Chapter 05 - Net Present Value and Other Investment Criteria

CHAPTER 5

1. Payback*
a. What is the payback period on each of the following projects?

b. Given that you wish to use the payback rule with a cutoff period of two years,
which projects would you accept?
c. If you use a cutoff period of three years, which projects would you accept?
d. If the opportunity cost of capital is 10%, which projects have positive NPVs?
e. “If a firm uses a single cutoff period for all projects, it is likely to accept too many
short-lived projects.” True or false?
f. If the firm uses the discounted-payback rule, will it accept any negative-NPV
projects? Will it turn down any positive-NPV projects?

1. a. A = 3 years; B = 2 years; C = 3 years

b. B

c. A, B, and C

d. B and C (At 10%, NPVA = –$1,011; NPVB = $3,378; NPVC = $2,405)

e. True. The payback rule ignores all cash flows after the cutoff date, meaning that future
years’ cash inflows are not considered. Thus, payback is biased towards short-term
projects.

f. It will accept no negative-NPV projects, but will turn down some with
positive NPVs. A project can have a positive NPV if all future cash flows
are considered but still not meet the stated cutoff period.

4. IRR. Write down the equation defining a project’s internal rate of return (IRR). In practice how is IRR
calculated?

4. Given the cash flows C0, C1, . . . , CT, IRR is defined by:

NPV = C0 + C1 / (1 + IRR) + C2 / (1 + IRR)2 + … + CT / (1 + IRR)T = 0

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Chapter 05 - Net Present Value and Other Investment Criteria

IRR is calculated by trial and error, by financial calculators, or by spreadsheet

programs.

11. IRR rule. Mr. Cyrus Clops, the president of Giant Enterprises, has to make a choice between two
possible investments:

’
The opportunity cost of capital is 9%. Mr. Clops is tempted to take B, which has the higher IRR.
a. Explain to Mr. Clops why this is not the correct procedure.
b. Show him how to adapt the IRR rule to choose the best project.
c. Show him that this project also has the higher NPV.

11. a. Because Project A requires a larger capital outlay, it is possible that Project A has both a
lower IRR and a higher NPV than Project B. (In fact, NPVA is greater than NPVB for all
discount rates less than 10%.) Because the goal is to maximize shareholder wealth,
NPV is the correct criterion.

b. To use the IRR criterion for mutually exclusive projects, calculate the IRR for the
incremental cash flows:
C0 C1 C2 IRR
A-B −200 +110 +121 10%

Because the IRR for the incremental cash flows exceeds the cost of capital, the
additional investment in A is worthwhile.

c. NPVA = –$400 + $250 / 1.09 + $300 / 1.092

NPVA = $81.86

NPVB = –$200 + $140 / 1.09 + $179 / 1.092

NPVB = $79.10

16. Capital rationing*. Suppose you have the following investment opportunities, but only $90,000
available for investment. Which projects should you take?

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Chapter 05 - Net Present Value and Other Investment Criteria

16. 1, 2, 4, and 6

The profitability index for each project is shown below:

Profitability Index (NPV

Project NPV Investment /Investment)

1 5,000 10,000 5,000 / 10,000 = .5

2 5,000 5,000 5,000 / 5,000 = 1

3 10,000 90,000 10,000 / 90,000 = .11

4 15,000 60,000 15,000 / 60,000 = .25

5 15,000 75,000 15,000 / 75,000 = .2

6 3,000 15,000 3,000 / 15,000 = .2

Start with the project with the highest profitability index and go from there. Project 2 has the
highest profitability index and has an initial investment of $5,000. The next highest profitability
index is for Project 1, which has an initial investment of $10,000. The next highest is Project 4,
which will cost $60,000 up front. So far we have spent $75,000. Projects 5 and 6 both have
profitability indexes of .2, but we only have $15,000 left to spend, so we will add Project 6 to our
list. This gives us Projects 1, 2, 4, and 6.
Just Just

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McGraw-Hill Education.