FIN320

Chapter 8

Spring 2016

Chapter 8 questions
1) Answer the following questions based on two projects with the following cash
flows:

a. If the opportunity cost is 11%, which of these project(s) is worth

pursuing?
b. Suppose that these projects are mutually exclusive and the discount
rate is still 11%, which project(s) would you choose?
c. Which project(s) would you choose if the opportunity cost of capital
were 16%?
d. What is the IRR of each project?
e. What is the payback period of each project?
2) Consider projects A and B:

Calculate the IRRs for A and B. Which project does the IRR rule suggest is
best? Which project is really best?
3) What is the profitability index of a project that costs $ 10,000 and provides
cash flows of $ 3,000 in years 1 and 2 and $ 5,000 in years 3 and 4? The
discount rate is 9%.
4) You are a manager with an investment budget of $ 8 million. You may invest
in the following projects. Investment and cash- flow figures are in millions of
dollars.

a. Why might these projects have different discount rates?

b. Which projects should the manager choose?

FIN320

Chapter 8

Spring 2016

c. Which projects will be chosen if there is no capital rationing?

5) A precision lathe costs $ 10,000 and will cost $ 20,000 a year to operate and
maintain. If the discount rate is 10% and the lathe will last for 5 years, what
is the equivalent annual cost of the tool?

FIN320

Chapter 8

Spring 2016

Solutions
1) Answer the following questions based on two projects with the following cash
flows:

a. If the opportunity cost is 11%, which of these project(s) is worth

pursuing?
NPVA = $200 + [$80 annuity factor (11%, 4 periods)]

1
1

$48.20
4
0.11 0.11 (1.11)

$200 $80
=

NPVB = $200 + [$100 annuity factor (11%, 3 periods)]

1
1

$44.37
3
0.11 0.11 (1.11)

$200 $100
=

Both projects are worth pursuing.

b. Suppose that these projects are mutually exclusive and the discount
rate is still 11%, which project(s) would you choose?
Choose Project A, the project with the higher NPV.
c. Which project(s) would you choose if the opportunity cost of capital
were 16%?
NPVA = $200 + [$80 annuity factor (16%, 4 periods)]

1
1

$23.85
4
0.16 0.16 (1.16)

$200 $80
=

NPVB = $200 + [$100 annuity factor (16%, 3 periods)]

FIN320

Chapter 8

Spring 2016

1
1

$24.59
3
0.16 0.16 (1.16)

$200 $100
=

Therefore, you should now choose Project B.

d. What is the IRR of each project?
RRA = discount rate (r), which is the solution to the following equation:

$200
4
r r (1 r )

$80

r = IRRA = 21.86%

IRRB = discount rate (r), which is the solution to the following equation:

$200
3
r r (1 r )

$100

r = IRRB = 23.38%

e. What is the payback period of each project?

Project A has a payback period of $200/$80 = 2.5 years.
Project B has a payback period of 2 years.
2) Consider projects A and B:

Calculate the IRRs for A and B. Which project does the IRR rule suggest is
best? Which project is really best?
IRRA = discount rate (r), which is the solution to the following equation:

$30,000
2
r r (1 r )

$21,000

r = IRRA = 25.69%

IRRB = discount rate (r), which is the solution to the following equation:

FIN320

Chapter 8

$50,000
2
r r (1 r )

Spring 2016

$33,000

r = IRRB = 20.69%

TheIRRofprojectAis25.69%,andthatofBis20.69%.However,projectBhas
thehigherNPVandthereforeispreferred.TheincrementalcashflowsofBoverA
are$20,000attime0and+$12,000attimes1and2.TheNPVoftheincremental
cashflows(discountedat10%)is$826.45,whichispositiveandequaltothe
differenceintherespectiveprojectNPVs.
3) What is the profitability index of a project that costs $ 10,000 and provides
cash flows of $ 3,000 in years 1 and 2 and $ 5,000 in years 3 and 4? The
discount rate is 9%.

NPV $10,000

$3,000 $3,000 $5,000 $5,000

$2,680.38
1.09
1.09 2
1.09 3
1.09 4

Profitability index = NPV/investment = 0.2680

4) You are a manager with an investment budget of $ 8 million. You may invest
in the following projects. Investment and cash- flow figures are in millions of
dollars.

a. Why might these projects have different discount rates?

The less risky projects should have lower discount rates.
b. Which projects should the manager choose?
First, find the profitability index of each project.
Project
A
B
C
D

PV of
Cash flow
$3.79
$4.97
$6.62
$3.87

Investme
nt
$3
$4
$5
$3

NPV
$0.79
$0.97
$1.62
$0.87

Profitabili
ty Index
0.26
0.24
0.32
0.29

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Chapter 8
E

$4.11

$3

Spring 2016
$1.11

0.37

Then select projects with the highest profitability index until the $8 million budget is
exhausted. Therefore, choose Projects E and C.
c. Which projects will be chosen if there is no capital rationing?
All the projects have positive NPV, so all will be chosen if there is no
capital rationing

FIN320

Chapter 8

Spring 2016

5) A precision lathe costs $ 10,000 and will cost $ 20,000 a year to operate and
maintain. If the discount rate is 10% and the lathe will last for 5 years, what
is the equivalent annual cost of the tool?
PV of costs = $10,000 + [$20,000 annuity factor (10%, 5 years)]

1
1

$85,815.74
5
0.10 0.10 (1.10)

$20,000
= $10,000 +

The equivalent annual cost is the payment with the same present value. Solve
the following equation for C:

1
1

$85,815.74 C EAC $22,637.98

5
0.10 0.10 (1.10)

Using a financial calculator, enter n = 5; i = 10; FV = 0; PV = ()85,815.74;

compute PMT.