Capital Budgeting Process and Techniques

93

Chapter 7: Capital Budgeting Process and Techniques

Answers to questions
7-1.

a.
b.

c.

Type I error means rejecting a good project. Payback could lead to Type 1 errors when
it rejects a good project that has large cash flows after the payback period cutoff.
Payback ignores cash flows after the cutoff.
Type II error means accepting a project that should have been rejected. Type II errors
occur when payback says to accept a project that doesn't return enough to compensate
for the risk taken. This occurs because payback makes no adjustments for risk or time
value of money.
If firms apply the payback rule with a fairly short cutoff period, then a type I error is
more likely good projects with higher cash flows in later years may be rejected. On
the other hand, if firms apply the payback rule but use a long cutoff period, then a Type
II error becomes more likely because the payback method makes no adjustment for the
time value of money.

7-2.

Discounted payback has a more severe bias discounted cash flows will be smaller, making it
even harder for a project to pass the payback hurdle. For example, if the cutoff period is four
years, then every project that satisfies the discounting payback rule will also satisfy payback,
but the reverse is not true.

7-3.

The NPV approach is consistent with shareholder maximization because it suggests that firms
should only accept projects that earn returns above the opportunity costs of the firms investors.
The NPV in effect measures the dollar contribution that the given project is expected to make to
the firms overall value. If a firm invests in a project with NPV > $0, then the share price will
rise. Conversely, a firms share price will fall if it invests in projects with NPV < $0.

7-4.

It is true that long-term projections are more prone to error than are short-term projections.
However, there are two reasons why this simple truth does not lead to the conclusion that the
payback approach is superior to NPV. First, the payback approach itself implicitly makes longterm cash flow projections. Specifically, the payback approach forecasts zero cash flows
beyond the payback horizon. The real question is not whether long-term forecasts are more or
less accurate than short-term forecasts are, but whether a long-term forecast can be more
accurate than a nave guess of zero. Second, via discounting, the NPV approach makes an
adjustment for the high degree of risk in long-term projections. The farther into the future that a
given projects cash flows arrive, the less valuable those cash flows are in an NPV calculation.
NPV automatically adjusts for project time by using an exponentially smaller discount rate
applied to later cash flows.

7-5.

Any method can be manipulated. Smart managers must be aware of this and must be prepared
to press analysts to justify their numbers. Opportunities to manipulate the numbers are not
unique to the NPV approach and can therefore not be used to justify payback, accounting rate of
return, or any other approach over NPV. It would be hard to argue that accounting numbers
cant be manipulated after all the accounting scandals, starting with Enron in late 2001.
Managers should have incentives to provide the most accurate information possible.

7-6.

a.

A firm that consistently earns returns higher than its opportunity cost of capital is
adding value to the firm, and its stock returns should increase. Stock returns should be
well above average for companies of this risk level.

94

Chapter 7
b.

For the project returning 18%, as long as it returns enough to compensate for the risk of
the project, it is adding value and shareholders will be happy about the decision to
accept the project.

7-7.

The IRR suffers from several problems. The IRR is not well suited to ranking projects with
very different scales or projects with very different cash flow timing patterns due to the
reinvestment assumption. The IRR method can also yield no solution or multiple solutions that
are hard to interpret. Despite the flaws, the IRR method enjoys widespread use because in most
investment situations it generates reliable accept/reject recommendations and it is easy to
interpret intuitively. The MIRR method uses a more realistic reinvestment rate. Also, there can
be only one MIRR for a project.

7-8.

Because the discounted payback period equals the life of the projected, the sum of all of the
discounted cash flows must equal the cost of the project. This indicates that the NPV must also
be zero and that the IRR equals 10% because the NPV is zero.

7-9.

The NPV is the most appropriate capital budgeting method because it yields correct
accept/reject situations and correct project rankings. Nevertheless, it is somewhat less intuitive
than the IRR. In projects with cash flow streams that switch signs, the IRR method can yield
multiple solutions. In those cases, it is difficult for a firm to know whether to accept or reject a
project based upon its IRR.

7-10.

The NPV is calculated by discounting all of a projects cash flows to the present. The IRR is
calculated by finding the discount rate, which equates the NPV to zero. The profitability index
is the ratio of the present value of a projects cash flows (excluding the initial cash outflow)
divided by the initial cash outflow. All three methods lead to the same accept/reject decision
when evaluating a single project, but IRR and PI have problems when ranking projects. NPV
generally overcomes these problems.

7-11.

IRR, NPV, and PI can lead to different decisions when they are used to rank projects or to select
between mutually exclusive projects. IRR and PI methods are not well suited to evaluating
projects that vary in scale. The NPV method yields correct project rankings no matter what the
scale of the project.

7-12.

If an unlimited capital budget exists, firms should always accept every independent project with
NPV > $0. When funds are limited, firms should select the group of projects which has the
highest aggregate NPV yet stays within the budget constraint.

7-13.

Project A recovers its cost in 2 years and Project B recovers its cost in 3 years. Consequently,
the payback period for Project A is two years and the payback period for Project B is three years
making Project A preferred based on the shortest payback period criteria. However, Project B is
the better project because of the $10,000.00 cash flow in the fourth year. The problem with the
payback criteria is that it does not encompass all of the cash flows of the project.

Answers to problems
7-1.

a.

If the computers are depreciated on a straight-line basis, depreciation will be $5,000 per
year for 4 years. Contribution to net income will be:
Year 1

Year 2

Year 3

Year 4

Capital Budgeting Process and Techniques

$7,500
5,000
$2,500

95
$9,1
00

5,00
0
$4,1
00

$9,1
00

5,00
0
$4,1
00

$9,1
00

5,00
0
$4,1
00

The average net income is ($2,500 + $4,100 + $4,100 + $4,100)/4 = $3,700

7-2.

7-3.

b.

The average book value of the investment is ($20,000 + 0)/2 = $10,000.

c.

The average accounting rate of return = Average net income/Average book value of the
investment = $3,700/$10,000 = .37 or 37%.

d.

The payback period is 2.37 years, based on cash flow numbers, not net income.

e.

This is not an appropriate method for evaluating capital budgeting projects. It does not
take time value of money into account, nor does it look at cash flows. It also does not
consider the risk of the project and what would be an appropriate discount rate in light
of the project's cash flows.

a.

Payback on this bond is 25 years. You pay $1,000; you receive $40 a year for 25 years,
a total of $1,000.

b.

The bond is not necessarily a bad investment. Payback does not take time value of
money into account, nor does it account for cash flows received after the payback
period. It is more appropriate to calculate the NPV of an investment. Given the risk
level of the bond, is 4% a fair return? If the answer is yes, then the bond may be a good
investment.

c.

The discounted payback, using a 4% discount rate, is 30 years. This shows that unless
the acceptable payback period is decreased when discounted payback is used, vs.
regular payback, then projects that return money late in the life of the investment are
even more disadvantaged under discounted payback than under regular payback. NPV
is a more appropriate method to use to determine the value of an investment project.
The general rule is that when a projects discounted payback period is the same as its
life, then the NPV must be zero.

a.

Payback of Alpha = 3.5 years, payback of Beta = 2.5 years, payback of Gamma = 3.33
years

b.

If the cutoff is 3 years, then only Beta is acceptable. If the cutoff is 4 years, then all of
the projects are acceptable.

c.

Beta has the fastest payback.

d.

If the firm uses discounted payback with a cutoff of 4 years, then Alpha will payback in

96

Chapter 7
more than 5 years, Beta in just under 3 years and Gamma in between 4 and 5 years.
This means only Beta is acceptable. Calculations are shown in the table that follows.

Capital Budgeting Process and Techniques

97

Alpha ($1,500,000)
Beta ($400,000)
Gamma ($7,500,000)
End
PV of
PV of
Cum
PV of CF
of CF
CF @
Cum PV CF
CF @
CF
Cum PV
PV
@ 15%
Year
15%
15%
1 300K $260,870 $260,870 100K $86,957 $86,957 2,000K $1,739,130 $1,739,130
2 500K 378,072 638,942 200K 165,997 252,954 3,000K 226,8431 4,007,561
3 500K 328,758

967,700 200K 151,229 404,183 2,000K 1,315,032 5,322,593

4 400K 228,701 1,196,401 100K 68,887 473,070 1,500K 857,630 6,180,223

5 300K 149,153 1,354,554 -200K -125,517 347,553 5,500K 2,734,472 8,914,695
Disc
>5 years
>3 & 4 years <
>4 & 5 years<
PayReject
Accept
Reject
back

7-4.

e.

Project Beta should be rejected. You must pay out a total of .6 million and take in .6
million. When there is a time value to money, in other words, a positive interest rate,
this is unacceptable. If cash inflows and outflows are the same, this is a negative net
present value project.

f.

Project Gamma is rejected using discounted payback (as noted in d.), but even without
discounting, seems to have a high dollar return for the investment. You pay $7.5
million and receive a total of $14 million in cash inflows. Unless the firm has a very
high discount rate, greatly lowering the value of the last $5.5 million cash flow, this is
likely to be an attractive investment.

a.

To determine the accounting rate of return (AAR) we need to first determine the annual
net income by subtracting the depreciation from the Cash Flow, as shown in the table
below.

Year
1
2
3
4
5

Asset A
$200,000 2 = $100,000
Net
CF
Depr.
Income
$70,000
$40,000
$30,000
$80,000
$40,000
$40,000
$90,000
$40,000
$50,000
$90,000
$40,000
$50,000
$100,000
$40,000
$60,000
Average = $46,000

Asset B
$180,000 2 = $90,000
Net
CF
Depr.
Income
$80,000
$36,000
$44,000
$90,000
$36,000
$54,000
$30,000
$36,000
$(6,000)
$40,000
$36,000
$4,000
$40,000
$36,000
$4,000
Average =
$20,000

ARRA = $46,000 $100,000 = 46%

ARRB = $20,000 $90,000 = 22.22%
Given that the minimum acceptable ARR is 30%, only Asset A is acceptable.
b.
Year

Asset A
Cash Flows Amount still to

Cash Flows

Asset B
Amount still to

98

Chapter 7
be recovered
0
1
2
3
4
5

-$200,000
$70,000
$80,000
$90,000
$90,000
$100,000

($130,000)
($50,000)

be recovered
-$180,000
$80,000
$90,000
$30,000
$40,000
$40,000

($100,000)
($10,000)

Asset A has $50,000 left to be recovered after year 2, or 0.56 of year 3. Thus, Asset As
payback is 2.56 years. Asset B has $10,000 to be recovered after year 2, or 0.33 of year
3. Asset Bs payback period is 2.33 years. According to the maximum payback period
requirement of 2.5 years, only Asset B is acceptable.
c.
Year

0
1
2
3
4
5

Asset A
Discounted Amount still to
Cash Flows
be recovered
($200,000)
$62,500
($137,500)
$63,776
($73,724)
$64,060
($9,664)
$57,197
$56,743

Asset B
Discounted
Amount still to
Cash Flows
be recovered
($180,000)
$71,429
($108,571)
$71,747
($36,824)
$21,353
($15,471)
$25,421
$22,697

After the third year, Asset A still has $9,664 left to be recovered. This represents 0.17
of the year; thus, Asset As discounted payback period is 3.17 years. Asset B still needs
to recover $15,471 after the third year. This is 0.61 of the fourth year. Thus, Asset Bs
discounted payback period is 3.61 years. Asset A is acceptable according to the firms
maximum discounted payback period.

7-5.

7-6.

d.

All the evaluation methods suffer from serious flaws. The firm should re-evaluate the
projects using the NPV method or the MIRR method.

a.

This project has CF0 = $15,000, and 20 inflows of $13,000. At a 14% discount rate, its
NPV is $71,100.70. This is a positive NPV and an acceptable project.

b.

This project has CF0 = $32,000 and 20 inflows of $4,000. At 14%, its NPV is
$5,507.48. This is a negative NPV and is not acceptable.

c.

This project has CF0 = $50,000, and 20 inflows of $8,500. At a 14% discount rate, its
NPV is $6,296.61. This is a positive NPV and an acceptable project.

CF0 = $19,000
Cash flows of $4,000/year for 8 years.
a.

NPV at 10% = $2,339.70, accept

Capital Budgeting Process and Techniques

b.

NPV at 12% = $870.56, accept

c.

NPV at 14% = $444.54, reject

99

Only positive NPV projects are acceptable. As the discount rate increases, NPV decreases. At
some point, if the discount rate is high enough, a previously acceptable project at lower discount
rates may become unacceptable.
7-7.

7-8.

Discount rate = 14%

Project
NPV

A
$4,351.65
$67,678.2
B
4

C
$71,798.0
7
$98,189.8
D
2
E
$8,548.44
Discount rate = 15%
Project
NPV

A
$5,253.57
B
$2,424.27
$17,992.9
C
5

Decision
Reject
Accept
Reject
Accept
Accept

Decision
Reject
Accept
Accept

Project C is the best, followed by Project B. Project A is the worst project, and is unacceptable.
7-9.

NPV of project = $9,972,742

Current firm value = $10 x 10,000,000 = $100,000,000
New firm value = $100,000,000 + $9,972,742 = $109,972,742
New stock price = $109,972,742 / 10,000,000 = $11.00 per share
This project should add $10,000,000 or $1 per share to the firms overall value.

7-10.

The NPV of Project LMN is $225.21: (-$10,000.00 + [$2,825.00 (1 + 12%)] + [$3,192.25

(1 + 12%)2] + [$3,607.24 (1 + 12%)3] + [$4,076.18 (1 + 12%)4] = $225.21).
The annual return is 8.19%: ([$13,700.67 $10,000.00]0.25 1 = 8.19%
Because the cash flows are not reinvested. This is contrary to an implicit reinvestment
assumption in the NPV calculation. If the cash flows earned 12% interest upon receipt then the
annual return would also be 12%.

7-11.

Project IRR
A
17.4%

100

Chapter 7
B
C
D

7-12.

7-13.

7-14.

8.7%
27.2%
21.4%

a.

Project A: IRR = 15.7%

Project B: IRR = 17.3%

b.

With a cost of capital of 15%, both projects are acceptable.

c.

Project B has a higher IRR, and is preferred to Project A, based on the IRR criterion.

a.

After three years of cash flows, only $426.87 of the fourth year cash flow is necessary
to recover the cost of the project. Thus, the payback period is 3.3024 years ( 3 years +
($426.87 $1,411,48) years).

b.

The discounted payback period is 4 years: (-$4,000.00 + [$1,090.00 (1 + 9%)] +

[$1,188.10 (1 + 9%)2] + [$1,295.03 (1 + 9%)3] + [$1,411.58 (1 + 9%)4] = $0.00).

c&d.

This is equivalent to an NPV of zero and an IRR of 9%.

The NPV for Project Z is $0.00: (-$6,000.00 + [$1,725.00 (1 + 15%)] + [$1,983.75 (1 +

15%)2] + [$2,281.31 (1 + 15%)3] + [$2,623.51 (1 + 15%)4] = $0.00). Because the NPV is
zero, the profitability index is 1.0, the discounted payback period is 4 years (i.e. the life of the
project), and the IRR is 15%.

7-15.
Project

NPV

Renovate
Replace

IRR

$1,128,30
9
$433,779

20.5%
36.1%

The Renovate project has a higher NPV and the Replace project has a higher IRR.
a.

Ranking on NPV: Renovate, Replace

b.

Ranking on IRR: Replace, Renovate

c.

The rankings provide mixed signals because of the differences in the site and timing of
the cash flow patterns and initial investments of the two projects. Projects that have
lower initial investments and return their cash flows earlier in the life of the project tend
to have higher IRRs, as is the case with the Replace project.

d.

The incremental project has the following cash flows:

Year
0
1

Renovate

$9,000,00
0
3,500,000

Replace

Renovate Replace

$1,000,000

$8,000,000

600,000

2,900,000

Capital Budgeting Process and Techniques

2
3
4
5

3,000,000
3,000,000
2,800,000
2,500,000

101
500,000
400,000
300,000
200,000

2,500,000
2,600,000
2,500,000
2,300,000

The IRR of the incremental project is 18.7%. This is greater than the discount rate of
15%. For a conventional project, accept projects with IRRs greater than the hurdle rate.
Since the incremental project is acceptable, this means the project on top (Renovate)
the one from which cash flows were subtracted, is the better project. This is consistent
with the NPV criterion accept the project with the highest NPV, in this case, the
Renovate project.
7-16.
a.

$0

$50,000
1

(1 IRR)

Let x

$10,000
(1 IRR)2

$20,000

1
(1 IRR)1

$0 $50,000x $10,000x 2 $20,000

$0 5x x 2 2
x 2 5x 2 0

Using the quadratic formula

ax2 + bx + c = 0
x

b b2 4ac
2a

x2

5 25 8 5 17 5 4.12

2
2
2

9.12
0.88
4.56 and x
0.44
2
2

4.56
b.

1
1 IRR

0.44

1
1 IRR

4.56 4.56 IRR 1

0.44 0.44 IRR 1

4.56 IRR 3.56

0.44 IRR 0.56

Because
0.56
3.56
the
IRR1
78.07%
IRR 2
127.27%
4.56
0.44
undiscounted NPV of the project is positive (i.e.; $20,000 + $50,000 $10,000 =
$20,000) the project will have a positive NPV at all discount rates between 78.07%
and +127.27%. Therefore the firm can accept the project as long as its cost of capital
falls between the two IRRs.
c.

To determine the MIRR, solve for the interest rate that equates the present value of the
outflows to the future value of the inflows, with the discount rate and compounding rate
equal to the firms cost of capital.
Year

CF

FV @ 15%

PV @ 15%

102

Chapter 7
0
1
2

-20000
50000
-10000

($20,000.00)
$57,500.00
($7,561.44)
$57,500.00 ($27,561.44)

$27,561.44 = $57,500 [(1+i)2]

MIRR = I = 44.44%
The project is acceptable according to the MIRR.
7-17.

a.

$0

$1,560,000
1

(1 IRR )

Let x

$120,000
(1 IRR ) 2

$480,000

1
(1 IRR)1

$0 $1,560,000 x $120,000 x 2 $480,000

Using the quadratic formula

ax2 + bx + c = 0
b b2 4ac
2a

$
1
,
560,000 $1,484,318
x2
$240,000

x 0.3153
12.68
b.

and

x 12.68

1
1 IRR

0.3153

12.68 12.68 IRR 1

IRR1 92.11%

Interest
Rate
0
50
100
150
200
250

1
1 IRR

0.3153 0.3153 IRR 1

NPV
IRR 2 217.16%
$960,000.00
$337,777.78
$135,000.00
$49,920.00
$8,888.89
($12,594.75)

Capital Budgeting Process and Techniques

103

c.

Yes, because at 25% the NPV is positive.

d.

To determine the MIRR, solve for the interest rate that equates the present value of the
outflows to the future value of the inflows, with the discount rate and compounding rate
equal to the firms cost of capital.
Year
CF
0 -480,000
1 1,560,000
2 -120,000
77%

FV @ 15%

PV @ 15%
($480,000)

$1,794,000
$1,794,000

$570,737 = $1,794,000 [(1+i)2]

MIRR = I = 77.29%
The project is acceptable according to the MIRR.
7-18.
a.

b.

Cost of Capital Project NPV

0
$0
5
$1.35
10
0
15
$0.56
20
0
25
$0.672
30
0
35
$3.46
50
$41.48

($90,737)
($570,737)

104

Chapter 7

7-19.

c.

The project has an IRR at every point where it crosses the discount rate axis, in this case
at 0%, 10%, 20% and 30%. The four IRRs correspond to the four changes in sign of the
projects cash flows.

d.

This project is acceptable at discount rates between 10% and 20% and when the
discount rate is greater than 30% in those cases the NPV is positive.

The PIs at the end of each project are listed below:

a.

PI of Liquidate = $138,161 / $100,000 = 1.38

PI of Recondition = $402,564 / $500,000 = 0.81
PI of Replace = $1,141,613 / $1,000,000 = 1.14

b.

Accept both Liquidate and Replace because both have a PI > 1.0

c.

Accept Liquidate because it has the highest PI.

d.

According to the NPV, the ranking would be Replace, Liquidate and then Recondition.
If the projects are independent, Replace and Liquidate are acceptable, while
Recondition is not viable. If the projects are mutually exclusive, Replace should be
chosen.

Year
0
1
2
3
e.

Liquidate
Discounted
Cash Flow
@ 15%
$(100,000) $(100,000)
$50,000
$43,478
$60,000
$45,369
$75,000
$49,314
NPV
$38,161

Recondition
Discounted
Cash Flow
@ 15%
$(500,000) $(500,000)
$100,000
$86,957
$200,000
$151,229
$250,000
$164,379
$(97,436)

Replace
Discounted
Cash Flow
@ 15%
$(1,000,000) $(1,000,000)
$500,000
$434,783
$500,000
$378,072
$500,000
$328,758
$141,613

When the projects are mutually exclusive, the PI method and NPV method result in a
dilemma, as PI argues for Liquidate while NPV argues for Replace. The reason for this
dilemma is due to the large scale differences in the projects.

Capital Budgeting Process and Techniques

7-20.

7-21.

105

a.

NPV1 = $4,000,000 + $1,000,000 x (1.12)-1 + $2,000,000 x (1.12)-2 + $3,000,000 x

(1.12)-3 = $622,586
NPV2 = $5,000,000 + $2,000,000 x (1.12)-1 + $3,000,000 x (1.12)-2 + $3,000,000 x
(1.12)-3 = $1,312,637
NPV3 = $10,000,000 + $4,000,000 x (1.12)-1 + $6,000,000 x (1.12)-2 + $5,000,000 x
(1.12)-3 = $1,913,493 [highest NPV]

b.

PI1 = $4,622,586 / $4,000,000 = 1.16

PI2 = $6,312,637 / $5,000,000 = 1.26 [highest PI]
PI3 = $11,913,493 / $10,000,000 = 1.19

c.

Although Project # 2 provides more bang for the buck as represented by its higher PI,
Project #3 should be accepted since it has the higher NPV and there are no other
investments under consideration. It adds most to the firm.

The NPV of Project ABC is $818.18: (-$1,000.00 + [$2,000.00 (1 + 10%)] = $818.18. The
NPV of Project QRS is $2,000.00: (-$10,000.00 + [$4,400.00 (1 + 10%)] + [$4,840.00 (1 +
10%)2] + [$5,324.00 (1 + 10%)3] = $2,000.00).
The profitability index of Project ABC is 1.818: ( 1 + [NPV Cost] = 1 + [$818.18
$1,000.00] = 1.818). The profitability index of Project QRS is 1.20: (1 + [$2,000.00
$10,000.00] = 1.20).
Based on NPV, Project QRS is considered better. Based on profitability index, Project ABC is
better.

7-22.

7-23.

a.

The discounted payback period for Project X is 3 years (36 months): (-$3,300.00 +
[$1,232.00 (1 + 12%)] + [$1.379.84 (1 + 12%)2] + [$1,545.42 (1 + 12%)3] =
$0.00). The discounted payback period for Project Y is 4 years (48 months): ($5,000.00 + [$1,412.50 (1 + 13%)] + [$1,596.13 (1 + 13%)2] + [$1,803.62 (1 +
13%)3] + [$2,038.09 (1 + 13%)4] = $0.00).

b.

Given the threshold of 42 months, Project X is the better project.

c.

The NPV of Project X is $1,100.00: (-$3,300.00 + [$1,232.00 (1 + 12%)] +

[$1.379.84 (1 + 12%)2] + [$1,545.42 (1 + 12%)3] + [$1,730.87 (1 + 12%)4] =
$1,100.00). The NPV of Project Y is $1,250.00: (-$5,000.00 + [$1,412.50 (1 + 13%)]
+ [$1,596.13 (1 + 13%)2] + [$1,803.62 (1 + 13%)3] + [$2,038.09 (1 + 13%)4] +
[$2,303.04 (1 + 13%)5]= $1,250.00). Using the NPV criteria, Project Y is better.

d.

The profitability index of Project X is 1.333: ( 1 + [NPV Cost] = 1 + [$1,100.00

$3,300.00] = 1.333). The profitability index of Project Y is 1.250: ( 1 + [$1,250.00
$5,000.00] = 1.250). Based on the profitability index, Project X is better.

Project Cash Flows (in millions):

Year
Cash Flow

a.

0
$ 4 .5

1
$2.0

2
$2. 0

3
$2.0

At Old Line's discount rate of 10%, this project has an NPV of about $474,000 and an

106

Chapter 7
IRR of 15.9%. This project would be acceptable for Old Line.
c.

At High Tech's 20% discount rate, the project NPV is about $287,000. This makes the
project unacceptable to High Tech due to its negative NPV.

c.

The cost of capital is very important to the acceptance of a project. A firm that has a
lower cost of capital will find more projects acceptable and, all other things equal, will
potentially add more value for shareholders.

7-24.

Year
CashFlow

0
$20,000

1
$4,400

2
$4,400

3
$4,400

4
$4,400

5
$4,400

6
$4,400

7
$4,400

7-25.

a.

At 10%, the NPV of the project is $1,421.04.

b.

The IRR is 12.13%

c.

This project is acceptable by both NPV and IRR criteria. It has a positive NPV and its
IRR is greater than its hurdle rate of 10%.

a.

The payback period is 3.56 years.

End of Year
1
2
3
4
5

CF
$18,000
22,500
27,000
31,500
36,000

Cum CF
$18,000
45,000
67,500
99,000
135,000

$85,000 $67,500

$31,500
3 .56 3.56years
3yrs

b.

NPV is $8,672.54

c.

IRR is 15.6%.

d.

This project is acceptable by both NPV and IRR criteria. It has a positive NPV and its
IRR of 15.6% is greater than its hurdle rate of 12%.

7-26.
Project
X
Y
Z

a.
Payback
2.96
years
3.17
years
3.37
years

b.
NPV
$14,965.2
4
$14,206.4
8

c.
IRR
20.4%

$6,240.94

14.75
%

17.4%

Capital Budgeting Process and Techniques

d.

107

Ranking on Payback: X,Y,Z

Ranking on NPV: X,Y,Z
Ranking on IRR: X,Y,Z
All measures agree that X is best, followed by Y, and then and Z. Since they are
mutually exclusive projects, accept the project with the highest NPV, which is Project
X.

7-27.
Year
0

All at once

$5,000,00
0

Gradual

$1,000,000

$2,000,000

$2,000,000

$2,000,000

1
2
3

The NPV of the immediate program is $5 million. The NPV of the phase-in program, at a
discount rate of 15%, is $5.57 million. It is cheaper to implement the immediate pollution
control program.
7-28.

All measures indicate project acceptability.

NPV > 0
IRR >11%
PI > 1.00
The * indicates the preferred project using each measure.
a.
b.
c.

NPVSQ = $87,313.87 NPVHT = $142,254.07*

IRRSQ = 16.07%* IRRHT = 15.17%
PISQ = 1.13 PIHT = 1.15*

Year
1
2
3
4
5
d.

Asset A
$200,000
Discounted
CF
CF
$70,000
$62,500
$80,000
$63,776
$90,000
$64,060
$90,000
$57,197
$100,000
$56,743

Asset B
$180,000
Discounted
CF
CF
$80,000
$62,500
$90,000
$63,776
$30,000
$64,060
$40,000
$57,197
$40,000
$56,743

Timing issues result between the two projects because Project SQ receives a substantial
amount of inflows early in its life while the bulk of Project HTs cash flows do not
arrive until later in its life. The reinvestment rate assumption of the IRR method leads

108

Chapter 7
to a conflict between project choices for the IRR method vs the NPV method. A scaling
problem also exists in that SQ costs about 1.5 times that of HT.

7-29.

e.

The firm should choose Project HT. First, according to the NPV Profile, at the 11%
discount rate, HT has the higher NPV. Secondly, according to the MIRR calculation,
Project HT has the higher MIRR (MIRRSQ = 13.29%, MIRRHT = 13.64%).

a.

NPV of Repackage is $0.384 million. NPV of Reformulate is $0.107. Choose the

higher NPV, Repackage.

b.

IRR of Repackage is 21.04%. IRR of Reformulate is 13.20%. Choose the higher IRR,
Repackage.

c.

PI of Repackage is PV of inflows divided by PV of outflows: $3,384,390/$3,000,000 =

1.13. PI of Reformulate is $25,102,163/$25,000,000 = 1.004. Choose the higher PI,
Repackage.

d.

At an interest rate of approximately 12% Reformulate becomes less desirable than

Repackage. Also, it is clear from the Profile that Reformulate is far more sensitive to
the discount rate than Repackage. A timing problem exists in the sense that
Reformulate receives the bulk of its inflows early on. And, a scaling problem exists in
that Repackage costs more than eight times Reformulate.

Capital Budgeting Process and Techniques

109

e.

No, the rankings do not yield mixed signals. Repackage is better under all criteria.

f.

The IRR of the incremental project:

Year
0
1
2
3
4
5

Repackage

$3,000,000
2,000,000
1,250,000
500,000
250,000
250,000

Reformulate

$25,000,000
10,000,000
9,000,000
7,000,000
4,000,000
3.500,000

Repackage Reformulate
$22,000,000
8,000,000
7,750,000
6,500,000
3,750,000
3,250,000

The IRR of the incremental project is its compound annual costs of 12.38%. For a
project of this type resulting from the smaller size of repackage versus reformulate, if
the IRR is less than the discount rate, it is acceptable. Repackage is therefore the better
project because its incremental cost is less than the cost of capital.
7-30.

a., b., c.
Year
0
1
2
3
.
.
.
.

A
$2.5
1.6
1.6

B
$2.5
.35
.35
.35

A-B
0
1.25
1.25
.35

110

Chapter 7
50

.35

Project

NPV
$276,86
A
0
$970,18
B
5
Rankings:
B, A

.35
IRR

18.16%
13.98%
A, B

PI
$276,860/$2,500,000 = 1.11
$3,470,185/$2,500,000 =
1.39
B, A

The PI rankings agree with the rankings on NPV.

d.

IRR and NPV yield mixed signals because of differences in the size and magnitude of
their cash flows. Project A returns cash sooner than B, a pattern that generally has a
higher IRR than one, like B, that returns cash flows over a longer period of time.

e.

Lundblad should choose project A. The NPV of the incremental project is $693,326,
and its IRR is 13.1%. When a project has nonconventional cash flows (+ inflows
followed by -outflows) its IRR is its compound annual costs. If this cost is greater than
the hurdle rate, the project is unacceptable. In this case the cost of 13.1% is greater than
the 10% cost of capital and therefore, Project A is inferior to Project B.

f.

If the cost of capital is 13.5%, Project A has an NPV of $151,711 and an IRR of
18.16%. At a cost of capital of 16%, A has an NPV of $68,371. At a cost of capital of
13.5%, Project B has an NPV of $87,980 and at 16%, $313,809. Project A is better
than Project B at a discount rate of 13.5%. At 16%, Project A is the only acceptable
project. At a cost of capital of 20%, Project As NPV is $55,556 and Project Bs NPV
is $750,192; both projects should be rejected at this cost of capital.

7-31.

Thomson One Business School Edition

7-32.

Thomson One Business School Edition

Answers to mini-case
Payback period:
Poofy Puffs:
Initial outlay: $24,890,000
Amount recovered in year 1: $12,950,000
Amount remaining that needs to be recovered: $24,890,000 - $12,950,000 = 11,940,000
Amount recovered in year 2: $10,923,000
Amount remaining after year 2 that needs to be recovered: $11,940,000 - $10,923,000 = -1,017,000
More than this amount is recovered in year 3, so we must calculate the fraction of year 3 it takes to
recover the remaining $1,017,000. It takes 0.1236 ($1,017,000 $8,231,000) of a year to recover the
remainder, or 1.5 months. Thus, the total payback for Poofy Puffs is 2 years and 1.5 months.
Filling Fiber:

Capital Budgeting Process and Techniques

111

Initial outlay: $13,500,000

Amount recovered in year 1: $7,230,000
Amount remaining that needs to be recovered after year 1: $13,500,000 - $7,230,000 = 6,270,000
More than this amount is recovered in year 2, so we must calculate the fraction of year 2 it takes to
recover the remaining $6,270,000. It takes 0.77 (6,270,000 8,100,000) of a year to recover the
remainder, or 9.29 months. Thus, the total payback for Filling Fiber is 1 year and 9.24 months.
Discounted Payback Period

Year
0
1
2
3
4

Poofy Puffs
$(24,890,000)
$12,950,000
$10,923,000
$8,231,000
$7,242,000

Filling Fiber
$(13,500,000)
$7,230,000
$8,100,000
$8,629,000
$5,238,900

Discounted
Poofy Puffs
Filling Fiber
$(24,890,000)
$11,772,727
$9,027,273
$6,184,072
$4,946,383

$(13,500,000)
$6,572,727
$6,694,215
$6,483,095
$3,578,239

Poofy Puffs:
Initial outlay: $24,890,000
Amount recovered in year 1 in discounted dollars: $11,772,727
Amount remaining after year 1 that needs to be recovered: $24,890,000 - $11,772,727 = $13,117,273
Amount recovered in year 2 in discounted dollars: $9,027,273
Amount remaining after year 2 that needs to be recovered: $13,117,273 - $9,027,273 = $4,090,000
More than this amount is recovered in year 3, so we must calculate the fraction of year 3 it takes to
recover the remaining $4,090,000. It takes 0.66 (4,090,000 6,184,072) of a year to recover the
remainder, or 7.94 months. Thus, the total discounted payback for Poofy Puffs is 2 years and 8 months.
Filling Fiber:
Initial outlay: $13,500,000
Amount recovered in year 1 in discounted dollars: $6,572,727
Amount remaining that needs to be recovered: $13,500,000 - $6,572,727 = $6,927,273
Amount recovered in year 2 in discounted dollars: $6,694,215
Amount remaining after year 2 that needs to be recovered: $6,927,273 - $6,694,215 = $233,058
More than this amount is recovered in year 3, so we must calculate the fraction of year 3 it takes to
recover the remaining $233,058. It takes 0.04 ($233,058 6,483,095) of a year to recover the
remainder, or .4 months. Thus, the total discounted payback for Filling Fiber is 2 years and 0.4 months.
Accounting Rate of Return:
Poofy Puffs:
The average book value of Poofy Puffs is $24,890,000 2, or $12,445,000. The average net income for
the project ($6,727,500 + $4,700,500 + $2,008,500 + $7,242,000) 4 = $5,169,625. Next, divide the
average net income by the average book value of the project, or ($5,169,625 $12,445,000) = 0.4154 or
41.54%.
Filling Fiber:

112

Chapter 7

The average book value is $13,500,000 2 = $6,750,000 while the average net income is $3,924,475, or
($3,855,000 + $4,725,000 + $5,254,000 + $1,863,900) 4 = $3,924,475. The projects accounting rate
of return is 58.14%, or $3,924,475 $6,750,000.
Net Present Value:
Year
0
1
2
3
4

Poofy Puffs
-24,890,000
12,950,000
10,923,000
8,231,000
7,242,000

Filling Fiber
-13,500,000
7,230,000
8,100,000
8,629,000
5,238,900
Sum =

Discounted
Poofy Puffs
Filling Fiber
$11,772,727
$9,027,273
$6,184,072
$4,946,383
$31,930,456

$6,572,727
$6,694,215
$6,483,095
$3,578,239
$23,328,277

Poofy Puffs: NPV = PVinflows PVoutflows = $31,930,456 $24,890,000 = $7,040,456.

Filling Fiber: NPV = $23,328,277 $13,500,000 = $9,828,277.
Internal Rate of Return:

Poofy Puffs : $0 - $24,890,000

$12,950,000 $10,923,000 $8,231,000 $7,242,000

1
2
3
4

1 r

1 r

1 r

1 r

r = 24.09%

Filling Fiber : $0 - $13,500,000

$7,230,000 $8,100,000 $8,629,000 $5,238,900

1
2
3
4

1 r

1 r

1 r

1 r

r = 41.54%
Profitability Index:
PI = PVinflows PVoutflows
PIPoofy Puffs = $31,930,456 $24,890,000 = 1.28
PIFilling Fiber = $23,328,277 $13,500,000 = 1.73
Analysis: The minimum required payback period is 1.75 years, therefore both projects would be
rejected using the payback and discounted payback period. From an accounting rate of return (AAR)
perspective, both projects would be acceptable as they have ARRs above the required 15%. Based on
the NPV method, both projects would be acceptable as the net present values are positive. Both projects
are acceptable using the IRR method as well, as the IRRs are greater than 10%. Also, the profitability
index (PI) is greater than 1.0 for both projects, thus both are acceptable using that criterion. Of course,
since both of these projects are independent and normal, one would not expect the NPV, IRR or PI
methods to conflict.
Technically, there is not a scaling issue with these two projects as the NPV method and the IRR method
rank Filling Fiber as the better project. Since the projects are independent, the firm should proceed with
both of them.

Capital Budgeting Process and Techniques

113