565 3,097 5,674 9,883 15,688
#4 6,500 2,955 4,985 4,985 12,000
Given R
f
= 5%, ER
m
= 12%, firm-beta = 1.2, after-tax cost of debt = 6.5%. The firm is
financed by 40 percent debt and 60 percent equity. Project 1, 2, and 3 have the same capital
structure as the firm, while project 4 has 1 percent risk premium. Calculate the cost of capital
for the four projects using the following methods:
A. The payback period: If cut-off period for screening projects 1 and 2 = 3.5 years vs. for
project 3 = 2.25 years, which project(s) should be rejected?
B. The discounted payback period method: If cut-off period for screening project 4 = 3.25
years, should it be accepted?
Solution:
r
e
= 5% + (1.2)(12% - 5%) = 13.4%
WACC = (13.4%)(60%) + (6.5%)(40%) = 10.64%
r
1
= r
2
= r
3
= 10.64%
r
4
= 10.64% + 1% = 11.64%
Project #1: n = 3 + (15,067 14,078)/ 21,495 = 3.05 years < 3.5 years
Project #2: n = 3 + (14,543 - 12,095)/ 19,067 = 3.13 years < 3.5 years
Project #3: n = 2 + (8,565- 5,674)/ 9,883 = 2.29 years > 2.25 years
Therefore, project #3 is rejected.
Project #4:
Year 1: 2,955/(1.1164) = 2,647
Year 2: (4,985 2,955)/(1.1164)
2
= 1,629
Year 3: 0
Year 4: (12,000 4,985) /(1.1164)
4
= 4,516
n = 3 + (6,500 2,647 1,629 - 0)/4,516 = 3.49 > 3.25 years
Therefore, project #4 should not be accepted.
43. Gis Inc now has the following two projects available:
Projects Initial CF
After-tax
CF
1
After-tax
CF
2
After-tax
CF
3
#1 12,095 5,500 6,000 9,500
#2 3,080 3,450 3,000
Assume that R
f
= 5%, risk premium = 10%, beta = 1.2. Use the chain replication approach to
determine which project(s) Gis Inc. should choose if they are mutually exclusive.
Solution:
Cost of capital (r) = 5% + 10% = 15%
471 , 3 095 , 12 566 , 15 095 , 12
) 15 . 1 (
500 , 9
) 15 . 1 (
000 , 6
) 15 . 1 (
500 , 5
3 2 1 1
+
1
]
1
+ + NPV
188 , 2 080 , 3 268 , 5 080 , 3
) 15 . 1 (
000 , 3
) 15 . 1 (
450 , 3
2 1 2
+
1
]
1
+ NPV
Only one of the projects can be chosen.
753 , 5 $ 282 , 2 471 , 3
) 15 . 1 (
471 , 3
471 , 3
3 1
+
1
]
1
+ NPV
093 , 5 $ 251 , 1 654 , 1 188 , 2
) 15 . 1 (
188 , 2
) 15 . 1 (
188 , 2
188 , 2
4 2 2
+ +
1
]
1
+ + NPV
Therefore, project #1 should be chosen.
44. Solve Problem 43 using EANPV and assuming market risk premium = 10%.
Solution:
Cost of capital = 5% + 1.2(10%) = 17%
920 , 2 095 , 12
) 17 . 1 (
500 , 9
) 17 . 1 (
000 , 6
) 17 . 1 (
500 , 5
3 2 1 1

1
]
1
+ + NPV
060 , 2 080 , 3
) 17 . 1 (
000 , 3
) 17 . 1 (
450 , 3
2 1 2

1
]
1
+ NPV
Solving the problem by financial calculator (TI BA II Plus):
Project #1: FV = 0; PV = 2,920; n = 3; I/Y = 17; Compute PMT = -1,322 or, $1,322.
Project #2: FV = 0; PV = 2,060; n = 2; I/Y = 17; Compute PMT = -1,300 or, $1,300.
Therefore, project #1 should be chosen, which is the same result as Problem 43.
45. SK Inc. has a project that requires $50,000 after-tax initial investment and produces these
after-tax cash flows at each year-end: $18,000; 20,000; $5,000; $40,050; $58,000;
$20,000. The appropriate domestic discount rate is 19.4 percent. The project is in another
developing country, where extra risk is assumed to be 4.6 percent. Calculate the projects
NPV. Should SK Inc. accept or reject the project?
Solution: WACC = (0.8)(18%) + (1 0.8)(25%) = 19.4%
Project discount rate (k) = WACC + risk premium = 19.4% + 4.6% = 24%
[CF][2nd][CLR WORK]
50,000 [Enter][]
18,000 [Enter][] []
20,000 [Enter][] []
5,000 [Enter][] []
40,050 [Enter][] []
58,000 [Enter][] []
20,000 [Enter][] []
[NPV][24][Enter] []
[CPT] gives $17,127.06
Since NPV > 0, SK Inc. should accept the project.
46. Calculate NPV and IRR of the following project and check whether they produce the same
decision. After-tax initial investment = $66,777; after-tax cash flows at each following six
year ends are all $20,000. The year-end cash flow at year 7 is $40,000. Assume k = 18%.
Solution:
[CF][2nd][CLR WORK]
66,777 [Enter][]
20,000 [Enter][]
6 [Enter][]
40,000 [Enter][] []
[NPV][18][Enter] []
[CPT] gives $15,732.05
Since NPV > 0, we should accept the project.
[CF][2nd][CLR WORK]
66,777 [Enter][]
20,000 [Enter][]
6 [Enter][]
40,000 [Enter][] []
[IRR][CPT] gives 25.35%.
Since IRR > k, we should accept the project.
Therefore, NPV and IRR yield the same decision.
47. A firm is considering two mutually exclusive projects as follows. Determine which project
should be accepted if the discount rate is 15 percent. Use the chain replication approach.
Assume both projects can be replicated.
Projects Initial CF CF1 CF2 CF3
A 5,000 2,500 4,050 0
B 3,000 750 1,750 2,000
Solution:
Project A:
[CF][2nd][CLR WORK]
5,000 [Enter][]
2,500 [Enter][][]
4,050 [Enter][][]
[NPV][15][Enter][]
[CPT] gives $236.29.
Project B:
[CF][2nd][CLR WORK]
3,000 [Enter][]
750 [Enter][][]
1,750 [Enter][][]
2,000 [Enter][][]
[NPV][15][Enter][]
[CPT] gives $290.46.
Replicate Project A three times:
29 . 550 $ 16 . 135 74 . 178 39 . 236
) 15 . 1 (
39 . 236
) 15 . 1 (
39 . 236
39 . 236
4 2
+ +
1
]
1
+ +
A
NPV

Replicate Project B twice:
44 . 481 $ 98 . 190 46 . 290
) 15 . 1 (
46 . 290
46 . 290
3
+
1
]
1
+
B
NPV
NPV
A
> NPV
B
, therefore choose Project A.
48. Redo Problem 47 using EANPV approach.
Solution:
From Problem 47, we get NPV
A
= $236.39; NPV
B
= $290.46
Project A:
N = 2, I/Y = 15, PV = -236.39, FV = 0, CPT PMT = 145.41
Project B:
N = 3, I/Y = 15, PV = -290.46, FV = 0, CPT PMT = 127.21
PMT
A
> PMT
B
, therefore choose Project A.
49. Assume that SK Inc. has a capital budgeting of $ 200,000. In addition, it has the following
projects for evaluation. Determine which project(s) should be chosen, assuming k = 13%.
Projects Initial CF CF
1
CF
2
CF
3
A 100,000 80,000 80,000
B 75,000 50,000 60,000 70,000
C 120,000 55,000 100,000 80,000
Solution:
First calculate each projects NPV:
Project A:
[CF][2nd][CLR WORK]
100,000 [Enter][]
80,000 [Enter][][]
80,000 [Enter][][]
[NPV][13][Enter][]
[CPT] gives $33,448.19.
Project B:
[CF][2nd][CLR WORK]
75,000 [Enter][]
50,000 [Enter][][]
60,000 [Enter][][]
70,000 [Enter][][]
[NPV][13][Enter][]
[CPT] gives $64,750.10.
Project C:
[CF][2nd][CLR WORK]
120,000 [Enter][]
55,000 [Enter][][]
100,000 [Enter][][]
80,000 [Enter][][]
[NPV][13][Enter][]
[CPT] gives $62,431.25.
Combinations Total budget Total NPV Within the budget?
A & B 175,000 98,198.29 Yes
A & C 220,000 95,879.44 No
B & C 195,000 127,181.35 Yes
Therefore, SK should choose Projects B and C because the total NPV is the greatest and the
total budget is within $200,000.
Legal Notice
Copyright
Copyright 2008 by John Wiley & Sons Canada, Ltd. or related companies. All rights reserved.
The data contained in this file is protected by copyright. This manual is furnished under licence and may
be used only in accordance with the terms of such licence.
The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified,
made available on a network, used to create derivative works, or transmitted in any form or by any
means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written
permission of John Wiley & Sons Canada, Ltd.
Note: Permission to post online obtained on December 10, 2007.

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CH 13

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Chapter 13: Capital Budgeting, Risk Considerations, and Other Special Issues

Multiple Choice Questions

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