Proposed Project Data

Keown is evaluating a new project for his

firm, Basket Wonders (BW). She has
determined that the after-tax cash flows
for the project will be $10,000; $12,000;
$15,000; $10,000; and $7,000, respectively,
for each of the Years 1 through 5. The
initial cash outlay will be $40,000.

Payback Period (PBP)

0
-40 K

1
10 K

12 K

15 K

4
10 K

PBP is the period of time required for

the cumulative expected cash flows
from an investment project to equal
the initial cash outflow.

5
7K

Payback Solution (#1)

0
-40 K (-b)

Cumulative
Inflows

3 (a)

10 K

12 K

15 K

10 K (d) 7 K

10 K

22 K

37 K (c)

47 K

PBP
=a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years

54 K

Payback Solution (#2)

0
-40 K
-40 K

10 K
-30 K

12 K
-18 K

PBP
Cumulative
Cash Flows

3
15 K
-3 K

4
10 K
7K

5
7K
14 K

= 3 + ( 3K ) / 10K
= 3.3 Years

Note: Take absolute value of last negative

cumulative cash flow value.

PBP Acceptance Criterion

The management of Basket Wonders has
set a maximum PBP of 3.5 years for
projects of this type.
Should this project be accepted?
Yes! The firm will receive back the initial cash
outlay in less than 3.5 years. [3.3 Years <
3.5 Year Max.]

Internal Rate of Return (IRR)

IRR is the discount rate that equates the present
value of the future net cash flows from an
investment project with the projects initial
cash outflow.

ICO =

CF1
(1+IRR)1

CF2
CFn
+...+
(1+IRR)2
(1+IRR)n

IRR Solution
$40,000 = $10,000
(1+IRR)1
$15,000
(1+IRR)3

$12,000
+
+
2
(1+IRR)

$10,000
+
+
4
(1+IRR)

$7,000
(1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000.

IRR Solution (Try 10%)

$40,000 =

10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444
[Rate is too low!!]

IRR Solution (Try 15%)

$40,000 =

$10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841
[Rate is too high!!]

IRR Solution (Interpolate)

.05

X
.05

.10
IRR
.15

$41,444
$40,000
$36,841

$1,444
$4,603

$1,444

$4,603

IRR Solution (Interpolate)

.05

X
.05

.10
IRR
.15

$41,444
$40,000
$36,841

$1,444
$4,603

$1,444

$4,603

IRR Solution (Interpolate)

.05

X=

.10
IRR
.15

$41,444
$40,000
$36,841

($1,444)(0.05)
$4,603

$1,444

X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

$4,603

IRR Acceptance Criterion

The management of Basket Wonders has
determined that the hurdle rate is 13% for
projects of this type.
Should this project be accepted?
No! The firm will receive 11.57% for each
dollar invested in this project at a cost of
13%. [ IRR < Hurdle Rate ]

Net Present Value (NPV)

NPV is the present value of an
investment projects net cash flows
minus the projects initial cash
outflow.
CF1
NPV =
(1+k)1

CF2
(1+k)2

+...+

CFn
- ICO
n
(1+k)

NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this project is
13%.
$10,000
$12,000
$15,000
NPV =
+
+
+
1
2
3
(1.13)
(1.13)
(1.13)
$10,000
$7,000
+
$40,000
4
5
(1.13)
(1.13)

NPV Solution
NPV =

NPV =

NPV =
=

$10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
$10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$7,000(.543) - $40,000
$8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
- $1,428

NPV Acceptance Criterion

The management of Basket Wonders has
determined that the required rate is 13%
for projects of this type.
Should this project be accepted?
No! The NPV is negative. This means that the
project is reducing shareholder wealth.
[Reject as NPV < 0 ]

Net Present Value Profile

Net Present Value

$000s
15

Sum of CFs

Plot NPV for each

discount rate.

10
5

IRR

0
-4
0

6
9
12
15
Discount Rate (%)

NPV@13%

Profitability Index (PI)

Method #1:

PI is the ratio of the present value of a

projects future net cash flows to the
projects initial cash outflow.

PI =

CF1
CF2
+
1
(1+k) (1+k)2

CFn
+...+
(1+k)n

<< OR >>
Method #2:

PI = 1 + [ NPV / ICO ]

ICO

PI Acceptance Criterion
PI

= $38,572 / $40,000
= .9643

Should this project be accepted?

No! The PI is less than 1.00. This means
that the project is not profitable.
[Reject as PI < 1.00 ]

MIRR Solution
40,000 = [$10,000(FVIF13%,4) + $12,000(FVIF13%,3) +
$15,000(FVIF13%,2) + $10,000(FVIF13%,1) +
$ 7,000] / (1+MIRR)5
40,000 = [$10,000(1.630) + $12,000(1.443) +
$15,000(1.277) + $10,000(1.13) +
$7,000 ] / (1+MIRR)5
40,000 = [$16,300 + $17,316 + $19,155 +
$11,300 + $7,000 ] / (1+MIRR)5
40,000 = 71,071 / (1+MIRR)5

MIRR Solution
PV = FV (PVIF i, n )
40,000 = 71,071 (PVIF ?, 5 )
PV = FV / (1 + i)n
40,000 = 71,071 / (1+ i)5
.5628 = ((1/ (1+i)5)
1.7768 = (1+i)5
(1.7768)1/5 = (1+i)
i = .1218

MIRR Solution
Using our time line and a 15% rate:
PV outflows = (40,000)
FV inflows (at the end of year 5) = 71,071
MIRR: FV = 71,071, PV = (40,000), N = 5.
Solve: I = 12.18%.
(40,000)

10,000

12,000 15,000 10,000

7,000

Evaluation Summary
Method

Project

Comparison

Decision

PBP

3.3

3.5

Accept

IRR

11.57%

13%

Reject

NPV

-$1,428

$0

Reject

PI

.96

1.00

Reject

MIRR

12.18%

13%

Reject