FIN 322 Week 2 Tutorial Questions and Answers

Chapter 5:
CQ: 4 Payback and Internal Rate of Return A project has perpetual cash flows of C per
period, a cost of I, and a required return of R. What is the relationship between the
project’s payback and its IRR? What implications does your answer have for long-lived
projects with relatively constant cash flows?
Ans:For a project with future cash flows that are an annuity:

Payback = I / C

And the IRR is:

0 = – I + C / IRR

Solving the IRR equation for IRR, we get:

IRR = C / I

Notice this is just the reciprocal of the payback. So:

IRR = 1 / PB

For long-lived projects with relatively constant cash flows, the sooner the project pays back, the
greater is the IRR, and the IRR is approximately equal to the reciprocal of the
payback period.

CQ8. Net Present Value The investment in Project A is $1 million, and the investment in
Project B is $2 million. Both projects have a unique internal rate of return of
20 percent. Is the following statement true or false? For any discount rate from 0
percent to 20 percent, Project B has an NPV twice as great as that of Project A.
Explain your answer.

Ans: The statement is false. If the cash flows of Project B occur early and the cash flows of Project
A occur late, then for a low discount rate the NPV of A can exceed the NPV of B. Observe the
following example.

C0 C1 C2 IRR NPV @ 0%
Project A –$1,000,000 $0 $1,440,000 20% $440,000
Project B –$2,000,000 $2,400,000 $0 20% 400,000

However, in one particular case, the statement is true for equally risky projects. If the lives of the
two projects are equal and the cash flows of Project B are twice the cash flows of Project A in
every time period, the NPV of Project B will be twice the NPV of Project A.

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FIN 322 Week 2 Tutorial Questions and Answers

QP: 3 Calculating Discounted Payback An investment project has annual cash inflows of
$5,000, $5,500, $6,000, and $7,000, and a discount rate of 12 percent. What is the
discounted payback period for these cash flows if the initial cost is $8,000? What if the
initial cost is $12,000? What if it is $16,000?

Ans:When we use discounted payback, we need to find the value of all cash flows today. The value
today of the project cash flows for the first four years is:

Value today of Year 1 cash flow = $5,000 / 1.12 = $4,464.29

Value today of Year 2 cash flow = $5,500 / 1.122 = $4,384.57
Value today of Year 3 cash flow = $6,000 / 1.123 = $4,270.68
Value today of Year 4 cash flow = $7,000 / 1.124 = $4,448.63

To find the discounted payback, we use these values to find the payback period. The discounted
first year cash flow is $4,464.29, so the discounted payback for an initial cost of $8,000 is:

Discounted payback = 1 + ($8,000 – 4,464.29) / $4,384.57 = 1.81 years

For an initial cost of $12,000, the discounted payback is:

Discounted payback = 2 + ($12,000 – 4,464.29 – 4,384.57) / $4,270.68 = 2.74 years

Notice the calculation of discounted payback. We know the payback period is between two and
three years, so we subtract the discounted values of the Year 1 and Year 2 cash flows from the
initial cost. This is the numerator, which is the discounted amount we still need to make to
recover our initial investment. We divide this amount by the discounted amount we will earn in
Year 3 to get the fractional portion of the discounted payback.

If the initial cost is $16,000, the discounted payback is:

Discounted payback = 3 + ($16,000 – 4,464.29 – 4,384.57 – 4,270.68) / $4,448.63 = 3.65 years

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FIN 322 Week 2 Tutorial Questions and Answers

QP 11

Ans: a.The IRR is the interest rate that makes the NPV of the project equal to zero. So, the IRR
for each project is:

Deepwater Fishing IRR:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$850,000 + $320,000 / (1 + IRR) + $470,000 / (1 + IRR)2 + $410,000 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation,
we find that:

IRR = 18.58%

Submarine Ride IRR:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$1,650,000 + $810,000 / (1 + IRR) + $750,000 / (1 + IRR)2 + $690,000 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation,
we find that:

IRR = 17.81% Based on the IRR rule, the deepwater fishing project should be chosen because it
has the higher IRR.

b. To calculate the incremental IRR, we subtract the smaller project’s cash flows from the
larger project’s cash flows. In this case, we subtract the deepwater fishing cash flows from
the submarine ride cash flows. The incremental IRR is the IRR of these incremental cash
flows. So, the incremental cash flows of the submarine ride are:

Year 0 Year 1 Year 2 Year 3

Submarine Ride –$1,650,000 $810,000 $750,000 $690,000
Deepwater Fishing –850,000 320,000 470,000 410,000

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FIN 322 Week 2 Tutorial Questions and Answers

Submarine – Fishing –$800,000 $490,000 $280,000 $280,000

Setting the present value of these incremental cash flows equal to zero, we find the
incremental IRR is:

0 = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + C3 / (1 + IRR)3

0 = –$800,000 + $490,000 / (1 + IRR) + $280,000 / (1 + IRR)2 + $280,000 / (1 + IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation,
we find that:

Incremental IRR = 16.84%

For investing-type projects, accept the larger project when the incremental IRR is greater
than the discount rate. Since the incremental IRR, 16.84 percent, is greater than the required
rate of return of 14 percent, choose the submarine ride project. Note that this is not the
choice when evaluating only the IRR of each project. The IRR decision rule is flawed
because there is a scale problem. That is, the submarine ride has a greater initial investment
than does the deepwater fishing project. This problem is corrected by calculating the IRR of
the incremental cash flows, or by evaluating the NPV of each project.

c. The NPV is the sum of the present value of the cash flows from the project, so the NPV of
each project will be:

Deepwater Fishing:

NPV = –$850,000 + $320,000 / 1.14 + $470,000 / 1.142 + $410,000 / 1.143

NPV = $69,089.81

Submarine Ride:

NPV = –$1,650,000 + $810,000 / 1.14 + $750,000 / 1.142 + $690,000 / 1.143

NPV = $103,357.31

Since the NPV of the submarine ride project is greater than the NPV of the deepwater
fishing project, choose the submarine ride project. The incremental IRR rule is always
consistent with the NPV rule.

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FIN 322 Week 2 Tutorial Questions and Answers

QP.20. NPV and Multiple IRRs You are evaluating a project that costs $75,000 today. The
project has an inflow of $155,000 in one year and an outflow of $65,000 in two years.
What are the IRRs for the project? What discount rate results in the maximum NPV for
this project? How can you determine that this is the maximum NPV? (the highlighted part
is NOT required)
Ans : The equation for the IRR of the project is:
0 = –$75,000 + $155,000 / (1 + IRR) – $65,000 / (1 + IRR)2

From Descartes’ Rule of Signs, we know there are either zero IRRs or two IRRs since the cash
flows change signs twice. We can rewrite this equation as:

0 = –$75,000 + $155,000X – $65,000X2

where X = 1 / (1 + IRR)

(the highlighted part of the solution is NOT required)

This is a quadratic equation. We can solve for the roots of this equation with the quadratic
formula:

 b  b 2  4ac
X=
2a

Remember that the quadratic formula is written as:

0 = aX2 + bX + c

In this case, the equation is:

0 = –$65,000X2 + $155,000X – $75,000

 155,000  (155,000) 2  4(75,000 )(65,000 )

X=
2(65,000 )

 155,000  4,525,000, 000

X=
2(65,000)

 155,000  67,268 .12

X=
 130,000

Solving the quadratic equation, we find two Xs:

X = .6749, 1.7098

Since:

X = 1 / (1 + IRR)
1.7098 = 1 / (1 + IRR)
IRR = –.4151, or – 41.51%

And:

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FIN 322 Week 2 Tutorial Questions and Answers

X = 1 / (1 + IRR)
.6749 = 1 / (1 + IRR)
IRR = .4818, or 48.18%

To find the maximum (or minimum) of a function, we find the derivative and set it equal to zero.
The derivative of this IRR function is:

0 = –$155,000(1 + IRR)–2 + $130,000(1 + IRR)–3

–$155,000(1 + IRR)–2 = $130,000(1 + IRR)–3
–$155,000(1 + IRR)3 = $130,000(1 + IRR)2
–$155,000(1 + IRR) = $130,000
IRR = $130,000 / $155,000 – 1
IRR = – .1613, or –16.13%

To determine if this is a maximum or minimum, we can find the second derivative of the IRR
function. If the second derivative is positive, we have found a minimum and if the second derivative is
negative we have found a maximum. Using the reduced equation above, that is:

–$155,000(1 + IRR) = $130,000

The second derivative is –$262,722.18, therefore we have a maximum.

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FIN 322 Week 2 Tutorial Questions and Answers

Chapter 6:
2. Incremental Cash Flows Which of the following should be treated as an incremental
cash flow when computing the NPV of an investment?
a. A reduction in the sales of a company’s other products caused by the investment.
Ans: Yes, the reduction in the sales of the company’s other products, referred to as erosion, should be
treated as an incremental cash flow. These lost sales are included because they are a cost (a revenue
reduction) that the firm must bear if it chooses to produce the new product.

b. An expenditure on plant and equipment that has not yet been made and will be made
only if the project is accepted.
Ans: Yes, expenditures on plant and equipment should be treated as incremental cash flows.
These are costs of the new product line. However, if these expenditures have already
occurred (and cannot be recaptured through a sale of the plant and equipment), they are
sunk costs and are not included as incremental cash flows.

C.Costs of research and development undertaken in connection with the product during
the past three years
No, the research and development costs should not be treated as incremental cash flows.
The costs of research and development undertaken on the product during the past three
years are sunk costs and should not be included in the evaluation of the project. Decisions
made and costs incurred in the past cannot be changed. They should not affect the decision
to accept or reject the project.

d. Annual depreciation expense from the investment.

Ans: Yes, the annual depreciation expense must be taken into account when calculating the cash
flows related to a given project. While depreciation is not a cash expense that directly affects cash
flow, it decreases a firm’s net income and hence lowers its tax bill for the year. Because of this
depreciation tax shield, the firm has more cash on hand at the end of the year than it would have had
without expensing depreciation.

e. Dividend payments by the firm.

Ans: No, dividend payments should not be treated as incremental cash flows. A firm’s decision
to pay or not pay dividends is independent of the decision to accept or reject any given
investment project. For this reason, dividends are not an incremental cash flow to a given
project. Dividend policy is discussed in more detail in later chapters.

f. The resale value of plant and equipment at the end of the project’s life.
Ans: Yes, the resale value of plant and equipment at the end of a project’s life should be treated
as an incremental cash flow. The price at which the firm sells the equipment is a cash
inflow, and any difference between the book value of the equipment and its sale price will
create accounting gains or losses that result in either a tax credit or liability.

g. Salary and medical costs for production personnel who will be employed only if the
project is accepted.
Ans: Yes, salary and medical costs for production employees hired for a project should be treated
as incremental cash flows. The salaries of all personnel connected to the project must be
included as costs of that project.

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FIN 322 Week 2 Tutorial Questions and Answers

QP: 1. Calculating Project NPV Flatte Restaurant is considering the purchase of a $7,500
soufflé maker. The soufflé maker has an economic life of five years and will be fully
depreciated by the straight-line method. The machine will produce 1,300 soufflés per year,
with each costing $2.15 to make and priced at $5.25. Assume that the discount rate is 14
percent and the tax rate is 34 percent. Should the company make the purchase?
Ans:

Using the tax shield approach to calculating OCF, we get:

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF = [($5.25 × 1,300) – ($2.15 × 1,300)](1 – .34) + .34($7,500 / 5)
OCF = $3,169.80

So, the NPV of the project is:

NPV = –$7,500 + $3,169.80(PVIFA14%,5)

NPV = $3,382.18

QP 3. Calculating Project NPV Down Under Boomerang, Inc., is considering a new three
year expansion project that requires an initial fixed asset investment of $1.65 million. The
fixed asset will be depreciated straight-line to zero over its three-year tax life, after which
it will be worthless. The project is estimated to generate $1.24 million in annual sales,
with costs of $485,000. The tax rate is 35 percent and the required return is 12 percent.
What is the project’s NPV?
Ans: Using the tax shield approach to calculating OCF, we get:

OCF = (Sales – Costs)(1 – tC) + tCDepreciation

OCF = ($1,240,000 – 485,000)(1 – .35) + .35($1,650,000 / 3)
OCF = $683,250

So, the NPV of the project is:

NPV = –$1,650,000 + $683,250(PVIFA12%,3)

NPV = –$8,948.79

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FIN 322 Week 2 Tutorial Questions and Answers

QP 10: Calculating EAC You are evaluating two different silicon wafer milling machines.
The Techron I costs $245,000, has a three-year life, and has pretax operating costs of
$39,000 per year. The Techron II costs $315,000, has a five-year life, and has pretax
operating costs of $48,000 per year. For both milling machines, use straight-line
depreciation to zero over the project’s life and assume a salvage value of $20,000. If your
tax rate is 35 percent and your discount rate is 9 percent, compute the EAC for both
machines. Which do you prefer? Why?
Ans: We will need the aftertax salvage value of the equipment to compute the EAC. Even
though the equipment for each product has a different initial cost, both have the same salvage
value. The aftertax salvage value for both is:
Both cases: aftertax salvage value = $20,000(1 – .35) = $13,000
To calculate the EAC, we first need the OCF and NPV of each option. The OCF and NPV for
Techron I is:

OCF = –$39,000(1 – .35) + .35($245,000 / 3)

OCF = $3,233.33

NPV = –$245,000 + $3,233.33(PVIFA9%,3) + ($13,000 / 1.093)

NPV = –$226,777.10

EAC = –$226,777.10 / (PVIFA12%,3)

EAC = –$89,589.37

And the OCF and NPV for Techron II is:

OCF = – $48,000(1 – .35) + .35($315,000 / 5)

OCF = –$9,150

NPV = –$315,000 – $9,150(PVIFA9%,5) + ($13,000 / 1.095)

NPV = –$342,141.20

EAC = –$342,141.20 / (PVIFA9%,5)

EAC = –$87,961.62

The two milling machines have unequal lives, so they can only be compared by expressing both
on an equivalent annual basis, which is what the EAC method does. Thus, you prefer the
Techron II because it has the lower (less negative) annual cost.

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FIN 322 Week 2 Tutorial Questions and Answers

Chapter 7:
QP: 1,
1. Sensitivity Analysis and Break-Even Point We are evaluating a project that costs
$588,000, has an eight-year life, and has no salvage value. Assume that depreciation is
straight-line to zero over the life of the project. Sales are projected at 70,000 units per
year. Price per unit is $36, variable cost per unit is $20, and fixed costs are $695,000 per
year. The tax rate is 35 percent, and we require a return of 15 percent on this project.
Ans: a.To calculate the accounting breakeven, we first need to find the depreciation for each
year. The depreciation is:

Depreciation = $588,000 / 8
Depreciation = $73,500 per year

And the accounting breakeven is:

QA = ($695,000 + 73,500) / ($36 – 20)

QA = 48,031 units

b. We will use the tax shield approach to calculate the OCF. The OCF is:

OCFbase = [(P – v)Q – FC](1 – tc) + tcD

OCFbase = [($36 – 20)(70,000) – $695,000](.65) + .35($73,500)
OCFbase = $301,975

Now we can calculate the NPV using our base-case projections. There is no salvage value
or NWC, so the NPV is:

NPVbase = –$588,000 + $301,975(PVIFA15%,8)

NPVbase = $767,058.91

To calculate the sensitivity of the NPV to changes in the quantity sold, we will calculate the
NPV at a different quantity. We will use sales of 71,000 units. The OCF at this sales level
is:

OCFnew = [($36 – 20)(71,000) – $695,000](.65) + .35($73,500)

OCFnew = $312,375

And the NPV is:

NPVnew = –$588,000 + $312,375(PVIFA15%,8)

NPVnew = $813,727.06

So, the change in NPV for every unit change in sales is:

NPV/S = ($767,058.91 – 813,727.06) / (70,000 – 71,000)

NPV/S = +$46.668

If sales were to drop by 500 units, then NPV would drop by:

NPV drop = $46.668(500) = $23,334.07

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You may wonder why we chose 71,000 units. Because it doesn’t matter! Whatever sales
number we use, when we calculate the change in NPV per unit sold, the ratio will be the
same.

c. To find out how sensitive OCF is to a change in variable costs, we will compute the OCF at
a variable cost of $21. Again, the number we choose to use here is irrelevant: We will get
the same ratio of OCF to a one dollar change in variable cost no matter what variable cost
we use. So, using the tax shield approach, the OCF at a variable cost of $21 is:

OCFnew = [($36 – 21)(70,000) – 695,000](.65) + .35($73,500)

OCFnew = $256,475

So, the change in OCF for a $1 change in variable costs is:

OCF/v = ($301,975 – 256,475) / ($20 – 21)

OCF/v = –$45,500

If variable costs decrease by $1 then OCF would increase by $45,500

QP4. Financial Break-Even L.J.’s Toys, Inc., just purchased a $375,000 machine to produce
toy cars. The machine will be fully depreciated by the straight-line method over its five-
year economic life. Each toy sells for $21. The variable cost per toy is $8, and the firm
incurs fixed costs of $280,000 each year. The corporate tax rate for the company is 34
percent. The appropriate discount rate is 12 percent. What is the financial break-even
point for the project?
4. When calculating the financial breakeven point, we express the initial investment as an
equivalent annual cost (EAC). Dividing the initial investment by the five-year annuity factor,
discounted at 12 percent, the EAC of the initial investment is:

EAC = Initial Investment / PVIFA12%,5

EAC = $375,000 / 3.60478
EAC = $104,028.65

Note that this calculation solves for the annuity payment with the initial investment as the
present value of the annuity. In other words:

PVA = C({1 – [1/(1 + R)]t } / R)

$375,000 = C{[1 – (1/1.12)5 ] / .12}
C = $104,028.65

The annual depreciation is the cost of the equipment divided by the economic life, or:

Annual depreciation = $375,000 / 5

Annual depreciation = $75,000

Now we can calculate the financial breakeven point. The financial breakeven point for this
project is:

QF = [EAC + FC(1 – tC) – D(tC)] / [(P – VC)(1 – tC)]

QF = [$104,028.65 + $280,000(1 – .34) – $75,000(.34)] / [($21 – 8)(1 – .34)]
QF = 30,690.98, or about 30,691 units

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To calculate financial break-even, NPV= - Initial investment +OCF*PVIFA=0

or Initial investment=OCF*PVIFA
divide both sides by PVIFA, we get EAC=OCF
EAC=[(P-VC)*Q-FC-D]*(1-t)+D

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