Chapter 10

CAPITAL BUDGETING DECISION CRITERIA AND REAL OPTION CONSIDERATIONS

ANSWERS TO QUESTIONS:
1. The net present value method computes the present worth of a project's benef
its over its costs, and is evaluated by using the firm's cost of capital. If a
project has a positive net present value it means that investors are receiving t
he minimum required rate of return, as measured by the cost of capital, plus the
y are receiving something extra. This positive net present value is an addition
al increment to shareholder wealth.
2. In the case of mutually exclusive investments it is possible for the net pre
sent value and internal rate of return approaches to give conflicting rankings.
This is most likely to occur when the two or more projects being considered are
significantly different in size or have very different patterns of cash flows.
3. Multiple rates of return are likely to occur when a project's cash flow stre
am contains more than one sign change (from positive to negative or negative to
positive). Under these circumstances it is best to use the net present value ap
proach.
4. The profitability index defines the number of dollars of present value benef
its that are received for each dollar of net investment. Hence it provides a me
asure of relative profitability. This measure can be used to guide a ranking of
investment projects in a capital rationing situation (see Table 9-5).
5. Strengths: Easy to use; may be used to consider a project's risk or its liq
uidity.
Weaknesses: Does not consider cash flows beyond payback period; ignores time va
lue of money; provides no objective criterion for decision making.
6. The objectives of a project post-audit/review are:
a. To identify systematic biases or errors in the cash flow estimates b
y individuals,
departments, plants or divisions. This analysis enables
decision makers to make better
evaluations of investment proposals subm
itted in the future.
b. To determine whether a project which has not lived up to expectation
s should be
continued or abandoned.
7. In an inflationary environment, the level of capital expenditures by private
firms tends to decrease, because the cost of capital generally increases with i
nflation. It is possible that in some cases inflation might increase projected
revenues from a project more than projected costs, thereby offsetting the increa
sing cost of capital. To the extent that this is not the case, there will be a
decline in capital investments.
8. The major problem is placing a dollar value on all costs and benefits genera
ted by a project. There tends to be more intangible costs and benefits in these
types of projects. This makes analysis more difficult and less precise.
9. MACRS pushes the tax benefits of the project forward to the first 8 years of
the project's life, thereby increasing the project's after-tax net cash flows i
n the early years and making it a more attractive investment.
SOLUTIONS TO PROBLEMS:
1. NPV = -$20,000 + $3,000(PVIFA0.12,10)

= - $20,000 + $3,000(5.650) = -$3,050

PI = $3,000(5.650)/$20,000 = 0.85
The project is not acceptable because it has a negative NPV and a PI of
less than 1.0.
2.

a. Net Present Value

Year
0
1
2
3
4
5
6
7
8

Cash Flows
PVIF @ 12%
-$30,000
1.000 -$30,000
5,000 0.893 4,465
8,000 0.797 6,376
9,000 0.712 6,408
8,000 0.636 5,088
8,000 0.567 4,536
5,000 0.507 2,535
3,000 0.452 1,356
-1,500 0.404 -606
Net Present Value
$158

Present Value

b. Because the project has a positive NPV it should be accepted.

c. The value of the firm, and therefore the shareholders wealth, is incr
eased by $158 as a result of undertaking the project.
3.

Net investment = $8,000

NCF1-10 = ( R - O - Dep)(1 - T) + Dep
= (0 - (-$1,554) - $800)(1 - .4) + $800 = $1,252.40
$8,000 = $1,252.40(PVIFAi,10)
PVIFAi,10 = 6.388 (From Table IV, r is between 9% and 10%)
(9.11% using a calculator)

4.

Net investment = $375,000

a. NPV = -$375,000 + $80,000(PVIFA0.12, 9) + [$80,000 + $75,000
+ $100,000(1 - 0.4)] (PVIF0.12,10)
= - $375,000 + $80,000(5.328) + $215,000(0.322)
= $120,470
b. The project is acceptable, because its NPV is positive.
c. The value of the firm, and therefore the shareholders wealth, is incr
eased by $120,470 as a result of undertaking this project.
d. The IRR of this project is 18.71% using a calculator.
e. The net present value calculation assumes the net cash flows are rei
nvested
at 12%, the projects required return. The internal rate of retur
n calculation assumes the net cash flows are reinvested at18.71%, the projects
IRR.
5.
6.

7.

$12,000 = PV0(FVIF0.15,25) = PV0(32.919); PV0 = $364.53

After tax cost of net investment:
$100,000(1 - 0.4) = $60,000
NPV = -$60,000 + $10,000(PVIFA0.12,10)
+ $22,000(PVIFA0.12,10)(PVIF0.12,10)
= -$60,000 + $10,000(5.650) + $22,000(5.650)(0.322)
= $36,525
a. Project A: $20,000 = $10,000(PVIFAi,4)
PVIFAi,4 = 2.000
i = 34.9% from Table IV
Project B: $20,000 = $60,000(PVIFi,4)
PVIFi,4 = 0.333
i = 31.6% from Table II
b. NPVA = -$20,000 + $10,000(3.17) = $11,700
NPVB = -$20,000 + 60,000(0.683) = $20,980

c. Project B should be chosen because it has the higher NPV. It is assu

med
that the firm s reinvestment opportunities are more accurately represent
ed by the firm s cost of capital than by the unique internal rate of return of
either
project in this case.
8.

a. 0%: NPV = -$1,000 + $6,000/(1+0)1 - $11,000/(1+0)2

+ $6,000/(1+0)3 = 0
b. 100%: NPV = -$1,000 + $6,000/(1+1)1 - $11,000/(1+1)2
+ $6,000/(1+1)3 = -1,000 + 3,000 - 2,750 + 750 = 0
c. 200%: NPV = -$1,000 + $6,000/(1+2)1 - $11,000/(1+2)2
+ $6,000/(1+2)3 = -1,000 + 2,000 - 1,222.22

+ 222.22 = 0
Computation of net investment:
New unit cost $29,000
Plus: Installation cost
:
3,000
Less: Proceeds from sale of old unit
$1,000
Plus: Tax on gain from sale of old unit
($1,000)(.4)
400
Equals:
Net investment $31,400
Computation of net cash flows:
Annual depreciation on new device =
[$29,000 + 3,000]/20 years] = $1,600
Net cash flows1-19 = ( R - O - Dep)(1 - T) + Dep
= (0 -(-$9,000) - $1,600)(1 - 0.4) +$
1,600
= $6,040
Net cash flow20 = $6,040 + salvage = $6,040 + $2,000(1 - 0.4)
= $7,240
9.

NPV = -$31,400 + $6,040(PVIFA0.12,19) + $7,240(PVIF0.12,20)

= -$31,400 + $6,040(7.366) + $7,240(.104) = $13,844
Therefore, the old control device should be replaced. Note that this problem ad
dresses the unequal project life problem by assuming that the old device could b
e operated indefinitely, with appropriate maintenance outlays.
10.

$1,230 = $800/(1 + i)1 + $200/(1 + i)2 + $400/(1 + i)3

Try i = 8%
$1,230 = $800(.926) + $200(.857) + $400(.794 ) = $1,229.8
Therefore IRR = 8%

11.
Project
PI
2
60,000 1.218
5
250,000
4,000 1.040
)
Project
estment
3

Net Investment

NPV
1
$200,000
$20,000 1.100
2
500,000 41,000 1.082 3
3
275,000
1
4
150,000 5,000 1.033 6
20,000 1.080
4 (tie)
6
100,000
5
7
275,000 22,000 1.080
4 (tie
8
200,000 -18,000 0.910 7
Rank

PI
Cum. NPV
1.218 $275,000

Net Investment
$275,000

Cum. Net Inv

$60,000

1
2
5
7
6
4

1.100 200,000 475,000 80,000

1.082 500,000 975,000 121,000
1.080 250,000 1,225,000
141,000
1.080 275,000 1,500,000
163,000
1.040 100,000 1,600,000
167,000
1.033 150,000 1,750,000
172,000
b. Projects 3, 1, and 2 should be adopted, using a total of $975,000
and leaving $25,000 unused.
c. If projects 3, 1, 5, and 7 are adopted, all funds will be expended a
nd the aggregate NPV is $122,000 vs. $121,000 when projects 3, 1, and 2 are adop
ted.
d. The opportunity cost of the unexpended funds is the amount o
f the unexpended funds times the firm s cost of capital.
12.
Net investment (cost of baboon) = $12,000
Annual depreciation on baboon
= $12,000 /20 years
= $600
Net cash flow calculation:
NCF1-20 = ( R - O - Dep)(1 - T) + Dep
= (0 - ($4,000 - $7,000) - 600)(1 - .4) + 600 = $2,060/yea
r
NPV = - $12,000 + $2,040(7.963) = $4,245
Yes, buy the baboon, since NPV > 0.
13.
a. NPV = -$10 + $20(PVIFk,1) + $5(PVIFk,2) - $17(PVIFk,3)
NPV @ k = 5%: -$10 + $20(.952) + $5(.907) - $17(.864)
= -$1.11 million
NPV @ k = 10%: -$0.46 million
NPV @ k = 15%: -$0.01 million
NPV @ k = 30%: +$0.61 million
NPV @ k = 71%: +$0.01 million
NPV @ k
= 80%: -$0.26 million
b.
The NPV is negative at discount rates between 0% and 15%,
positive from 15% to 71% and negative beyond 71%.
c.
If L-S s cost of capital is 10%, the project is unacceptable (negative N
PV).
If L-S s cost of capital is 20% the project is acceptable (positive NPV
).
NPV @ k = 20%: -$10 + $20(.833) + $5(.694) - $17(.579)
= +$0.29 million
14.

a. Net investment calculation:

Land
$150,000
Plus: Packing equipment
20,000
Equals:
Net investment $170,000
Net cash flow calculation:
Depreciation/year = $20,000/20 = $1,000/year
NCF1-10 = [200($400) - $50,000 - $1,000](1 - .3) + $1,000
= $21,300
NCF11-19 = [200($500) - $60,000 - $1,000](1 - .3) + $1,000
= $28,300
NCF20 = $28,300 + after-tax land value

Land value in 20 years = $150,000(FVIF0.05,20) = $150,000(2.653)

= $397,950
Tax on gain from land sale:
Sale price of land
$397,950
Less: O
riginal cost
150,000
Equals: Capital gain $247,950
Times: Capital gains tax rate
.30
Equals: Tax on gain
$74,385
Land value net of taxes = $397,950 - $74,385 = $323,565
NCF20 = $28,300 + $323,565 = $351,865

NPV = -$170,000 + $21,300(5.426) + $28,300(5.132)(.295)

+ $351,865(.087) = $19,031
Yes, because NPV > 0
b. NCF20 = $28,300 + $50,000 + $100,000 loss(.30) = $108,300
NPV = -$170,000 + $21,300(5.426) + $28,300(5.132)(.295)
+ $108,300(.087) = $-2,160
No, because NPV < 0
15.

a. Net investment:
b. Basis for MACRS
First year revenues
; operating costs increase

Year

Revenues

$80,000
depreciation = $80,000
= $2 x 50,000 = $100,000; Revenues increase 7%/year
at 8%/year.

Operating Costs

Depreciation

Tax

OEAT

NCF
1
2
3
4
5
6
7
8
9
10

$100,000
107,000 54,000
114,490 58,320
122,504 62,986
131,080 68,024
140,255 73,466
150,073 79,344
160,578 85,691
171,819 92,547
183,846 99,950

$50,000 $11,432
19,592
13,992
9,992
7,144
7,136
7,144
3,568
0
0

$15,427
13,363
16,871 25,307
19,810 29,716
22,365 33,547
23,861 35,792
25,434 38,151
28,528 42,791
31,709 47,563
33,558 50,338

$23,141 $34,573
20,045 39,637
39,299
39,708
40,691
42,928
45,295
46,359
47,563
50,338

c. NPV = $80,000 + $34,573(.833) + $39,637(.694)

+ $39,299(.579)+ $39,708(.482) + $40,691(.402)
+ $42,928(.335) + $45,295(.279) + $46,359(.233)
+ $47,563(.194) + $50,338(.162)
= $89,761
Yes, build the plant because NPV > 0.
d. Payback calculation:
Payback period is slightly more than two years because the sum o
f the first two years of NCF is $74,210,
compared to the NINV of $80,000.
e. The project has one internal rate of return because its cash flows h
ave one sign change.
16.

a. NPVA = -$30,000 + $10,000(3.433) = $4,330

NPVB = -$60,000 + $20,000(3.433) = $8,660
b. IRRA: $30,000 = $10,000(PVIFAr,5)
PVIFAr,5= 3.000
From Table IV, IRRA = 20% (19.86% by calculator)
IRRB: $60,000 = $20,000(PVIFAr,5)
PVIFAr,5= 3.000
From Table IV, IRRB = 20% (19.86% by calculator)
c.
PIA = $34,330/$30,000 = 1.14
PIB = $68,660/$60,000 = 1.14
d.
PBA = 3 years
PBB = 3 years
e. Monroe should accept project B because its NPV is positive and highe
r than the NPV of project A.
17. $3,300,000,000 = $651,000,000(PVIFA0.19,n)
PVIFA0.19,n = 5.069
From Table IV, n
19

18.

NINV = $31,400
Basis for MACRS depreciation: $32,000
NCF1 = (0 - (-$9,000) - $4,572.8)(1 - .40)
NCF2 = (0 - (-$9,000) - $7,836.8)(1 - .40)
NCF3 = (0 - (-$9,000) - $5,596.8)(1 - .40)
NCF4 = (0 - (-$9,000) - $3,996.8)(1 - .40)
NCF5 = (0 - (-$9,000) - $2,857.6)(1 - .40)
NCF6 = (0 - (-$9,000) - $2,854.4)(1 - .40)
NCF7 = (0 - (-$9,000) - $2,857.6)(1 - .40)
NCF8 = (0 - (-$9,000) - $1,427.2)(1 - .40)
NCF9-19 = (0 - (-$9,000) - 0)(1 - .40) + 0
NCF20 = $5,400 + $2,000(1 - .4) = $6,600

+
+
+
+
+
+
+
+
=

$4,572.8
$7,836.8
$5,596.8
$3,996.8
$2,857.6
$2,854.4
$2,857.6
$1,427.2
$5,400

=
=
=
=
=
=
=
=

$7,229.12
$8,534.72
$7,638.72
$6,998.72
$6,543.04
$6,541.76
$6,543.04
$5,970.88

NPV = -$31,400+ $7,229.12(0.893) + $8,534.72(0.797)

+ $7,638.72(0.712) + $6,998.72(0.636) + $6,543.04(0.567)
+ $6,541.76(0.507) + $6,543.04 (0.452) + $5970.88(0.404)
+ $5,400(5.938)(.404) + $6,600(.104)
= $17,785
The NPV is higher with accelerated (MACRS) depreciation
than with straig
ht-line depreciation.
19.

a.

NPV = -$1,200,000 + $168,000(PVIFA0.12,10)

= -$1,200,000 + $168,000 (5.650)
= -$250,800

b. The project is unacceptable.

c. The project has one internal rate of return because its cash flows h
ave only one sign change.
d. Internal rate of return calculation:
$1,200,000 = $168,000(PVIFAr,10)
PVIFAr,10 = 7.143
IRR = r = 6.64% (by calculator)
20.

a. NPV = -$400,000 + $196,000(0.847) + $214,600(0.718)

+ $234,982(0.609) + $257,309(0.516) + $281,759(0.437)
+ $292,525(0.370) + $321,818(0.314) + $353,866

(0.266)
+ $388,920(0.225) + $633,250(0.191)
= $830,970
b. Yes, the store has a positive net present value.
c. IRR = 57.1% (by calculator)
d. PI = 3.08, i.e., $1,230,970/$400,000.
21.

a. Net investment:
Installed cost $15,000,000
Less: After-tax salvage (old) -1,200,000
Less: Net working capital
recovered from old asset -1,000,000
Plus: Net working capital
needed for new asset
500,000
Equals: Net investment $13,300,000

b.

Basis for MACRS depreciation = $15,000,000

Year

Revenues
NCF

Operating Costs

Depreciation

OEAT

1
$2,537,400
2
3,149,400
3
0
4
0
5
0
6
0
7
0
8
0
9
0
10
0*

$2,000,000

$-800,000

$2,143,500

$393,900

2,000,000

-800,000

3,673,500

-524,100

2,000,000

-800,000

2,623,500

105,900 2,729,40

2,000,000

-800,000

1,873,500

555,900 2,429,40

2,000,000

-800,000

1,339,500

876,300 2,215,80

2,000,000

-800,000

1,338,000

877,200 2,215,20

2,000,000

-800,000

1,339,500

876,300 2,215,80

2,000,000

-800,000

669,000 1,278,600

1,947,60

2,000,000

-800,000

1,680,000

1,680,00

2,000,000

-800,000

1,680,000

2,180,00

*Year 10 NCF includes impact of incremental net working capital change of -$500,
000.
c. NPV = $-13,300,000 + $2,537,400 (0.870) + $3,149,400(0.756)
+ $2,729,400(0.658) + $2,429,400(0.572) + $2,215,800(0.4
97)
+ $2,215,200(0.432) + $2,215,800(0.376) + $1,947,600(0.327)
+ $1,680,000(0.284) + $2,180,000(0.247)
= $-982,149
22.

IRRAlpha:

$10,000 = $20,000 [1/(1 + r)1]

1 + r = 2
r = 1 (or 100%)
IRRBeta:
$20,000 = $35,000 [1/(1 + r)1
1 + r = 1.75
r = 0.75 (or 75%)

NPVAlpha = - $10,000 + $20,000 (PVIF0.10,1)

= - $10,000 + $20,000 (0.909)
= $8,180
NPVBeta = - $20,000 + $35,000 (PVIF0.10,1)
= -$20,000 + $35,000 (0.909)
= $11,815
The company should accept project Beta because its NPV is positive and higher t
han the NPV of project Alpha.
23. PVNCFf = FF5.0(4.833) = FF24.17 million
PVNCFh = FF24.17 x $0.16/FF = $3.87 million
NPV = $3.87 - $8.0 = $-4.13 million
The project is unacceptable.
24.

Project evaluation is based on cash flows, not accounting earnings. The project

s could

nts;

have deferred returns;

Lack of profitablity could be based on assets in place, not incremental investme
Risk projects that were not successful;
The impact of competition; cost variations, etc.
Possibly biased cash flow estimates.

25. No recommended solution.

SOLUTION TO INTEGRATIVE CASE PROBLEM:
Capital Budgeting
Net investment calculation:
Cost of equipment
$1,000,000
livery and installation 100,000
rking capital 50,000
Equals: Net investment $1,150,000
Net cash flow calculation:
Calculation of year 1 revenues:
Q = 20,000 - 200($14) = 17,200 units
Revenues = 17,200 units($14 / unit)
= $240,800

Plus: De
Plus: Additional net wo

Additional
Work
ing
Year

Revenues
Operating Costs*
Depreciation
Taxes
Capital
NCF
1
$240,800
$-100,000
157,190 $62,427 $25,000 $253,3

73
2
3
4
5
6
7
8
9
10

228,760
217,322
206,456
196,133
186,326
177,010
168,160
159,752
151,764

-93,700
-86,959
-79,746
-72,028
-63,770
-54,934
-45,480
-35,364
-24,539

269,390
192,390
137,390
98,230
98,120
98,230
49,060
-

18,044
38,043
50,596
57,777
51,672
45,463
55,957
66,339
59,943

-75,000

304,416
266,238
235,606
210,384
198,424
186,481
157,683
128,776
257,360**

* Operating costs reflect the $190,000 saving plus the annual operating costs (
including costs related to off-system sales) on the new system.
**Year 10 net cash flow includes recovery of $75,000 of net working capital and
$66,000 recovery of after-tax salvage value.
NPV = $-1,150,000 + $253,373 (0.870) + $304,416(0.756)
+ $266,238(0.658) + $235,606(0.572) + $210,384(0.497)
+ $198,424(0.432) + $186,481(0.376) + $157,683(0.327)
+ $128,776(0.284) + $257,360(0.247)
= $22,624
Therefore the project is acceptable.
APPENDIX 9A
MUTUALLY EXCLUSIVE INVESTMENTS
HAVING UNEQUAL LIVES
SOLUTIONS TO PROBLEMS:
1. a.

NPVA = -$30,000 + $10,500(3.037) = $1,888.50

NPVB = -$30,000 + $6,500(4.968) = $2,292
b.
NPVA(chain) = $1,888.50 - $30,000(PVIF.12,4 )
+ $10,500(PVIFA.12,4)(PVIF.12,4) = $3,089.5

9
c. Alternative A should be chosen because it has the higher positive net p
resent value when the two alternatives are compared for an equal period of time.
d. NPVA = $1,888.50 (from part a)
NPVB = $2,292 (from part a)
Equivalent annual annuity (A) = $1,888.5/3.037 = $621.83
Equivalent annual annuity (B) = $2,292/4.968 = $461.35
NPVA (infinite replacement) = $621.83/.12 = $5,181.92
NPVB (infinite replacement) = $461.35/.12 = $3,844.58
The equivalent annual annuity method also recommends project A.
2.

NPVP = - $100,000 + $22,000 (PVIFA0.12,10)

= - $100,000 + $22,000 (5.650)
= $24,300
NPVR = - $85,000 + $18,000 (PVIFA0.12,8)
= - $85,000 + $18,000 (4.968)
= $4,424
Equivalent annual annuity (P) = $24,300/(PVIFA0.12,10)
= $24,300/5.650
= $4,300.9
Equivalent annual annuity (R) = $4,424/(PVIFA0.12,8)
= $4,424/4.968
= $890.5
NPVP (assuming infinite replacement)
= $4,300.9/0.12 = $35,841
NPVR (assuming infinite replacement)
= $890.5/0.12 = $7,421

Investment P should be selected, because it has the higher net present value whe
n evaluated over an infinite replacement horizon.

3.

NPVA = - $50,000 + $25,000 (PVIFA0.19,3)

= - $50,000 + $25,000 (2.140)
= $3,500
NPVB = - $79,000 + $28,000 (PVIFA0.19,5)
= - $79,000 + $28,000 (3.058)

= $6,624
Equivalent annual annuity (A)

= $3,500/(PVIFA0.19,3)
= $3,500/2.140
= $1,636

Equivalent annual annuity (B)

= $6,624/(PVIFA0.19,5)
= $6,624/3.058
= $2,166

NPVA (assuming infinite replacement)

= $1,636/0.19 = $8,611
NPVB (assuming infinite replacement)
= $2,166/0.19 = $11,400
alue

Investment B should be selected, because it has the higher net present v

when evaluated over an infinite replacement horizon.

4.

a. NPVD = -$50,000 + $24,000(2.322) = $5,728

NPVE = -$50,000 + $15,000(3.889) = $8,335
b. NPVD (replacement chain)
= $5,728 - $50,000 (PVIF0.14, 3) + $24,000(PVIFA0.14, 3) (PVIF0.

14, 3)
= $9,594

c.
Investment D should be chosen because it has the higher positive net pre
sent value when the two investments are compared for an equal period of time.
d.

NPVD = $5,728 (from Part a)

NPVE = $8,335 (from Part a)
Equivalent annual annuity (D) = $5,728 / (PVIFA0.14, 3) = $2,467
Equivalent annual annuity (E) = $8,335 / (PVIFA0.14, 6) = $2,143
NPVD (assuming infinite replacement) = $2,467 / 0.14 = $17,621
NPVE (assuming infinite replacement) = $2,143 / 0.14 = $15,307

Investment D should be selected because it has the higher net present

ue when evaluated over an infinite replacement horizon.

val